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Summary

  • Whole Foods' recent earnings miss and guidance adjustment led to a 20%+ correction in the stock.
  • Aside from the one-off quarterly miss Whole Foods has several external factors contributing to its price adjustment.
  • As Whole Foods works to aggressively expand its footprint it will become increasingly difficult for the firm be able to maintain its margins and growth.

Last week Whole Foods (NASDAQ:WFM) reported a second-quarter earnings miss. The firm posted $0.38 per share, shy of the general analyst consensus of $0.41. Even though Whole Foods missed on the EPS estimate, the firm basically was in line with the revenue numbers. Posting $3.3 billion in revenue for the quarter, the street was hoping for $3.34 billion.

Whole Foods announced earnings after market close on May 6th, but the following day the stock cratered, closing down some 20% for the day. Aside from the earnings miss the main reason for the sharp sell-off came when management adjusted down forward guidance for the year. The new estimate came in at $1.52-$1.56, compared to the original $1.58-$1.65.

At first glance a $0.02 EPS miss and guidance correction of 3.5%-5.5% does not seem to warrant the type of steep correction that the stock was given. Below I have highlighted some of the deeper rooted issues that led to this larger correction.

· First and foremost this cut in guidance marks the third time that the grocery retailer has had to cut expectations due to rising competition from larger grocery chains hoping to mimic some of Whole Foods' success. Competitors like Kroger (NYSE:KR), Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Sprouts Farmers Market Inc. (NASDAQ:SFM), and Safeway (NYSE:SWY) have all started to aggressively sell organics in store for prices that are either on par or cheaper than rival Whole Foods.

· Whole Foods has been continually priced for above-average industry growth. Prior to the 20% sell-off that occurred post its earnings announcement the stock had been trading for around 32-35 times trailing earnings. Even after the recent correction the stock still trades for 26.50 times trailing earnings and 22.8 times forward earnings. Compared to Kroger at 13.11 times forward earnings and Wal-Mart at 13.72, Whole Foods still seems expensive especially given its lowered growth projections.

· Part of Whole Foods lowered EPS guidance also included lowered same-store sales guidance. The street has grown very accustomed to Whole Foods' higher than average margins and same store sales growth rate of 8%. During the conference call management adjusted that range down to 5% to 5.5%. Making investors reexamine whether or not the high multiple that is currently being paid for Whole Foods' stock is warranted given the new lower growth potential.

· As competition continues to increase providing consumers with alternative options to acquire organic products Whole Foods continues to face gross margins pressures. During the most recent quarter the firm posted gross margins of 35.8%. This was down 0.80% from the 36.3% gross margins posted the year prior. Compared to Kroger with gross margins around 21% and Safeway at 26%, Whole Foods is still higher. If Whole Foods is to remain competitive those margins may need to continue to come in.

· As per usual when earnings miss expectations and guidance is lowered it is not too long before banking analysts are quick to downgrade the stock and price targets. After the earnings miss Deutsche Bank was quick on the scene to downgrade the stock from Buy to Hold. With a new price target of $40 per share, down from the previous $60. Now I will be the first to admit that selloffs related to downgrades are more short-term reactions versus real fundamental issues, but the downgrade did not help the sudden sell-off and overall market perception of the grocer.

There is no denying that Whole Foods most likely will continue to face some significant head winds, but that does not mean that the stock is an outright sell. Whole Foods is planning on extending its footprint into more of the U.S. By the end of 2014 the firm hopes to have 36-39 new stores open with an ultimate goal of hitting the 500 store mark by 2017. The firm currently has 379 stores nationwide. Longer term co-CEO Walter Robb sees U.S. demand supporting around 1,200 stores.

Aside from expanding market penetration the firm is also actively working on making its pricing structure more competitive. It still has a way to go (see chart comparison below), but the fact that it is addressing the issue is a step in the right direction. The catch is that as pricing gets more competitive, margins ultimately take a negative hit which could continue to hurt stock performance.

Food Product

Whole Foods

Safeway

Parsley

$1.29

$0.99

Cilantro

$1.29

$0.99

Green Lettuce

$1.99/lb.

$1.99/lb.

Green Onion

$1.29/lb.

$0.99/lb.

Carrots

$0.99/lb.

$0.99/lb.

Gala Apples

$2.49/lb.

$1.99/lb.

Free Range Whole Chicken

$3.99/lb.

$0.89/lb.

Organic Gallon Milk

$5.99

$5.89

Simply Orange Juice

$5.49

$4.29

Mozzarella Cheese

$4.99

$4.49

Dozen Eggs

$2.99

$3.19

Mild Cheddar

$6.99/lb.

$7.49/lb.

Hummus

$0.30/oz.

$0.43/oz.

Jar of Pickles

$3.79

$3.99

The ultimate question is can Whole Foods remain cost competitive while still maintaining above average margins? Or does Whole Foods remain being a more specialized shopping experience for higher end consumers?

Personally, I like to think of Whole Foods as the Apple (NASDAQ:AAPL) of grocery shopping. They have their own model that they like to follow and don't really care too much of what the competition is doing. They have a very strong following of supporters who will shop there and buy their products regardless of price point. Majority of their competitors are all scrambling to copy their design or at least mimic parts of it. They have above-average industry margins that are currently struggling as the company works to reinvent itself.

Now, I am not calling any kind of bottom in Whole Foods here, even if the stock is off almost 40% from its recent 52-week high. What I will say is that I think longer term Whole Foods will continue to deliver above average results simply because they are offering a product and experience that few can fully duplicate. That experience and product is what will continue to drive sales and growth for the firm in the years ahead, provided that the firm is successful in its aggressive expansion while maintaining its existing brand identify.

Source: Why It Will Be A While Before Whole Foods Is Made Whole