Ever since I began working on the idea of a Christian investing website a little over a year ago, I've been enamored with Whole Foods Market (NASDAQ:WFM). In my view, conscious capitalism represents the best hope we have for sustainable economic prosperity in the world. So, I absolutely love Whole Foods Market, the company.
But I had never gotten very interested in the stock until May 7th. At that point, I began digging into the issues and trying to get a sense of the potential value to be found in WFM. The end result is a 26 page stock report on Whole Foods Market (which is available for free at the preceding link).
One thing I noticed early in my research, was that analysts and writers often pointed to the fact that company management has indicated they see room for 1,200 stores in the U.S. Given that there are less than 400 stores now, that means the company is going to triple in size, offering great returns to shareholders, right?
Well, it's not quite that simple. Even if they were to triple in store count and sales, it's likely they will struggle to maintain those insane gross margins they've been able to generate recently. Everyone seems to be aware of that issue. But it seemed like there was one thing no one was talking about: share dilution.
Intuitively, the effect of this impressive store count potential is somewhat ambiguous to shareholders, if the company has to issue new shares to achieve that number. Taking the extreme example, if the company had to triple their share count (through new issues) in order to raise the cash needed to triple their current store count, it conceivably wouldn't benefit shareholders at all.
But most healthy companies these days are net buyers of their own shares, right? I'm not sure, but it's definitely not the case with WFM. Share dilution has been somewhat concerning in the past:
Part of the share dilution should be expected to continue, and part of it should not be expected to continue (more on that below). This question compels us to come up with a way to model the true effects of a growing store count for existing shareholders, while accounting for the share dilution that is likely to be ongoing. First, we must determine what number to use for valuation purposes. Should we be concerned with gross profits? Earnings? EBITDA? Free cash flow?
I chose to model Owner's Cash Profits. Owner's Cash Profit is a simple concept that was introduced to me by Erik Kobayashi-Solomon, Director of Research at YCharts. The idea is so simple that it's hard to imagine it also being incredibly useful, but it is. It's built on the premise that a stock is ultimately worth the cash profits it generates for owners over time. That makes sense, right?
Well, maybe. If the company never pays out that cash in dividends, what does it matter to individual investors? You and I may not be able to gain control of a company such that we can take advantage of all of the cash profit being generated by a business. That's why dividends are so important to individual investors. But, a large company, private equity firm, or other suitor would be able to purchase a company and extract the full value of cash profits being generated. So, the value of a company's stock should converge to the value of OCP over time. Specifically, investors can try to calculate the present value of estimated future Owner's Cash Profits.
But first, how do we measure OCP? We start with the CFO being generated by the business. Then subtract out our best estimate of maintenance capex. Maintenance capex is the amount of capital expenditures the company requires to keep the business running. Capital expenditures on a new factory or store, for example, represents growth to investors and is typically classified as growth capex. Capital expenditures that go to replace worn equipment or outdated decor are considered to be maintenance capex. Ongoing operating expenses are already coming out of the CFO number. But capital expenditures aren't. So, we need an estimate of maintenance capex to subtract from CFO.
"Total Depreciation and Amortization - Amortization of Intangibles" is one estimate for maintenance capex over time. It's at least the best estimate that can be pulled directly from most financial statements and applied over many different equities. By the way, if you're interested in exploring this concept in further detail across various companies, YCharts puts out some great research reports on various stocks that even someone like me can easily understand.
When I am initially checking out a company's OCP, I look at three things:
1) OCP yield, which is basically a current yield number measured as OCP/Market Cap. Obviously, a higher number is better, all else equal.
2) The past trend in OCP. If OCP has been consistently rising for many years, I view that as a very positive sign.
3) The past growth rate of the company. Obviously, a company that has been growing rapidly is going to experience higher than normal depreciation expense. In the case of WFM, it's intuitive that the depreciation number should begin to go down as growth levels off. Once they hit their goal of 1,200 stores and capital expenditures associated with new store openings ceases, depreciation should decline before leveling off to a sustainable amount that is associated with remodeling of existing stores, replacement of worn out or obsolete assets such as machinery and equipment, relocation of existing stores, etc.
However, the hope is that CFO will not go down, but rather continue to rise, thus increasing cash profits to owners. So, if things go smoothly and the company retains its customer loyalty and affection, WFM could become an absolutely massive cash cow at some point in the next 15-20 years. Hopefully, that also means they will be churning out ever increasing dividend payments to shareholders for many years to come.
But before I get too far ahead of myself, let's look at the current level of OCP:
TTM OCP Yield is $674.59 million/ $15.21 billion = 4.44%. First of all, with current market valuations, that's not a terrible current yield, at least not on a relative basis. I don't have any way to produce market average numbers for this metric. But, I can say anecdotally that about half of the stocks I've screened lately on this metric fall below 3.5%.
Second, OCP is increasing significantly over time.
Third, Total D&A expense is probably overstating maintenance capex for a company that is in growth mode. As evidence, check out the following table:
As you can see, the majority of capital expenditures is going toward new store development right now. That should be considered growth capex, as opposed to maintenance capex. WFM is doing a good job of breaking out what they believe to be the true maintenance capex versus growth capex. Using their 2013 numbers of $198 million for "Remodels and other property and equipment expenditures" as well as $2.4 million for "Relocation, store closure, and lease termination costs" to estimate maintenance capex, WFM produced Owner's Cash Profit closer to $838 million last year.
I should note that it's possible that I'm double counting at least some of the "Relocation, store closure, and lease termination costs" number. It may be partially accounted for as an operating expense, but I can also see how relocation costs could get lumped in with capital expenditures, in which case it would eventually come out as depreciation. I'm not sure because I'm not a WFM accountant or auditor, and we've hit my limit for understanding exactly how they may be accounting for those costs elsewhere. So, to be on the safe side, I add it back in as an ongoing cash expense associated with moving store locations. For the record, I should also note that I've now parted ways with Kobayashi-Solomon's methodology just because WFM is one of the relatively few companies that breaks out their own estimate of maintenance capex.
But back to the $838 million, that would make the OCP yield (using a $15.21 billion market cap) = 5.51%. That's starting to sound pretty good, especially if this company still has plenty of growth ahead.
If we wish to try to model that version of OCP going forward, we need to keep in mind that as all of these new stores age, we can expect "remodels and other property and equipment expenditures" to rise accordingly. However, I think remodels will start to spike as the average age of stores gets into the range of 25-40 years. Most large retail centers can make it to the 20 year mark without looking very outdated. So, we will assume the current remodeling trend continues for the next 10 years.
So, let's look at the last 10 years of data to get a baseline average per store:
The 10 year average maintenance capex per store is $534,782. Adjusting each year's number for inflation, using actual CPI from each year, gives us a baseline proxy for maintenance capex per store of $605,764 for 2014. This non-growth capex number that WFM provides should be a nice proxy for maintenance capex.
However, as previously indicated, I think it also makes sense to try to estimate store relocation expense and add that amount into forward estimates of maintenance capex. Even after the U.S. market has become saturated with WFM stores, there will continue to be significant capital expenditures associated with store relocations. The desirability of particular areas and particular shopping centers changes over time. Naturally, this will lead to some store relocations ongoing each year.
The last 10 years can also give us a baseline for this number:
Over the last 10 years, WFM has had to relocate 1.76% of its stores per year, on average. This number can be affected dramatically by mergers and acquisitions, but we have no way to know if and when those will occur. So, we'll have to use 1.76% as a baseline number going forward. The inflation adjusted cost of store relocations over the last 10 years has been $3.32 million per store.
So, we've pretty much got the basic information we need to be able to model our best estimate of maintenance capex going forward. But we also need to be able to model CFO. Since we are looking at everything else on a per store basis, it makes sense to do the same with CFO. The last 10 years, WFM has delivered an inflation adjusted average CFO of $2.39 million per store.
As for the number of stores modeled going forward, I use the midpoint of management estimates for new stores opened over the next 2 years and then a 9% growth rate thereafter. The other numbers are adjusted for an inflation factor going forward of 3% annually.
This model is showing an 8.8%, 10 year growth rate in Owner's Cash Profit (from the current level of my version of OCP, $838 million). That's growth in a number that starts from a relatively attractive current yield of 5.5% (though my model reverts back to average, inflation adjusted CFO per store, which means a dip in OCP for 2014-2015). My model basically assumes that real same store sales growth, while very strong over the last 10 years, will grind to a halt, and that CFO per store will simply rise with inflation. So again, my model is conservative in some ways.
However, the actual result of CFO per store will be highly sensitive to gross margins staying level at their historical average, as well as SG&A expenses rising in line with historical averages per store, adjusted for inflation. If SG&A expense is not strictly controlled, and/or COGS as a percentage of sales revenue continues to creep up, this scenario won't look nearly as positive.
Also, this model assumes no recession in the coming 10 years, which there almost certainly will be. So, while conservative in other ways, 9% average annual store count growth might be considered quite rosy. But the company has grown the store count at increasing rates the last two years (store count growth was 4.01% in 2011, 7.72% in 2012, and 8.06% in 2013).
As a relevant aside, I think it's likely that WFM would have to acquire one of its up and coming competitors in order to reach its goal of 1,200 stores anytime soon. But I wouldn't feel comfortable trying to model a hypothetical acquisition. Too many questions arise. Would they buy a firm that has a complementary footprint? Does such a firm exist? What would be the effects of cannibalization? How many stores would have to be closed? Would they issue stock to make the purchase? Debt? You get the idea. Also, the company says they don't expect acquisitions to be material going forward. So let's continue to work on the assumption of organic growth.
The company estimates the store count growth to be roughly 9-11% the next two years. Further, they continue to indicate that they see 1,200 stores in the U.S., long term. They simply aren't going to get to 1,200 stores in any meaningful time frame without trying to speed up the growth rate at some point, so 9% as a forward looking 10 year average could be quite realistic.
Challenges are clearly present. But, WFM has done a great job of growing its store count while maintaining and even growing gross margins, controlling high level corporate expenses, and increasing CFO in the past. There's good reason to believe that while the near term presents challenges, the company retains competitive advantages and can produce good operating results in the future. If they do, and WFM is producing Owner's Cash Profit of $1.9 billion 10 years from now, owners of this stock should be pretty happy.
But there's one remaining problem with this scenario, and that's the previously mentioned issue of share dilution:
Over the last 10 years, WFM has diluted existing shareholders through both the issuance of convertible securities, and through stock based compensation. For example, in 2008, the company issued 425,000 shares of convertible preferred stock that was converted in November 2009 to a split adjusted 59.4 million shares of common stock. This is why it's difficult to model total share dilution going forward. The company has, in the past, been more than happy to issue new shares to fuel growth. If they were to continue this policy in the future, that would make it difficult to gauge the benefit to existing shareholders of the company reaching its goal of 1,200 stores in the U.S.
However, my model doesn't assume that they will get even close to 1,200 stores in 10 years. I've tried to model a growth rate in store count that is reasonable for the company to fund with its own cash generation. So we're basically assuming that the company won't issue new shares in order to achieve a higher growth rate in store count (above 9%), or that if they do, the net effect won't be accretive.
The company has said that it plans to use CFO to fuel growth going forward, at least for the foreseeable future. Indeed, the company appears to have matured to the point that it is no longer issuing shares or taking on debt in order to fuel growth. Instead, it is producing strong CFO, growing without tapping capital markets, and paying dividends. That allows us to focus on the other dilutive activities.
Here are a few relevant excerpts from WFM's most recent Annual Stakeholders Report.
From page 28:
[The Company intends to keep its broad-based stock option program in place, but also intends to limit the number of shares granted in any one year so that annual earnings dilution from share-based payment expense will not exceed 10%. The Company believes this strategy is best aligned with its stakeholder philosophy because it limits future earnings dilution from options and at the same time retains the broad-based stock option plan, which the Company believes is important to team member morale, its unique corporate culture and its success.]
From page 30:
[The Company maintains several share-based incentive plans. We grant both options to purchase common stock and restricted common stock under our Whole Foods Market 2009 Stock Incentive Plan.]
From page 26:
[We believe we will produce operating cash flows in excess of the capital expenditures needed to open the 94 stores in our current development pipeline.]
So, the company expects new store openings to be funded by operating cash flows. We're not concerned with modeling any growth related dilution, such as the issuance of new shares to fund an acquisition. Further, it's reasonable to assume that much of the share dilution to be expected going forward will be the result of WFM's policy of awarding stock to its team members across the board.
It should be noted that the company is not enriching senior management at the expense of shareholders. Last year 14,000 team members exercised options for an average gain of $8,400. Since inception, approximately 95% of the equity awards granted under WFM's stock plan have been granted to team members who are not executive officers. This policy is great for the company, great for the employees, and great for society. They also allow employees to purchase stock at a 5% discount to market price, which results in further share dilution. Personally, I think it makes all the sense in the world to promote an ownership culture among employees and award their hard work with shares of the business. But, potential investors simply have to calculate the effects of this policy when pricing the security.
Again, the policy in question is the issuance of new shares of stock due to stock based compensation. In the case of WFM, we can pull the number "Issuance of common stock pursuant to team member stock plans" from the Statement of Shareholder's Equity. Using the average stock price during the year (calculated from YCharts data), we can estimate the total dollar cost required to offset the dilution that occurred. That number should encompass the cash inflow associated with the exercise of options, the employee stock purchase plan, etc. Basically, we have to add back in the associated cash inflow to the company, which is highly significant in the case of WFM. There are many moving parts, but to get our best estimate of that number, we can pull in the cash inflow associated with "Issuance of Common Stock" from the Cash Flow Statement.
After we pull all of this information and perform the necessary calculations, we can then account for the dollar cost associated with offsetting share dilution, as a percentage of CFO:
Finally, we can calculate the present value of estimated future net Owner's Cash Profit, with the "net" meaning net of the effects of non-expansionary share dilution (Kobayashi-Solomon uses a somewhat similar process that results in what he calls Free Cash Flow to Owners). Then, we can apply the current multiple for net Owner's Cash Profit (which is 23.2), minus a 20% haircut to get the future market cap of the company. I think the 20% haircut on the multiple is appropriate because as the market becomes saturated, growth expectations at that point are likely to have become significantly lower than they are today. I use a discount rate of 9.5%, which is in line with the historical average for equities, and pretty much what I expect to get from investing in stocks. The result is that the model gives a fair value for the price of WFM stock to be $44.62.
As you can see, I haven't been able to determine that WFM is incredibly undervalued at the moment. Of course, there are other methods of valuation besides the one I've presented here. But even after accounting for the effects of ongoing share dilution, the stock is undervalued by about 9% according to this particular model.
However, as I analyzed and modeled the business, I found that it is extremely sensitive to small moves in gross margin. If gross margin drops just a few points from its historical average of 34-35%, the scenario isn't nearly as rosy. Further, competition is increasing. That's very clear. It's surely not easy for the management of this company to keep average gross margin in the range of 34-35%, even without the increased competition. They also have to work hard at keeping SG&A expense growth from getting out of control as they grow. There is no doubt this company has challenges ahead.
However, they continue to be a market leader. They have a strong first mover advantage. Their business model and position in the market place, and their fierce customer loyalty is not easily replicated. They have sustainable competitive advantages (if you'd like more detail about that, please check out my full report). The market for organic and natural foods still has plenty of room to grow. All of these facts have pretty much led to intense investor loyalty in the past. So, the recent drop in price does not necessarily mean that new investors are getting a huge bargain.
Instead, it means that the stock is no longer priced for perfection. Investors are starting to price in the possibility that the company will struggle to reach its goals. But that's only one possibility. Real same store sales growth could continue. They could grow their store count at a rate greater than 9%. They may have massive potential internationally. They could continue to capture more and more fiercely loyal customers as awareness of their brand and mission continues to increase. There are plenty of reasons to believe WFM, at the moment, represents ownership in a great company at a very reasonable price.
There are much worse things you can do with your money than to buy shares of a great company at a reasonable price. Thank you so much for reading and best wishes in your investing!
Disclosure: I am long WFM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.