The current trend of healthy eating without pesticides and GMOs has sparked a similarly popular trend of expressing a position regarding the outlook of Whole Foods Market (NASDAQ:WFM). Is the stock a buy or a sell, and is the company overpriced or undervalued?
Investors have confidently sided with either one of the two views in effect of Whole Foods' uneasy second quarter earnings. Waters have calmed and the 'decline' of Whole Foods can be scrutinized, focusing on the company's value as opposed to the single earnings event. However, another tidal wave, third quarter results, is fast approaching.
Whole Foods is due to issue its third quarter results after the markets close on Wednesday. It has been a tumultuous time for Whole Foods since it reported lower than expected second quarter earnings on May 6th, with revenues of $3.32 billion missing estimates of $3.34 billion, and less $0.03 earnings per share. Shares plummeted 20% and remain down 40% from their $65 high back in October. Claims are rampant that increased competition is to blame, pricing Whole Foods out of the market they helped establish.
Nonetheless, the past five years has seen Whole Foods grow its revenue by 70% and free cash flow by 122%. The company also has a solid balance sheet, with no long-term debt as well as cash and short-term investments comprising 27% of shareholder's equity. A recent report by Barron's titled 'Summer Bargains' lists Whole Foods as one of six inexpensive growth stocks to watch, noting how Whole Foods has projected that earnings will increase 13% in fiscal 2015, with another boost in the next three years.
The market is potentially overestimating competitors' power to take down this well-established company. Additionally, there could be failure to recognize Whole Foods' current expansion game plan, with an increase of nearly 200 stores totaling 575 by fiscal 2018, utilizing nearly no debt.
Speculators dragged down Whole Foods' share price after conjecture that the low returns were rooted in the high level of saturation in the organic market, caused by competitors such as Walmart (NYSE:WMT) and Sprouts Farmers Market (NASDAQ:SFM). A well-timed announcement by Walmart broadcasting a cheaper line of organic produce, "making organic foods a reality for all", sowed doubts in investor minds that Whole Foods could not maintain its loyal customer base, effectively pricing itself out of the market it helped create.
The claim that Walmart could steal Whole Foods' customers is baffling for two reasons. Firstly, the market demographic is different. The high-end patrons of Whole Foods are extremely unlikely to swap to the discount department store for a range of 100 cheaper organic products. And secondly, the organic world is far from what Walmart values and knows how to do well. The price cut retailer will inevitably endeavor to "Walmartize" their organic produce, undermining the organic standards for a discount. Whole Foods is the embodiment of healthy, high-quality living - Walmart represents value for money.
Comparing the Stats
Newly public organic grocery store chain Sprouts Farmers Market has also been labeled as a threat to Whole Foods, as well as a more profitable investment opportunity. The stock has been favourable for its low share price (albeit being only ~5 points below WFM), cheapness on a forward P/E basis and having the highest return on equity. In actuality, Whole Foods beats Sprouts on the latter two points, with a forward P/E of 21.32 compared to 36.75, and ROE of 14.68% rather than 13.87%:
|Forward P/E||ROE (%)||Debt/Equity||Net Profit Margins (%)|
This is impressive considering SFM's high total debt-to-equity ratio of 76.35 boosting its ROE. Whole Foods maintains an incredibly low total debt/equity of 1.54, well below the industry average of 68.9. Additionally, WFM's net margins almost double those of Sprouts, at 4.14% versus 2.59%.
The buzz behind Sprouts stands in its lower costs, middle-income market and expansion opportunities. The company is still relatively new and has yet to expand, which could signal a buying opportunity for some, but also means it has yet to enjoy the loyalty base an established company like Whole Foods has. However, with a trailing P/E of 67.62 it is priced as if it were an established company, compared to the industry P/E of 16.10.
Risks in Identity Change
Sprouts' motto "Healthy Living for Less" could signal potential stress on Whole Foods' profit margins, providing middle income earners an alternative to WFM's higher priced offerings. However, Whole Foods has a renowned identity for high quality, customer loyalty and overall satisfaction. WFM's management team is one of the company's main strengths. They have endeavored to secure an air-tight marketing message specifically geared towards young adults, efficiently promoting the store and further insulating their market position, attracting the health conscious consumer willing to pay more for higher quality produce.
Risk would present itself if Whole Foods strayed from its identity by surrendering to the "cost-cutter" route. Its competitive edge right now is by providing an enjoyable shopping experience, as opposed to Walmart and most grocery stores. The recent fines imposed on Whole Foods for overcharging customers, in addition to keeping up with the competition, has renewed worry for profitability over time if profit margins were squeezed. But crucially, without the allure of quality for the consumer, the basis of Whole Foods would be nonexistent.
Current expectations for Whole Foods' third quarterly earnings call for moderate growth, with analysts looking for earnings per share of $0.39 and revenue of $3.40 billion: an increase from $0.38 and $3.06 billion the previous year. The number of new stores opened will also be important, in order to check Whole Foods is on track to achieve its goal of 36-39 new stores for the year. At this point 18 new stores have been opened, with seven new stores planned for Q3 and 11-14 for Q4. WFM's free cash flow has declined 27% so far this year due to their capital expenditure.
Whole Foods has demonstrated solid financials and right now appears to be undervalued. This presents an opportunity to buy quality at a discounted price, and for value investors this reduced risk allows for more upside potential. The market will likely react more dramatically to negative results than to positive results when the time comes on Wednesday, but should that be the case it will only drive a better bargain for the investor.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.