As I had anticipated earlier this month, Whole Foods (WFMI) (40.75, $5.7 billion, S&P 500 member) disappointed investors yet again. Since peaking in late 2005, the stock is now down almost 50%. While same-store sales were actually a bit stronger than I had expected, profitability was significantly lower than anticipated. I had thought that many investors were excited about instant gratification from the recent large acquisition of rival Wild Oats, but that isn’t the case. As always, the conference call was quite interesting. The comment that struck me the most is that CEO Mackey doesn’t believe the company is a luxury retailer. This is the same guy who over the past few years has told us it isn’t a grocery store either. Of course, he also has admitted in the past to not knowing why the same-store sales had been so strong in the early part of this decade or why they had suddenly weakened last fiscal year.
Rather than rehash my views on the stock (too expensive relative to growth prospects amidst rising competition and a challenging macro-economic environment), I would like to discuss that WFMI actually is a luxury retailer and increasingly a grocery store (in the negative sense of that term).
One of the myths out there about Whole Foods Markets, I mean, is that we are some kind of luxury retailer and we get once in that category and whenever the economy gets weak everybody comes out and says: “gosh, Whole Food sales are going to fall”. However, that's never been the case. We've been doing this for 29 years and every time there is a recession our sales don’t fall, in fact, during the recession our comps went up into double-digits, they increased during the recession.
John Mackey, CEO in response to a question by Simeon Gutman of Goldman, Sachs
Source: Transcript provided by Seeking Alpha
First, how can WFMI not be a luxury retailer (if not a high-end grocery store)? The company physically resembles a luxury retailer in terms of its appearance (marble, good lighting, display). Second, in the categories in which it competes, it tends to offer the highest quality products. Finally, check out all of the “luxury” automobiles in the parking lot – guilt by association! As far as discussing the last recession, it was a capital spending recession not a consumer recession as this one is/will be. The prior recession was in the early 90s, when the company was so small it isn’t relevant to anticipating how a weaker economy might affect demand at its stores.
Grocery stores are traditionally a safe-haven during times of economic weakness due to the ongoing demand for food no matter what. While Mackey has suggested that WFMI isn’t a grocery store, they really are. They were a completely different type of grocery store, but many of the more traditional ones have learned from some of their remarkable business practices. While being a grocery store in a recession isn’t such a bad thing to be, I would argue that it is if you have a 27PE. I can remember evaluating WFMI earlier this decade, and one could argue that it really wasn’t a grocery store in terms of margins and balance sheet. 7 years later, that is clearly a questionable statement. In the most recent quarter, this is what it looked like:
WFMI still maintains higher GM, which has been constant over the past several years. The EBITDA margin has dropped due to the recent acquisition. Even adjusting though, the two other large chains have expanded their profitability over the past few years, while WFMI has not. WFMI, historically known for its superior capital structure, has downgraded its balance sheet significantly in buying Wild Oats. 2007 had been described by management as a “transition year” for WFMI, but clearly 2008 is as well, with EPS forecast to be up single-digits and well below the other two peers. Will investors continue to pay up so much in advance of the return that is continually pushed out?
I am sticking to my view that this is a horrible time to be a shareholder at WFMI. The earnings estimates are probably going to continue to decline. The PE will almost certainly decline. The company is expanding too rapidly (beyond just the big acquisition) while not having a better handle on its existing base of stores. Capital spending next year is supposed to be about $600mm, which is a massive number in comparison to the operating cashflow that the company will generate. I expect that the stock will trade in the next year between 44 and 31, with a year-end 2008 price target of about 35 (1.60EPS-FY09*22PE).
Disclosure: Short WFMI
