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Whole Foods Market Inc. (WFMI)

F2Q07 Earnings Call

May 9, 2007 5:00 pm ET

Executives

Jack Mackey - Chairman and CEO

Glenda Chamberlain - EVP and CFO

Jim Sun - EVP of Growth and Business Development

A.C. Gallo - Co-President and COO

Analysts

Steve Chick - JP Morgan

Simeon Gutman - Goldman Sachs

Mark Husson - HSBC

Mark Wiltamuth - Morgan Stanley

Scott Mushkin - Banc of America

Greg Badishkanian - Citigroup

Meredith Adler - Lehman Brothers

Andrew Wolf - BB&T Capital Markets

Chuck Cerankosky - ATS Midwest

Operator

Welcome to today's teleconference. At this time, all participants are in a listen-only mode. Later, there will be an opportunity to ask questions during our Q&A session. Please note this call may be recorded. I would now like to turn the call over to Jack Mackey. Please go ahead.

Jack Mackey

Good afternoon. Joining me today are A.C. Gallo, Co-President and Chief Operating Officer, Glenda Chamberlain, Executive Vice President and Chief Financial Officer; Jim Sud, Executive Vice President of Growth and Business Development; Lee Valkenaar, our Executive Vice President of Global Support and Cindy McCann, Vice President of Investor Relations.

First for the legalities. The following constitutes a Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Except for the historical information contained herein, and the matters discussed in this press release are forward-looking statements that involve risks and uncertainties, which could cause our actual results to differ materially from those described in the forward-looking statements.

These risks include but are not limited to general business conditions, timely development and opening of new stores, the impact of competition, and other risks detailed from time to time in the Company's SEC reports, including the reports on Form 10-K for the fiscal year ended September 24, 2006. The Company does not under take any obligation to update forward-looking statements.

Our press release is now available on our website www.wholefoodsmarket.com along with the scripted portion of this call and additional supplemental financial data.

I am hoping you all had a chance to read our press release. Please note it includes a reconciliation to non-GAAP, diluted earnings per share of $0.34 for the second quarter of last year, which excludes $3.6 million of credits related to Hurricane Katrina.

Our sales for the second quarter increased 12% to $1.5 billion. Average weekly sales for all stores increased 6% to $635,000, translating to sales per square foot of $932.

Our 17 new stores, including three relocations and four new markets, averaged 54,000 square feet in size and produced average weekly sales of $588,000 in the quarter translating to sales per square foot of $565.

We believe the best indication of our new store productivity is to look at the trend over a period of time long enough to smooth out particular mix of new stores being compared. For example, over the last five fiscal years, while our average store size has increased 20%, our average weekly sales per store have increased 68%. And we have seen our average contribution per store increase 69%. Both more than triple the increase in store size.

In addition, our new stores open at least one year continue to run ahead of our ROIC targets for the first year and we are on track to reach our overall hurdle rate of cumulative positive EVA within seven years or less.

Our comparable store sales grew 6% on top of the 12% increase in the prior year. Year-over-year, average transactions per week increased approximately 3% to $3.4 million, and our average basket size increased approximately 3% to $34.

Last year Easter was April 16th, which fell into our third fiscal quarter. This year Easter was April 8th, which fell into our second fiscal quarter. This Easter shift resulted in a positive impact on our second quarter comparable store sales growth of approximately 87 basis points, and we estimate will result in a negative impact on third quarter comparable store sales growth of approximately 50 to 100 basis points. We saw sequential improvement each period of the second quarter, and for the last five weeks ended May 6, which includes the Easter holiday in both years, our comparable store sales growth was 7.5%. We are hopeful that our current trends are an indication that our comps bottomed out in the second quarter and that the pendulum is starting to swing back the other way.

As we previously stated, while we cannot state conclusively why our comp trends have been running below our historical 8% to 10% average, we continue to believe it is most likely the result of many factors including the tough comparisons we face due to our three consecutive years of extraordinary double-digit comps, as well as the heightened competitive food retailing environment, a higher degree of cannibalization, and our selective price investments.

Compared to several years ago, many food retailers are making significant capital investments in their new stores, remodels, new formats, and expanded natural and organic product offerings, and, on the margin, we believe some of these investments are having an impact on our sales.

Regarding cannibalization, our experience has typically been that our new stores average positive comps in their first quarter in the comp base and by then the cannibalized store is back to positive comps as well, reflecting our increased market share and making it the right growth strategy over the longer term. However, as we accelerate the opening of new stores, we may see a higher number of stores being cannibalized year-over-year creating a larger negative impact on our comps. For example, in the second quarter, 24 of our existing stores were experiencing cannibalization, up from 14 stores in Q2 last year and up sequentially from 18 stores in the first quarter.

We are continuing to make selective price investments which, although hard to quantify, are having some negative short-term impact on our comps as well. We believe strengthening our price image on commodity-type branded products to broaden our appeal is still the right long-term strategy, and we are fortunate that we continue to find many opportunities to lower our cost of goods sold to help offset these price investments and minimize the gross margin impact.

We believe that competition makes us better, and we aren't standing still. We are constantly experimenting, innovating and evolving. We are opening a record number of stores this year, many of which are incredibly exciting stores that will allow us to redefine the marketplace and further differentiate our shopping experience from other food retailers.

We have many global buying initiatives in place that are benefiting our customers. We are actively continuing to further differentiate our product offering in ways that speak to our authenticity and leadership role within natural and organic products. Some elements of this strategy include: Private Label. In the quarter, our private label SKU count increased 16% year-over-year to 1,900 SKUs, and our private label sales increased to 18% of our total grocery and Whole Body sales. We expect Private Label to grow to a much higher percentage of our sales over time.

Buying Global. During the quarter, we launched our Whole Trade Guarantee program which offers our shoppers a differentiated guarantee on products from developing countries with strict criteria to ensure exceptional product quality, more money for producers, better wages and working conditions for workers, and sound environmental production practices that promote biodiversity. The program will also support eliminating poverty through a donation of 1% of sales to our Whole Planet Foundation.

One of our first products is our EARTH University bananas which are very high quality and are grown using low-impact earth-friendly agriculture techniques in Costa Rica. Other Whole Trade products include tea, cocoa, mangoes, rice, sugar, vanilla and coffee. Within the next 10 years, our goal is to have over 50% of our imported products from the developing world fall under our Whole Trade Guarantee program, and, over the longer term, 100%.

Buying locally, an opportunity to differentiate our product selection while fulfilling several of our core values is to highlight the locally grown products in our stores. We hope to have close to 20 percent of our produce purchases sourced locally this year. We have further empowered our individual store and regional buyers to seek out locally grown produce, and additionally creating a Local Producer Loan Program through which we are offering up to $10 million in annual financial assistance.

In February, South Florida beekeeper David Rukin of Buzzn Bee became the first recipient of a low interest rate, long-term loan, and we have since announced additional loans to five local producers in Colorado and New Mexico.

We expect to make further announcements in the upcoming months about other programs that differentiate our products.

In addition, while the Whole Foods Market brand is synonymous with the highest quality natural and organic products, we are also known for our emphasis on perishables, beautiful stores uniquely designed for their market, and exceptional customer service, all of which translate into a fun shopping experience that is very hard to replicate.

Now, back to our results for the quarter. For the quarter, gross profit decreased 18 basis points to 35.2% of sales. Year-to-date, our gross profit at 34.7% of sales was inline with our 5 year fiscal-year average.

Excluding Hurricane Katrina credits in the prior year, direct store expenses for the second quarter increased 49 basis points to 25.9% of sales, higher than our 5 year average and range.

For stores in the comparable store base, direct store expenses increased 8 basis points to 25.5% of sales due primarily to higher healthcare and workers' compensation costs as a percentage of sales, which were partially offset by leverage in wages.

Year-to-date, our higher-than-expected direct store expenses have led to lower-than-expected store contribution and growth in operating income before pre-opening and relocation expenses.

As we guided, our materially higher pre-opening and relocation costs resulting primarily from our acceleration in leases tendered and square footage opening this year and next year is having a significant negative impact on our diluted earnings per share growth.

For the quarter, our pre-opening and relocation costs were $15.6 million, or $0.07 per share, more than double our costs in the prior year of $7.3 million, or $0.03 per share.

For the quarter, operating cash flow was $0.47 per share. The decrease year-over-year was due primarily to timing differences related to taxes paid during the quarter.

In the second quarter, we opened a record six new stores in Fairfax, Virginia; Chicago, Illinois; Birmingham, Alabama; Manhattan, New York; Cleveland, Ohio; and Portland, Maine, ending the quarter with 194 stores and approximately 6.9 million square feet in operation.

Our Bowery and Houston store located on Manhattan's Lower East Side is our fourth and largest New York City location at 71,000 square feet and has opened with sales above our projections. The two-storey store includes three eateries, one of the nation's only genuine fromageries featuring 80 exclusive aged cheeses; homemade pies, baked fresh throughout the day; as well as foods from a variety of top-tier local artisans and growers.

Innovations include mini French and Japanese-inspired bouquets in the floral department, an expanded selection of handmade sausages, and a huge selection of meats and seafood smoked in-house.

Also located on the second floor is the Culinary Center, which will offer dozens of hands-on classes and demonstrations with some of the best New York and Whole Foods Market chefs, artisans and growers.

So far in the third quarter, we have opened one store in El Segundo, California, closed one Fresh & Wild store in London that will be relocated to our new 80,000 square foot Whole Foods Market store location opening in early June and we expect to open one store in Sonoma, California. As of today, we have opened 15 new stores over the last 12 months.

On April 24, 2007, we announced that we extended the expiration date for our tender offer to purchase outstanding shares of Wild Oats Markets, through May 22, 2007. We are working diligently with the FTC regarding the Hart-Scott-Rodino review. Although the FTC has not yet decided whether to challenge the Wild Oats transaction, members of the FTC staff have voiced concerns regarding perceived anticompetitive effects resulting from the proposed tender offer and merger. Any further updates regarding the Wild Oats transaction will be made through public filings.

Now I will turn to our thoughts for the remainder of the year.

Our guidance for fiscal year 2007 excludes any impact from the proposed merger, as it has not yet closed. We are maintaining our guidance of 13% to 17% sales growth, 6% to 8% comparable sales growth, and 18 to 20 new store openings resulting in 16% ending square footage growth, but we now expect operating income before pre-opening and relocation costs as a percentage of sales to be in line with our performance year to date.

Our business model is very successful and continues to benefit all of our stakeholders. We are executing at a high level, continuing to produce higher sales, comps and sales per square foot than our public competitors. Given our strong historical sales growth, record store development of pipeline, and acceleration in store openings, we believe we are well positioned to achieve our goal of $12 billion in sales in the year 2010. Over the longer term, however, we believe the sales potential for Whole Foods Market is much greater than $12 billion as the market continues to grow and as our company continues to improve.

Our company is constantly experimenting, innovating and evolving and has a demonstrated track record of competing, executing and delivering strong results. Based on our 19% sales growth last year, we were pleased to learn that we moved up 38 spots to No. 411 on the Fortune 500 list of the largest public companies in the United States.

As expected, we are going through an investment period as we accelerate our new store openings while coping against tough comparisons. We have grown our stock price at an average compound annual rate of 22% since going public, and we encourage our shareholders to stay focused on the long term.

Operator, we'll now take questions.

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Question-and-Answer Session

Operator

Thank you at this time. (Operator Instructions). We'll take our first question from Steve Chick with JP Morgan. Please go ahead.

Steve Chick - JP Morgan

Hi, thanks. Well a couple of questions just I guess in terms of your, so I can clarify your operating income guidance for the second half. In the first half it looks like operating income, margins has been down, say 50 basis points year-over-year is, so the second half is that, that's the trajectory you are saying we should you think about in your guidance? Is that right?

Jack Mackey

Glenda?

Glenda Chamberlain

Yes, we are saying that, often any significant information to the contrary, we think that current trends are the best way to look at the future, so obviously we hope to do better than that. But given a fact that we were significantly below our guidance we felt like it was appropriate to change it.

Steve Chick - JP Morgan

Okay. But, are you kind of thinking about it, I mean, is it direct store expenses and the investments that I guess the continuation of accelerating new stores. I mean is that how we should think about the components of what's dragging margins? And actually related to that, John used to talk about, the paradox of growing, and you guys used to have a slide along the way that show kind of margins of new stores and contribution margins of I think it was 3%, versus your average of 9%. Is that the same type of economics that these new stores have?

Glenda Chamberlain

Well, let me just reiterate that, we are talking about operating income before pre-opening expense. Because obviously, pre-opening impacts significantly year-over-year, and that's a completely separate set of reasons and that's primarily due to the increase in number of stores opening and being tendered.

Yes, it is primarily direct store expenses. The gross margins are right in line with our five year average. And that is both new stores and existing stores, are having higher direct store expenses, than we had projected.

For existing stores, generally, we have greater leverage there. That helps to offset, the fact that new stores always have higher direct stores expenses, and we didn't see quite as much leverage or we didn't see any leverage from existing stores, in this quarter, primarily because of healthcare cost and workers' comp cost. And we certainly are working diligently on those two line items. Healthcare costs, as you know are an issue for most employers across the company, and we do have, a great plan for our team members that cover every person in that, every full-time team member, that works for us. We did see leverage in wages in the quarter.

Steve Chick - JP Morgan

Okay.

Glenda Chamberlain

I hope, that gives you some additional. Is that what you are looking for?

Steve Chick - JP Morgan

Yeah, it helps. I guess, when I am thinking about, because I think this is consistent to some extent with, what you guys have said in the past. I'm thinking about as we go into next year. What prevents us from having another year of where margins go down again, assuming that, if you open up 18 to 20 new stores this year, you haven't said yet how many it's going to be next year, but I am assuming it's going to be more. I mean, just on the math, is it logical to say that the investment period is going to extend in the next year or two?

Glenda Chamberlain

I don't think that there is anything unreasonable on what you have said. But, we are not prepared to give guidance regarding next year at this time. Whole Foods is the company that's always looking for ways to improve, everything that we are doing, and our direct store expenses and income statement results are certainly no exception to that. We have historically, been able to generate leverage in our existing stores and we hope to continue that in the future.

Jack Mackey

Steve, it's happening exactly like we said, it was going to happen. We are accelerating our growth, and that sacking is a drag on earnings and this is raising direct store expenses. And with the overall comp slowdown, I mean, when you have triple-digit or double-digit comps for three years in a row, that kind of growth accelerates your leverage. And when that comp growth slows down, like it's done, then the amount of leverage we are going to get in the existing store base also slows down. So, the new stores are acting as a bigger drag then they have in the past years, because in the past years or at least past three years, those double-digit comps covered them up. Without the double-digit comps, the comps appearing to be kind of in our historical averages now, particularly with the upward trend over the last five weeks. We are going to be in our 6% to 8% target range. We don't have those double-digit comps, making up for the new stores dragging them down. So, we are opening a lot of stores. We are going to grow a lot faster. And we are going to build a lot of shareholder value over the long term. But that's going to act as a bit of a drag on earnings while the gross is ramping up as we guided.

Steve Chick - JP Morgan

All right, okay. Two others, if I could. Yeah, I noticed on the sign leases, it looks like the average square footage was, I think you said 42,000 square feet, which is on the, I think the low end of the leases you have been signing. Is that kind of indicative of a little bit of a change of looking at a revision of the prototype, so to speak? Or is there anything there to think about?

Jack Mackey

Jim, do you want to comment on that?

Jim Sud

Sure, Steve. In this quarter, we did sign nine leases. Three of those leases were smaller stores. Two of which, one was an acquisition from Albertsons in Lafayette of about 25,000 square feet and one from Ralphs in Capitola of about 28,000 square feet. So, our average square footage in development I think is about 55,000 square feet. But the average for the stores that are currently in operation is about 32,000 square feet. So, basically, we operate stores anywhere from 10,000 square feet up to 80,000 square feet.

And as we continue to see opportunities in markets where it's more difficult to get larger stores, but there are opportunities that we think are good opportunities to build stores, we will do so. So, we are not tied to any one particular size or format or really making any changes to our strategies based on where we are today.

Steve Chick - JP Morgan

Okay. Because I noticed your productivity metric, the way I calculated, did increase a little bit this quarter. So, the average stores size of 55,000 square feet in the lease pipeline, if some of the ones that are big, I mean you are pretty happy generally with what you sign and you don't need to revisit any along the way and reduce 5,000 square feet here or there.?

Jim Sud

Well, we are continually looking at our stores in development and there are certain instances where, particularly in suburban markets, where we've learned that particularly large stores may not be as effective as a smaller store in the short run. So, there are some isolated instances where we are considering dropping the size of the store may be by 5,000 or 10,000 square feet. But there is just a few of those cases that we are looking at today.

Jack Mackey

If we get the right size store in a particular market that's in, I mean in urban environment, the paradox is that you would like to get as larger stores as you can, larger stores we can get into, say place like Manhattan or London or Chicago. But they are also the hardest stores to get. So, from a real estate standpoint, it's easier to get larger stores in the suburban areas, but those stores don't tend to do high volumes for us. So, the right sized store for us in suburbs is probably a little bit smaller. So, that's the paradox of it.

But I think in general, I mean we are not going to keep opening the 70,000 - 80,000 square foot stores that we are opening. It's going to be in very selected markets. So, these are going to be in dense urban areas, where there's a lot of college graduates or there's going to be relocations of smaller stores that are highly successful for us. Not looking to open 70,000 to 80,000 square feet stores in new suburban markets where we don't have a market presence. That's a bad bet, too risky.

Steve Chick - JP Morgan

And last question if I could, so related to your comp store sales slowdown and it's encouraging data you put out from the five weeks in May. But I am wondering, we've seen kind of Causal down in trend slow and Starbucks even did a 4% comp and I'm wondering as you look at the categories of where the softness has been, I mean is there anything that could be maybe macro and what you are seeing? And you point out some categories that might stand out maybe between whole body and I mean you have a lot of culinary in your stores, and you use to brag about that the Columbus Circle store being the biggest restaurant, I think in the country or something to that extent, something like that. I mean is it, is there a chance it's correlated a little bit with what we are seeing in other types of outlets?

Jack Mackey

I think we laid it out in the script and the press release. I mean it's -- there are a number of factors, and we don't really, I have said this before I didn't know why our comps grow double-digits, we don't know why they spiked up, we don't know why they go down I mean. [Heck it]. This company always knew that and I suppose we figure out a way to keep growing up the double-digits forever.

Our success has bred a lot more competition. We have a lot more competition today than we had say five years ago. We've seen Safeway come out with your Lifestyle stores and Wal-Mart's selling organic and Trader Joe's is opening up more competitive markets and strong regionals like Wegmans and HEB. I mean Whole Foods faces more competition everywhere in United States than we've ever faced before.

That plus we mentioned the cannibalization effect and then they are probably larger. So a lot of big numbers, let's hope this gets larger you start to revert to kind of the mean that food retailing we are affected by macro trends more than we used to be, particularly as we've penetrated more into a mainstream customer base. We are tracking a little more accurately than we used to basic slowdowns that might be occurring in the economy. So, I think it will always help us to counter those trends I think we counter them less strongly than we once did. But again I mean, I still think our comps are great and they were just spoiled because they were double-digits for three consecutive years but we have 6% comp and it's still better than anybody else I know out there.

Steve Chick - JP Morgan

Okay. Thanks.

Operator

(Operator Instructions). We'll take our next question from Simeon Gutman with Goldman Sachs. Please go ahead.

Simeon Gutman - Goldman Sachs

Hi, it's Simeon Gutman. John just continuing on that last thought. Are you seeing any trading down in your stores from your core customers?

Jack Mackey

In trading down I mean I don't think so. It's more like on the margin, people on the margin well, actually to be completely accurate since our comps were 6% I mean they are 6% higher than they were a year ago. So and that's on top of it of a 12% comp a year before. So it's not like our growth in same store sales has slowed down but they're still growing at a very rapid rate. We are still gaining share, we are just not gaining it as fast as we used to gain. So it's important to understand that, it's not that we're losing customers, so much as we are not gaining them quite as fast as we used to. We were getting a double-digit comp and we were gaining share at the expense of the supermarkets on the margin pretty rapidly and we are still gaining share, but we are not gaining it at the same rate.

So, it's not like people are trading down or that we are losing customers, so much, as we are just not growing quite as fast as we were. That's a very important distinction. I don't think people completely understand. So, on the margin possibly, we are gaining more customers, but on the margin perhaps, that's partly offset by, if there is a Safeway, Lifestyle store like there is in Boulder, Colorado now, may be they don't come to us quite as frequently they were coming to us once a week, maybe they come once every two weeks, some of those customers on the margin. And you see that magnified over the entire country, and our growth is still excellent, but it is not as excellent as it was a year ago.

Simeon Gutman - Goldman Sachs

And then, with respect to mitigating the moderation and something for older stores, is that an issue of getting those stores relocated? Is that cannibalization issue? And then, related to that can you comment specifically on how some of your recently loss, unlike the one in Portland, Preston and Dallas, how those are being performing?

Jack Mackey

Well. Relocations are a sure thing, because we're relocating stores that are already highly successful, and then they just go to a new height. So, we just consider that kind of a low risk EVA bet. So, the answer to the relocation questions, all of the relocations are doing very well. And what was your question about before that?

Simeon Gutman - Goldman Sachs

It was just, with respect to mitigating, what's happening in some of the older stores? How do you fix that, is it just a simple function of relocating it or some of this cannibalization going away in the market?

Jack Mackey

Yeah. What happens is, cannibalization, it's over in 12 months right, because in anniversary the opening of the cannibalized store, and so it's got a lower comparison numbers. So, you don't see that cannibalization from a number standpoint impact of store passed to 12 months anniversary period. And, yeah, we are going to continue to relocate the smaller stores and as we mentioned in the script and in the press release. We do have 24 stores that are being cannibalized, right now, that's significantly higher than any other time in our history.

Those are anniversary. And when they do they stop being a drag on comps. So, we are going to open a lot of stores and we got over 90 in the pipeline now, and they are popping out. We are going to open to 18 to 20 this year. So, there will be some ongoing cannibalization as some of those new stores open up in existing markets, but again the cannibalization is a temporary impact of 12 months.

Simeon Gutman - Goldman Sachs

And just one last one for Glenda, gross margin is holding pretty firm despite some of the new store openings, are you seeing less shrink in some of these new stores or you're seeing just a more favorable mix or is it sold as you expected?

Glenda Chamberlain

Hi. It's pretty much as expected, I mean, that the shrink is higher in new stores than it is in existing stores, is that your question?

Simeon Gutman - Goldman Sachs

Yes.

Glenda Chamberlain

Okay.

Simeon Gutman - Goldman Sachs

All right. Thanks.

Glenda Chamberlain

Sure.

Operator

We will take our next question from Mark Husson with HSBC. Please go ahead.

Mark Husson - HSBC

Yes, I wonder if you could actually tell us what the cannibalization number is. What the effect on sales has been or effects on comparable stores sales? And if the 24 being cannibalized now, what number would that be in six month or years time?

Jack Mackey

Well, it's up to 14 from last year, as quarter to last year, and it was 18 in Q1, so there has been -- in terms of the percentage I don’t know do we have that, do we do an internal estimate on that, that we want to share, Glenda?

Glenda Chamberlain

I think that's good idea.

Jim Sud

Yeah. So, we are going to keep that one to ourselves.

Mark Husson - HSBC

Okay. We will make it up then. And then, as far as the competitive heat is concerned, I mean, if you're opening a million square feet this year, hindsight price remodeling 10 million square feet in Lifestyle stores and that’s just Safeway. Can you actually look at some of these stores like Boulder and say, that's like a Whole Foods opening up next to us in terms of the cannibalization effect on your stores?

Jack Mackey

Well, technically a competitor doesn't cannibalize you. They are not cannibalizing you. They are taking sales from you, but it's not a form of cannibalization, just to be technical about it. If you see these store open up like, I mean I don't want to make a too big a deal out of Safeway in Boulder, because it did impact us, but not super, wasn't like a devastating blow or anything, but it did make us hurt a few percentage points. But, if you do that all over the United States that has an impact.

And these conventional supermarkets are upgrading their stores. They are putting a lot of capital in their stores and they are seeing how successful Whole Foods has been and they are copying us. And they are picking up organic and natural products. We're no longer differentiated on the basis of products.

Trader Joe's has continued to expand in the new market, such as entering the Atlanta markets in 2007. That impacts you on the margin, although we coexist fine with Trader Joe's. On the margin, they do take some sales from us. So, it's a much more competitive environment today than it was 5 years ago. And that just hopefully just got to improve. We've got to get better and we have a number of initiatives to do so.

Mark Husson - HSBC

And final question is, I mean have you had separate meetings inside the business to ask yourselves, how do we design a cost base in this business to deal with 3% to 5% comp stores sales number? Or do you still think that you are going to stay in 6% to 8%?

Jack Mackey

Well, I think we'll stay in 6% to 8% until we don't stay at 6% to 8%. So, we have been doing this business for 29 years and we've never comped really below 5% in 29 years. And I guess it will happen some day and when it does we will probably have to redesign the business model to a certain extent. I don't see that happening in the near future though.

Mark Husson - HSBC

But, your older stores now are 8 plus or below that sort of 3.5% range right now and they've never been there before.

Jack Mackey

No, we didn't track it. We didn't break it out, like that over the long term. We've only been doing that a few years. So, you are comparing it to when, I think we started doing that detailed breakdown in the last five years. So, I don't think your data points are good comparison there.

Mark Husson - HSBC

Okay. Thanks very much.

Operator

We will take our next question from Mark Wiltamuth with Morgan Stanley. Please go ahead.

Mark Wiltamuth - Morgan Stanley

Hi. I just wanted to ask about to Wild Oats transactions. You've had a little more time to look inside the company. Do you have any more insights on --

Jack Mackey

Mark, let me interrupt you. We have not looked any further into the company. We have no more information on Wild Oats than we had last quarter. We haven't peaked under the kimono yet. So, we don't really know anything more about Wild Oats than we knew three months ago other than the FTC has taken a very hard look at it, and hopefully sometime soon, they will start to act on it.

Mark Wiltamuth - Morgan Stanley

Okay. And the timing of the closure of your tender, you have several of the antitrust issues resolved before the tender is closed. Is that correct?

Jack Mackey

Glenda?

Glenda Chamberlain

Yes. I mean, look, there really isn't any additional information we can give about Wild Oats at this time. We hope, as John said, we do hope to have additional information in the near future and as soon as we do, we will issue a press release and an 8-K.

Mark Wiltamuth - Morgan Stanley

Okay. And if the antitrust review is unfavorable, is there's some threshold of divestures where you are allowed to get out of the contract?

Jack Mackey

Yeah. I don't think we want to comment on that. We are going to see how these all unfold and we have to plan our strategy as we go along.

Mark Wiltamuth - Morgan Stanley

Okay, thank you.

Operator

We will take our next question from Scott Mushkin with Banc of America. Please go ahead.

Scott Mushkin - Banc of America

Hey guys. I think I had a quick question regarding the development process of stores and how you allocate costs associated like kind of back-end costs. If you look at a Birmingham, Alabama versus say your 15 store in Boston or something like that. It seems like the costs associated with supporting that Birmingham, Alabama store will be a lot greater than your end of the store from Boston given the facility jab up there. So, how do you view that, and do you take a bigger charge with Birmingham or (inaudible)?

Jack Mackey

Glenda that question didn't come too clear to me.

Glenda Chamberlain

I'll answer it. Owing to the extent that it shows that in pre-opening as people traveling to that site generally for something that's out of the core market area would have higher pre-opening expenses for that reason. But, otherwise, no, we don't allocate regional or national G&A to stores.

Scott Mushkin - Banc of America

I will say Birmingham surprising us is performing far above our initial projection of the store. A.C., do you want to throw any color on Birmingham?

A.C. Gallo

No, we have been pretty amazed. It's way above projections. And it seems to be holding real steady now. The whole town has really embraced the store and we've got a lot of a positive reviews locally from different reporters and which seems to be a real homerun.

Scott Mushkin - Banc of America

And then just one more actually I am following up on some of Steve's question earlier in the call. We are looking at margins and I know you guys went from a five year seven year EVA model and now we're going to kind of a bubble of growth. If we are going to say okay all else being equal on the comps store, they hold flat. Are we just in a period where margins are going to be lower because of this period is this kind of a new reality for the next two to three years, is that kind of a way to look at it?

Jack Mackey

Glenda, again I can't understand for some reasons, Scott's question is not coming clear to me.

Glenda Chamberlain

We look at our new stores on an EVA basis and we did a couple of years ago switch from a five-year hurdle to a seven-year hurdle. And the seven year hurdle still implies return on invested capital, that's comparable to what we are producing now. So, I don't think that implies will see a significant change in return on invested capital.

Scott Mushkin - Banc of America

My question actually is related to the margin drag from them that we're going to, as we wrench square footage back to extended out the models which as over the next two to three years if they hold. The comp store is kind of equal that it will mediate a permanently lower margin or at least extended period of a lower margin for a while to digest this growth. Does that make any sense to anyone?

Glenda Chamberlain

Yes, that definitely makes sense. It's the percentage of sales from new stores increases year-over-year than the drag on your margin from new stores certainly will increase also.

Scott Mushkin - Banc of America

Okay, that's it. Thanks very much.

Operator

We'll take our next question form Greg Badishkanian with Citigroup. Please go ahead.

Greg Badishkanian - Citigroup

Yeah, great, thank you. Just two quick questions. First one is just with respect to the FTC, really no matter how you cut the numbers, I mean whether you look at the overall food industry or just all the channels within the natural food industry, still have less than 20% share. So, I am just wondering, what type of concerns are they actually raising with you?

Jack Mackey

Greg, why don't you volunteer to go testify to the FTC?

Greg Badishkanian - Citigroup

That's okay. Thanks.

Jack Mackey

I'd always sort of like to see listening in on the call, or we'll have a transcript so, which we really don't want to comment on, we don't want to piss the FTC off, it gets a lot of power obviously in the situation. So, I don't know what's going on their minds, could be there's a lot of politics going on, that we are hopefully just out of the loop on, we don't know who has objected to this transaction, and we don't know, what's going on there but, I know you we've gotten some pushback and hopefully, the staff will make a recommendations soon, although they've delayed it a few times and then the FTC commissioners will vote and we'll will have more definitive information at that point.

Greg Badishkanian - Citigroup

Okay, thanks. And second question just, if there is ultimately a strike, like there's some speculation about, what do you think the impact would be on your business? And also what the retention would be if that were to lastly sort of the like one that happened a few years ago?

Jack Mackey

Well, last time there was a strike you told in Southern California?

Greg Badishkanian - Citigroup

Yeah.

Jack Mackey

That certainly was a good strike out Southern California so, I wouldn't object to that, if that was to happen. However, the thing about it is that, that sort of, jet-propelled our triple digit comps. Hope this get a lot of publicity and we gained a lot of momentum and now we are turning to 7% comp, we are turning to 6% comp and everybody thinks our business model is broken. So, it's kind of like if you get high on those comps then they anniversary eventually and peoples they tend to be disappointed. So, I kind of like, if I can just make it automatic, I would have the comps the same every quarter, every year for ever. Wouldn't have that up and downs effect.

But certainly if there is a strike there, it's going to be good for Whole Food. We've got a lot more stores in Southern California now, than we had, when that last strike occurred. I mean, I don't think, I personally I doubt the strike is going to occur because I think there is too much to loose on both sides haven't those guys went through it before but, I keep my fingers crossed.

Greg Badishkanian - Citigroup

Great. Thank you, very much.

Operator

We'll take our next question from Meredith Adler with Lehman Brothers. Please go ahead.

Meredith Adler - Lehman Brothers

Great. I would like to go back to the question about the new stores, the pipelines. You have said that you haven't it’s a one-off kind of situation where you're looking to shrink the stores. But I would like to understand how you really feel about the risk of that pipeline of new stores and compared that to maybe how you felt when you sign the leases and more first identify the properties. Do you think that given slowdown in new store productivity and in comps and higher expenses that these new stores have a greater risk than they did?

Jack Mackey

I mean, we obviously don't believe that and actually don't think there is any evidence for that. On balance, our new stores together that we've opened are, I mean, are all performing above expectations no, there is a bell curve, some performed below, some performed right on expectations some performed above. But on average the new stores are performing according to our projections. So of course there is greater risk today than there was simply because there are lot more stores that haven't been opened yet. So, there are bigger percentage of our total square footages in stores and development, by definition. Therefore, there's greater risk because there is a certain unknown. All we can go back and say is that in 29 years of business, our company never had a store reopened or self failed, over the long-term.

So, you saw the comps, stores that has inner comp base, they will comp at 20% for the quarter so. The new stores are doing fine and we are happy with them. And I think in some cases, we are going to work on our capital side of the business. We want to get our ROICs up on our new stores. I think there's not so much precise as a stores, but I think we are putting a little more capital in some of the, we internally we call it the modest act. Our store in Austin has been so phenomenally successful for us and we've taken some of those ideas and we have shoehorned them into some of the stores that we have in development. And what we've learned is that some of the more expensive venues are not appropriate in all the stores and development. They are appropriate. They have been very successful, in some cases on average success, in other cases are not successful at all in some of the stores.

So, we are going to be a little more judicious going forward in terms of the capital we're investing in stores. But I think as Jim said previously, we have got to hold line of different stores sizes and developments and I mean, in some cases a few stores might be 3,000 to 5,000 square feet or little bigger than we'd like in, but more often in the case there are 5,000 or 10,000 square feet smaller than we would like it. It just depends upon the market. We can't always get the exact ideal size that we would like. And I think that's true of every retailer out there, not from any Wal-Marts.

Jim Sud

Meredith, this is Jim. I would just add to that. I wouldn't read too much into the fact that we are tweaking two or three stores here and there by 5,000 or 10,000 square feet. If you take a look at our overall pipeline of 92 stores and the fact that we are still continuing to add anywhere from seven to eight, nine, ten stores a quarter, we are very pleased with our real estate process and strategy and we are going to continue to try and keep adding source to the pipeline in that manner.

Glenda Chamberlain

Meredith, this is Glenda. I think you could also R&D there, because there is less risk associated with that in new store, simply because Whole Foods is a larger company. We have a lot more experience in more markets. We are better on the buy side. We have better systems disciplines in a lot of cases. So, I totally agree with what John said, but I think that there is another side to be argued there as well.

Meredith Adler - Lehman Brothers

Okay. And then another question, you clearly are making efforts at the margin change, your price image, to what extent do you think that is having an impact on those lower comps?

Jack Mackey

Well, it's having some impact. But again, it's hard to quantify those types of things. I know you guys want us quantify all that stuff, but it's still more an art than a science. And what you don't know is how it changes, because it's dynamic, it's not static. You make a change in prices, the immediate impact when that happens generally is your sales will decline a little bit, because a customer is paying a little bit less for that same product, right?

But, it’s dynamic in the sense that on the margins, somebody somewhere said, hopefully this isn't as expensive as I though it was. I am going to do more shopping. So, it tends to be accretive or increase sales over the long term. So, we are making some investments in selected markets where we've got strong, well, we are going up against the Trader Joe's, for example. We are going to be more aggressive on price and because we are forced to competitively. Or if there's Safeway, Lifestyle store across the street or HEB Central Market or Wegman's in the market and we obviously have to cross our T’s and dot our I’s more carefully. So, it does have an impact. If you want me to give you figure, I don't think we know what it is. And I think if we, I'm not sure if we had that information it would be very accurate anyway. Glenda you want to comment on it?

Glenda Chamberlain

I think your answer was perfect.

Meredith Adler - Lehman Brothers

My final question is, it relates to question that somebody else asked that if you believe that your comp was going to fall to 3%, and I understand you don't believe that, would you take a look at your cost structure. But, in fact, your comps have fallen pretty substantially and I want to know, I would be curious to know whether you've taken steps already to address the cost structure?

Jack Mackey

Well, I mean I really think the most revealing statistics are our G&A did decline as a percentage. It's in fact lower than it's being in the five year average, you look at that. Our direct store expenses and the comp store base went up very slightly, eight basis points. So, they basically were flat and are close to flat and we've explained that that's due to healthcare and workers' comp increases which I think every retailer in the world plagued, United States plagued with.

So, there is not anything wrong with our cost system. The drag is coming from the new stores, because we've got or opening a lot of new stores. And that's accelerating and that's having a drag on our drug store expenses. So, we have a very good model that produces very high returns on invested capital on a store-by-store basis. Hopefully this model, it's not broken, it's working very well.

Meredith Adler - Lehman Brothers

Allow me to quibble little, but you did say that even on the newest stores, direct stores expenses were higher than you had anticipated?

Jack Mackey

I don't know that we say that they were higher and they were anticipated.

Glenda Chamberlain

We did say that the same line items, healthcare and workers' comp were higher than we had anticipated for all stores including new stores.

Meredith Adler - Lehman Brothers

Got it. Okay. Thank you very much.

Operator

We'll take our next question from Andrew Wolf with BB&T Capital Markets. Please go ahead.

Andrew Wolf - BB&T Capital Markets

Good afternoon. Just on the guidance change. Glenda, if the sales are getting a little better, then why not, I can understand some reluctance given the way the year is turning out. But, when you expect a little better leverage, offsetting these unexpected increased costs and the benefits in the workers' comp, so little better results on the profit line of the second half, I am just trying to understand, are you just being conservative because it's been only a month of better sales?

Glenda Chamberlain

We do hope that you are correct, yes. But, after any information to the contrary yet, we thought the most judicious thing to do was to just say that we expect the second half of the year to be comparable to the first half in that respect.

Andrew Wolf - BB&T Capital Markets

And the other two questions I want to ask you about are about product costs, which using some government statistics and stuff and talking to other folks, it looks like there is a lot of inflation at least in conventional products and sometimes natural organic products don’t necessarily jibe with those. Looking at your LIFO index or your LIFO chart I should say, which was the same as last year, should we infer that there wasn't that much inflation for Whole Foods product cost?

Glenda Chamberlain

Well, the LIFO charge certainly is greatly dependent upon the CPI index that's built into the calculations along with several other factors. So, we didn't see anything significant in the CPI index different than it was last year.

Andrew Wolf - BB&T Capital Markets

Okay. And lastly how about the scallops, the freeze and citrus products and other things in California, just having to by those products in procurement high costs, does that have an impact on the quarter?

Jack Mackey

A.C. or Lee, you want to comment?

A.C. Gallo

I will. Andy, there were shortages of some citrus products in California, in maple oranges and a few tangerines, but it didn't really have a material impact on us. There was a little shortage of strawberries for a while in the early spring and artichokes started a little late. But they may have cost us a little bit of an impact in sales for sure, for may be a month to six weeks. But it's rebounded nicely there. So, we didn't see a significant impact on our business.

Andrew Wolf - BB&T Capital Markets

Okay, thanks. And I would assume that part of the rebounding means there is plenty of supply and the pricing tend to normalizing on those products?

A.C. Gallo

Yes. That's right.

Andrew Wolf - BB&T Capital Markets

Thank you.

Operator

And we'll take our last question from Chuck Cerankosky with [ATS] Midwest. Please go ahead.

Chuck Cerankosky - ATS Midwest

Hello, everybody. I wanted to just talk about your interest in improving your return on capital and looking at various sizes of stores. Could you envision markets where you have some larger stores and sort of smaller sale like stores to improve the overall return on the investment in the real estate?

Jack Mackey

I could imagine that, sure. That's the way it is now.

Chuck Cerankosky - ATS Midwest

All right. Thank you.

Operator

That concludes our question-and-answer session today. I would now like to turn it back over to John Mackey. Please go ahead.

Jack Mackey

Okay. Thanks for listening in. Visit our website for a transcript of the scripted portion of this call. A recording of call will also be available online through a link on our website at www.wholefoodsmarket.com. We will talk to everyone next quarter. Take care.

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Source: Whole Foods Market F2Q07 (Qtr End 4/8/07) Earnings Call Transcript

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