Whole Foods Market: A Hidden Opportunity

| About: Whole Foods (WFM)

Summary

Investor sentiment for WFM is low, which has caused the share price to drop almost 20% from this year's high.

I don't think share price can feasibly drop any lower than $25 in the short term.

If WFM's new brand, 365 Everyday Value, takes off and produces good sales numbers, we could have the potential for large gain with relatively low underlying risk.

Whole Foods Market (NASDAQ:WFM) is generally considered by many to be unsavory, and given their apparent mediocrity, it's easy to see why. I don't necessarily think highly of this company for investment purposes, but I also think that WFM is undervalued right now and deserves another chance.

WFM is a high-end grocery store that has suffered because of their select niche and lackluster execution. They offer very controlled, humanely cultivated, 'organic' foods. I personally hate the organic label, but it gets sales. And even if the organic label is ultimately a marketing ploy, WFM still offers the 'most organic' selection there is in a supermarket setting. They are "the United States' first certified organic grocer." You would be hard-pressed to find anything more strictly guaranteed to be organic, pesticide/antibiotic/hormone-free, etc.

  • Background

Ridiculously volatile. This past year alone WFM has seen 15-20% swings almost monthly. Unappealing performance coupled with volatile markets have given investors little reason to keep their money in a vehicle known to crash on whims.

A 1-year graph from Google Finance showing WFM Click to enlarge

Investors are scared of an interest rate hike because of natural opportunistic certainties that arise from such an event (or the knowledge of likely future events). With investor sentiment as low as it is now for the entire market, it's not impossible to think WFM could crash even further with or without a negative market day.

I think these negative reasons, however, make WFM undervalued, and that even marginally good news will propel share price.

The economy is still doing great[1]. People are spending more money[2] and have more money to spend[3] as well. General economic outlook, at least among the middle class and above, is positive.

[1] Unemployment Rate (U3 national standard) is a general indicator of economic health. The current rate is very low by historical standards. We can expand this statistic to show other unemployment standards, such as U4-6 unemployment rates, but the general trend remains the same.

[2] Consumer Price Index estimates the amount of money (on average, presented as month-by-month net change) people spend on traditional consumer goods.

The raw values for Consumer Price Index, showing that the increase in recent years has been much more dramatic than prior. Click to enlarge

(Raw values for Consumer Price Index, showing that the increase in recent years has been much more dramatic than prior.)

[3] Average Hourly Earnings is a much stronger indicator of wealth when coupled with unemployment rates and consumer price index.

  • Negatives

WFM offers a specialized selection but carry some major faults in how they run their business and in-store experience. If you've ever been to a WFM, you would realize that simply picking something out is made unreasonably difficult. You can do a simple Google image search to see how aisles are stacked with items.

Trader Joe's and Costco are also specialty stores, but they don't stock over 10 brands for each specific type of item right next to each other. Choosing is difficult when given multiple options that aren't better or worse than each other by a significant margin, and this is an area where I think WFM has failed in bounds. WFM is already destroying their profitability by wasting money on items they could very easily remove without losing the customers that come along looking to buy said items. Not only that, but they're offering a stressful shopping experience to customers who have more than enough specialty stores to give their money to.

If WFM could specialize their niche further and cut down on wasteful selection, I would be extremely confident in the company's ability to succeed.

And this point leads to…

  • Positives

WFM recently opened up their new store brand called 365 Everyday Value. These 365 stores are attempting to address exactly the issues I explained above. They also have ridiculously good sales on high quality items. I don't know if WFM will be successful in this venture, but having seen the improved and reduced selections online for these 365 stores, I think that WFM has a very good chance to regain investor trust.

A sale in one of the 365 brand stores showing 12 ounces of high quality, humanely farmed beef on sale for $12 Click to enlarge

(A sale in one of the 365 brand stores showing 12 ounces of high quality, humanely farmed/raised beef on sale for $12.)

The first three 365 stores have only just been revealed, but WFM plans on building many more. These 365 stores cost less to make, maintain, and staff because of their reduced property size (a lot smaller than traditional WFM stores) and curtailed item selection[4].

[4] WFM's 3rd quarter earnings report shows that an average 365 store is much smaller than a traditional WFM store. The company also has leases for twenty 365 stores as of YTD.

Numer of new leases for both WFM traditional and 365 brand stores. Also shows the square footage of these properties. Click to enlarge

(Number of new leases for both WFM traditional and 365 brand stores. Also shows the square footage of these properties. )

Furthermore, we can see that newer stores (<5 years old), whether or not they're of the 365 brand, are still generating increasing profit YoY. Older stores are bringing down the YoY average so the overall sales numbers show only part of the story. We can therefore expect that WFM's 365 brand will perform as well or even better than these newer stores.

From WFM Click to enlarge

  • Profit expectations

If WFM's 365 brand takes off and reports good numbers in their upcoming earnings report (not until November 2nd), I think share price will move up to $35 easily. The company is very volatile and $35 was WFM's share price during the months of June and July this year, which is a large reason why I'm offering such an increase. Just between now and then, share price could probably undergo $10 swings with no news whatsoever. However, if this positive scenario is correct, I think that $35 could be established as WFM's new theoretical floor.

  • Loss expectations

Potential loss is a bit hard to say. WFM can't really crash too far below $28 if they keep up with what they're doing. Their very short-term price floor is probably around $25 because share price can only drop so low without negative news to back it up.

Despite a crash in share price, WFM has continued to profit and presents respectable numbers regardless. As per their annual earnings reports, WFM posted an EPS of 1.51 in 2015, 1.58 in 2014, 1.49 in 2013, and 1.28 in 2012. We know from their projected annual report, also presented in the recent earnings report linked above, that WFM will have an EPS of around 1.55 this year. Dropping below a share price of $25 with average and expected performance would be unlikely.

The company currently has a market valuation of 9 billion dollars and an annual net revenue of around 550 million dollars. If we compare WFM to a company like Kroger (NYSE:KR), Kroger has a market cap of almost 30 billion dollars and annual revenue of 2 billion. These ratios are well in line considering Kroger is also well established and more stable than WFM, but also has less room for potential growth.

Without any further improvements in business model, and a good or improving economy, WFM's revenue will stay relatively stable and generate profit. And this is without innovation, which we know WFM is pursuing.

I think the current share price of $28-29, while not the lowest WFM can drop in the short term to, is still a fairly decent investment opportunity. We already know what WFM will announce regarding annual EPS in their 4th quarter report. What we don't know is how the 365 brand will perform. In the case these new stores do not perform well, I do not expect WFM's share price to drop further because it is very unlikely that a beat from these stores has been priced into current valuation. Looking at the initial release of 365, WFM share price actually went down.

This is a simplistic approach, but you would be hard-pressed to find a stable company that generates over 500 million in yearly revenue and is valued at less than 8 billion dollars. If market valuation drops to 7 billion dollars, WFM would have a share price of roughly $22 and a P/E ratio of 14. For a small and growing company, this would be very low. I do not believe investor sentiment has fallen that low.

With any investment at all, potential of risk should be equivalent to potential of gain. Share price for WFM, especially in response to a general market crash, could easily dip below $25. I personally expect $25 to be the theoretical short-term floor and $22 the hard short-term floor, but this prediction could be incorrect. You can always wait to buy shares and hopefully get a better position. 4Q earnings report isn't until November, so there is plenty of time and no need to rush.

I bought options last week anyway because I have this hunch that major hedge funds stalk my posts and follow my advice religiously.

Disclosure: I am/we are long WFM.

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.