On Tuesday afternoon, Whole Foods (NASDAQ:WFM) reported quarterly results that left Wall Street unimpressed, sending shares down over 10%. This quarter was important for Whole Foods as its last quarter was disappointing, and this was an opportunity to right the ship. There has been increasing concern that the organic market is slowing down. At the same time, competition has grown tremendously over the past three years with Sprouts (NASDAQ:SFM), The Fresh Market (NASDAQ:TFM) and Fairway Market (NASDAQ:FWM) opening locations. Legacy grocers like Safeway (NYSE:SWY) and Kroger (NYSE:KR) have expanded into organic food as well. It seems that this market is closer to saturation than previously thought, and Whole Foods may not have the growth potential investors long expected. Given this backdrop, it isn't surprising investors are getting out of the stock.
In the company's second fiscal quarter, it earned $0.38 on sales of $3.32 billion (all financial and operating data available here). Both numbers missed as analysts were looking for $0.41 on sales of $3.34 billion. Total sales were up 10%, but much of this increase was driven by an expanding store count. Same-store sales were up 4.5%, which is a significant deceleration from last year's 6.9% pace. The company did blame a late Easter for 0.5%. Ex-Easter, same-store sales would have jumped 5%, which is still an appreciable deceleration. The company did generate a solid $282 million in operating cash flow and $139 million in free cash flow. Total cash stands at $1.5 billion. Management continues to believe the company can increase sales by nearly 85% over five years to $25. I'm hesitant that this goal can be reached.
While the company maintained a positive long-term outlook, it cut its fiscal 2014 guidance. Sales growth will now be 10.5-11%, down from 11-12%. Same store sales will be up 5-5.5%, down from 5.5-6.2%. This lowered sales growth comes despite an increase in the anticipated number of store openings to 36-39 from 33-38. Operating margin is also lower at 6.5-6.6% from 6.7-7%. EPS should be $1.52-$1.56 from $1.58-$1.65. This means EPS growth will be a paltry 3-6%, which barely qualifies Whole Foods as a growth company. Over the next five years, gross margins are forecasted to decline by 1%.
This guidance is troubling. On most metrics, the new high-end is below the prior quarter's low end. This suggests business has underperformed appreciably. We are seeing a sequential decline in same-store sales growth, which indicates the market is nearing saturation, though we are not quite there yet. This slowdown is pronounced among Whole Food's older stores. Now, older stores do typically grow slower than new ones, but comps were a meager 2.6% for stores over 15 years old. For stores 8-11 years old, comps were 1.7%. New stores are providing a disproportionate amount of the same-store sales growth. The weaker performance of old stores is also suggestive of a market whose best growth days are in the rear-view mirror.
It is also important to note that margins are falling alongside the sales deceleration. Gross margins are down 0.5% year over year, and operating income margins were also down 0.5% year over year. Whereas Whole Foods used to be the only organic grocer, competitors like Sprouts and the Fresh Market are moving into its territory, which is putting pressure on prices. Lower margins and decelerating sales further prove that Whole Foods is facing more competition in a saturating market, which is the opposite of what an investor hopes for.
The fact that 11% sales growth will only power 3-6% EPS growth shows the severity of the margin compression. It is also worth noting that if Easter posed a mere timing issue for comps, guidance would not have been cut so seriously. Easter certainly posed some problems, but there is also a deceleration in Whole Foods' business. New stores are showing strong comps, though a return on invested capital of 16% is not as strong as it used to be. While Whole Foods is able to expand into some untapped markets, its existing business is facing substantial pressure as shown by lower comps and margins.
From 2014-2018, Whole Foods plans on expanding its store count by about 58%. New stores generate less revenue than existing ones because it takes some time to build a customer base. To meet its long-term forecast, Whole Foods will actually need to reaccelerate same-store sales growth to the 6% area. If Whole Foods executes like it anticipates, it could earn $2.65 in 2018. However, these goals seems lofty. There is currently no evidence to suggest we can expect same store sales to accelerate for several years. Aging stores are not performing particularly well, and competition will only grow more fierce. While Whole Foods definitely can expand its store count, investors may have to get used to slower same store sales growth and lower margins.
This quarter was very disappointing for Whole Foods. It missed on most numbers, and it was forced to significantly cut guidance for the balance of the year. Lower margins and slower sales indicate that competition and a saturating market are starting to weigh on results. Put simply, Whole Foods' growth runway is shorter than I previously hoped. At this time, I do not see a catalyst for growth to reaccelerate and think the long-term guidance is probably too optimistic. Whole Foods should earn about $1.54 this year. The company is a strong operator, and there is the potential to grow the store count. I would be willing to pay 25x earnings or around $38 per share. With signs of a growth slowdown, I would be hesitant to pay any more than 25x numbers and would be a seller at current levels. Investors should watch margins and same-store sales growth very carefully in case growth decelerates even faster.