Whole Foods: Love the Company, Avoiding the Stock

| About: Whole Foods (WFM)

I have been shopping at Whole Foods (WFMI) (43.50, $6.3 billion, S&P 500) for over a decade and continue to do so. I really like not only the products that they carry, especially some of the private-label ones (365 brand), but also the way they treat their customers. I have spent enough time and money there to consider myself somewhat of an expert.

I never bought the stock, as my former employer had an aversion to “grocery store” stocks, and I will confess that I tried to make some money from the short-side briefly after they reported their last quarter and the acquisition of Wild Oats (OATS) (only to get stopped out in the mad short-covering rally that briefly followed).

With that said, I want to share both my opinion and some facts about the company and the stock that lead me to expect that the stock will not beat the market for a while. As you can see from the chart below, it hasn’t exactly been beating the market in a while:


The (Lack of) Growth Story

I expect that growth at Whole Foods will not meet expectations. The current consensus for the next 3-5 years is that they can grow EPS 19%. My experience suggests that analysts don’t put a lot of thought into this type of number, as they aren’t graded on it the same way they are on quarterly or annual earnings estimates or recommendations. The consensus has been in the 18-20% area since 1999. It isn’t that surprising, as historically the company has produced 21% compounded EPS growth for the last 5 years. Folks, this is a stale number! Many, many investors are using that number as the denominator in their PEG ratio or in their valuation analysis, which begs the question: Can the company grow EPS anywhere close to that number? I will discuss valuation in more depth, but, with the stock trading at 28X the forward EPS estimates; clearly someone is expecting some growth.

If I were buying this stock, I would want to make sure that I understood the growth drivers. Prior to the recent Wild Oats acquisition announcement, the exercise was somewhat easier, as now one has to make a judgment regarding their potential success with integrating a poorly run competitor. This acquisition is totally out of context with their historical M&A strategy, as the overlap is significant. Traditionally, the company has used acquisitions to expand geographically. I don’t want to credit them in advance as Wall Street has seemingly done. While I wouldn’t rule out a near-term earnings boost if everything goes right, I don’t think that it raises their level of growth over the long-term. The mistake that many analysts are making is the assumption that OATS was “the” rather than “a” competitor. This leads me to my main point: Whole Foods isn’t so unique anymore.

As I mentioned, I am a long-time customer of the firm. I noticed their raising prices about a year ago and became quite alarmed. Why? It was clear to me that competition was emerging. People were talking about Wal-Mart, but I was seeing my local grocery stores not only start to mimic some of WFMI’s better differentiating features, but also start to carry a lot of the same products at lower prices. I didn’t have evidence at the time, but I now firmly believe that WFMI raised prices in order to combat flagging unit volume. This is an irrational and dangerous response if that is the case. I may be a “growth-stock” kind of investor, but I am a “value” shopper, and I noted that many of the products that had appealed to me had appallingly high increases. I had so often defended the company’s “high prices” by correlating them with higher quality. Well, “organic foods”, fancy salad bars and better customer service have become commoditized, and WFMI is no longer the draw that it once was. As we unwind from the “house as a piggy-bank” mentality that has been in effect since 1995 (and especially post-2001), customers may become more price-conscious and move to some of the cheaper alternative suppliers.

Well, what was above is certainly just my opinion. For the facts, one need only listen to the last two conference calls. I was astounded by the company’s revelation late last year that it didn’t understand why same-store sales were decelerating (or why they had been so strong before!). Real comforting... Then, this past quarter, defending tepid same-store sales, the CEO benched the grocery store business as how investors should view WFMI (positively). Well, for years, I have heard (and believed) that WFMI wasn’t in fact a grocery store but rather a high-end retailer. When the CEO starts using a moribund group of companies as a benchmark, he is telling us to forget about the high growth that the company historically enjoyed. Finally, amidst turmoil, the company announces a huge acquisition that is inconsistent with their historical practices. I guess this is opinion too, but that, folks, is a giant red flag.

So, absent this rabbit in the hat (fed organic carrots, no doubt), the company was going to be challenged to meet long-term EPS expectations. They have decelerating same-store sales (and no plan to address that), have had to move to increasingly less attractive markets (Seeking Alpha had a great discussion of this) and now face their largest integration ever.


I wonder what type of investor is buying WFMI now. It certainly isn’t a “value” investor, as the stock is quite expensive still. “Growth” investors typically don’t like falling EPS estimates, increased business risk and poor price momentum. That leaves the “rear-view mirror guys”, the “hope and pray” crowd, “falling knife” fans and some potentially smart people who have figured out something that isn’t apparent to me.

I think that WFMI ultimately settles in at about 22.5X forward earnings over the next 6 months. The estimates have been falling, but I will assume that the Sep 2008 estimate of 1.69 holds (not an expectation, just an assumption). 22.5X would represent a PEG ratio of about 1.5 assuming a more reasonable (but still perhaps generous) 15% long-term growth rate. That represents a “target” in September of about 38, a good 10% or so below current levels.

Note in the chart below that the PE has come down, but it is still a healthy 28X, about double the S&P 500. RPS and EPS are decelerating. With increased competition, a risky merger that will devalue its pristine balance sheet and clearly slowing growth, this stock doesn’t justify its current valuation.

WFMI 2_1

Disclosure: Author has no position in WFMI.