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Summary

  • Whole Foods Market's stock dropped 40% since its peak in November 2013, while the company's total sales and earnings have increased during the same period.
  • The stock is likely undervalued. However, the market will likely continue to be pessimistic about the stock in the short term because of the increasing competition from other grocery stores.
  • Whole Foods should still be a good long-term investment because the company is benefiting from the increasing demands of natural and organic foods in North America.
  • The stock should be worth around $16 billion in market cap or $44 per share based on my intrinsic value estimate.

The best time to invest in a stock is when it is undervalued-which means the stock is trading below its intrinsic value (business value)-because the investment risk is lower and the potential return is higher. Warren Buffett once stated, "When investing, pessimism is your friend, euphoria the enemy." Interestingly, many investors do the opposite: they buy when the market is euphoric and sell when the market is pessimistic.

I decided to write an article about Whole Foods Market (NASDAQ:WFM) because there has been a lot of pessimism around the stock recently and the stock is at a two year low (see image below). The stock dropped as much as 40% since its peak in November 2013 while the company's total sales and earnings have increased during the same period. The stock plunged 40% because the company's reported earnings and outlook did not meet the market's expectations. This could be a good buying opportunity for long-term investors provided that 1) Whole Foods still has good long-term prospects and that 2) the stock is traded below its intrinsic value. We will examine both topics in this article.

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About Whole Foods Market

Whole Foods Market is the leading retailer of natural and organic foods in the U.S. and was the first nationally "Certified Organic" grocery store. The grocery store chain is known for providing high quality natural and organic foods that are often priced at a premium compared with other grocery stores. The company earns most of its revenues in the U.S., where it has the most stores. As of April 13, 2014, it operated 374 stores: 357 stores in the U.S. and the District of Columbia; 8 stores in Canada; and 9 stores in the U.K. (source: Q2 2014 10-Q Report).

Whole Foods' Short-Term Prospects and Pessimism

In the short term, many investors and analysts are pessimistic about Whole Foods because competition has increased rapidly in the grocery market-especially in the natural and organic food segment-in recent years, which has impacted Whole Foods Market's comparable store sales growth (comps). For example, the company's total sales increased 10% to a record $3.3 billion for the latest quarter ended on April 13 (source: Press Release). However, its comps were 5.0% (excluding Easter shift), which were much lower than its historical 7-9% comps between fiscal 2010 and 2012. And its net income and diluted earnings per share (EPS) were flat year-over-year. In addition, the management had lowered its earnings guidance for fiscal 2014, which is never a good sign for investors.

All of these financials suggest that Whole Foods is facing increasing competition from other grocery stores and supermarkets-such as Kroger (NYSE:KR), Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), The Fresh Market (NASDAQ:TFM) and Sprouts Farmers Market (NASDAQ:SFM)-that are expanding in the natural and organic food segment while reducing their prices. As a result, Whole Foods was forced to change its strategy to focus more on value and to reduce the prices for certain food products in order to attract more sales. Moreover, the management stated that they intend to appeal to "a broader customer base," according to the latest conference call. This may suggest that they will continue to lower their prices for certain food products that could further impact comps, sales growth and gross margin.

Whole Foods' Long-term Prospects and Growth Strategy

While competition has impacted Whole Foods' sales growth, I believe that the company still has good long-term prospects because the demand for natural and organic foods is continually growing in North America; the company has the leading grocery brand in organic, natural and non-genetically modified foods; and the company has the potential to reach about 1,200 stores in the U.S. There were about 357 stores in the U.S. as of Q2 2014.

Over the past 10 years, Whole Foods' total sales grew from $3.87 billion to $12.9 billion, with a compound annual growth rate (CAGR) of 14.35%. Its net income had grown from $137 million to $551 million, with a CAGR of 16.72% for the same period. The company achieved these results through a combination of new store openings, acquisitions, comparable store sales growth, product differentiations and offerings of high-quality natural and organic foods. Whole Foods' branding image also allowed the company to charge a premium for most of its products.

For the next 5 years, the management stated that the company will continue to expand aggressively by opening more stores in the U.S. They expect that their total sales will grow from an expected $14 billion in 2014 to around $24 billion in 2018 (see image below). In addition, store counts are expected to grow from 398 in 2014 to about 575 in 2018.

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Source: Q2 2014 Financial Release.

Since competition in the natural and organic food market has increased rapidly in recent years, it is unlikely that Whole Foods can achieve the same revenue growth rate as it did the past decade. Its total sales grew at a revenue CAGR of 14.35% over the past 10 years, as stated earlier. Hence, I believe that a more reasonable revenue CAGR should be around 8 to 11% over the next 5 to 10 years.

Whole Foods' Intrinsic Value Estimates

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I have estimated the company's intrinsic value (business value) based on three free cash flow (FCF) growth scenarios (see image above). The discount rate is assumed to be around 10%:

  • An optimistic valuation with a FCF CAGR of 11%.
  • A fair valuation with a FCF CAGR of 8%.
  • A pessimistic valuation with a FCF CAGR of 5%.

Based on my estimates, Whole Foods Market should be worth around $16 billion in market cap or $44 per share, assuming that its free cash flow will grow at a CAGR of 8% over the next decade. If the company's free cash flow grows at a CAGR of 11%, the stock should be worth around $19 billion in market cap or $51 per share. (Note that Whole Foods' free cash flow grew at a CAGR of 15.7% between fiscal 2004 and 2013.) Its current price is $40.93, at the time of writing.

The Bottom Line

Whole Foods Market is likely undervalued at the time of writing, and the stock should recover over time as the company continues to open more stores in the U.S. and achieve higher sales. In the upcoming quarters (the short term), the market will likely continue to be pessimistic about the stock because of the increasing competition from other grocery stores that are impacting Whole Foods' comps and sales growth. However, I believe that the company still has good long-term prospects because it is still benefiting from the growing demands of natural and organic foods in North America.

Sources: Whole Foods Market's Q2 2014 10-Q Report, Press Release, Conference Call, Morningstar, Yahoo Finance, SA Transcripts and Intelligent Stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Whole Foods Market Is Undervalued, Should You Buy It?