I just returned from Whole Foods (WFMI) and feel compelled to reverse my long-term publicly-expressed bearishness on the stock. I first shared my negative thesis in March 2007 in an article that generated some disagreement. The main points of the article:
- EPS growth would fall short of 20% projections
- OATS merger made little sense and was risky
- Increased competition was a real threat, especially in light of weakening economy
- My belief that the firm needed to cut prices to maintain or grow same-store volumes
- Too high of a valuation for "value" investors
I concluded 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." I followed up that original article in July (where I was also quite negative on Starbucks (SBUX)) and then twice in November (before FY07EPS and after FY07EPS).
When you contribute as often as I do, you are bound to get one or two right and one or two very wrong (which I have!). My point is not really to pat myself on the back for nailing this one for seemingly all the right reasons, but rather to determine if what I had projected has played fully out leaving the stock quite possibly now undervalued. The stock did fall more than I ever anticipated, but the results did too. When I wrote that first article, analysts had expected the company to earn $1.69 per share in Fiscal 2008, which is now almost complete. With two quarters to go (they report Q3 8/5), analysts now expect the company to earn just $1.16. The FY09 estimate has declined from $2.04 to $1.59 in those 17 months as well.
As you can see in the chart below, the PE has plunged as well:
As I mentioned, what I saw at the store made me think a little more urgently about what I already believed to be the case: The stock is done going down.
I will share the advice that I gave a friend of mine on Friday: Double up on your shares and hold the extra shares for at least 31 days (to then take the tax-loss on her existing shares). This was the same friend who I had warned back in November 2006 not to buy the stock.
WFMI has gotten very serious about offering better value to its customers. I never believed that the company was overcharging, but the competitive environment and the very tough economy necessitated changes. The company goes out of its way to highlight "great deals" throughout the store. It has started coupon advertising in the local newspaper to encourage customer traffic. It has implemented several brand new loyalty card programs (though, unfortuntely, paper-based), rewarding customers for frequent purchases of coffee, flower bouquets, vitamins, fresh bread, etc. No doubt any analyst worth his weight in salt will recognize that these programs will come at a cost of permanently lower margins, but that is reality. In a nutshell, I recognize that the company is facing reality.
So, what about the numbers? I don't profess to have a long-term model or to be in a position to suggest that the earnings aren't still going to be under pressure. Valuation, though, has become much more realistic, with the PE now at 15X, the lowest in history. While the balance sheet isn't as nice as it used to be, it's not so bad either relative to peers in the industry (grocery stores, restaurants and high-end retailers). Here are some representative PE ratios:
- Kroger (KR): 13.4
- Safeway (SWY): 10.8
- Panera Bread (PNRA): 18.7
- Cheescake Factory (CAKE): 12.0
- Coach (COH): 11.1
- Costco (COST): 19.0
- Starbucks (SBUX): 16.1
The point is that one certainly isn't paying up a lot for WFMI any longer. Another consideration is that the company is generally a significant cash-flow generator. It has ramped up Capex lately due to expansion and the Wild Oats merger, but that will slow again. The company already pays a large dividend (3.55% yield), but its payout ratio is a rather high 69%, so I don't expect the dividend to grow significantly faster than earnings. The company could, however, use FCF to repurchase stock in FY2010, which would be a first.
Unlike SBUX, which is clearly saturated, WFMI can still grow "organically" as well. My belief is that their expansion strategy should be more measured until there are clearer signs of better in-store productivity. This next chart shows that the company has seen tremendous margin erosion, though its returns on capital are still respectable. The valuations, using Enterprise Value, highlight again how inexpensive the stock has become:
As I previously stated, margins are not likely to ever be as high as they were. Still, though, they could expand significantly from here as the stores mature and Wild Oats integrates better. Even without significant expansion, valuations could certainly improve. I believe that the recent print near 20 will prove to be the bottom and that the stock has a decent chance of retracing a large portion of its decline in the coming months (call it 28-30). I intend to watch the stock closely between now and the company's next report, perhaps going long before the numbers are released. I have always loved the company, and I am now warming up to the stock.
Short-interest is massive: 25mm shares, up 50% from when I last wrote in November. In Q1, the investor base shifted dramatically, with value-oriented Davis Selected Advisors adding 5mm shares and several other large buys and sells. I anxiously await the Q2 data - it would be nice to learn that some capitulation was behind some of the massive selloff during the quarter. Insiders haven't been selling and appear to have been exercising expiring options. I like these dynamics. From a trading perspective, 28-30 seems rather realistic. From a longer-term investment perspective, though, the rewards could be much greater. For FY2010, if I assume that the analysts 2009 estimate is correct and that sales can grow 10%, the company should see sales of about $8.5 billion. The current EPS consensus for FY2010 is $1.92. A year from now, that number will represent the one-year out estimate.
Is it reasonable? If we assume a 4.5% pre-tax margin, that generates about $1.64 per share in earnings, so that seems a bit aggressive to me. I believe that the PE ratio, though, could rise to 20X as growth begins to pick up again over the next year, yielding a 33 target. Maybe sales grow faster, maybe margins do a little better than I expect. Still, 33 represents a 50% return over the next year, making this one worth some extra due dilligence.
Disclosure: No position in WFMI.
This article has 16 comments:
Wish I had been watching WFMI much earlier, but I do not think the pain is over. Yes, I see they are trying to point out bargains at the stores, but this will be too little, too late.
Example: I stopped buying wine at Whole Foods. I could not find a decent bottle for under $15, which is way over the "everyday bottle" level for me. The 365 label bottles are not drinkable. At Trader Joe's, I found a delicious Bordeaux for $7. I bought 5 bottles of it.
Sure, in some areas Whole Foods has a better selection, and Trader Joe's can't compete in the meat department. But I have found some amazing cheeses at Trader Joe's that must be half as much as Whole Foods.
I think Trader Joe's is shrewder at selecting items with value.
$29.99 per pound for high grade salmon??? WTF? I'll go out to a fine restaurant in L.A. and get a salmon entree for that much. $10 for a small piece of Parmesean? Too, too much for me. And I thought I would never think twice about spending $ on food. If I am at my breaking point, there must be lots others.
WFMI morphed into a luxury brand. Can a large scale supermarket chain thrive as a luxury brand in a recession? We will find out soon enough.
On Aug 01 10:31 PM Alan Brochstein wrote:
> 2X as much? Sorry, the margins just aren't that great to be accurate.
> Are you saying that the same thing costs twice as much, or are you
> suggesting that the quality is such that the price points are higher?
> I don't believe that the dynamics have changed much on the competitive
> front - the 50% off price on WFMI is just a reflection of what the
> market didn't seem to realize a year ago. No, WFMI isn't a bargain
> because it has fallen 50%. It will take 4-6 years to get back to
> the 40s.
I find the 365 wines just fine for my palette and pocket. The 365 organic label and bulk items are the core of value shopping at WF.
On these items WF can compare favorably with anybody.
Yes, you will find wild caught salmon for over $20/lb. Again there is no comparison to farm raised salmon in most any restaurant.
Just because WF carries a lot of ultra high end items they get the the prohibitively expensive label. We too quickly delude ourselves into thinking we can't afford food without pesticides, antibiotics and steroids. Our grandparents didn't settle for less. Why should we?
In my analysis (and shopping) I try not to get distracted by the really high end stuff alongside the 365 brand stuff. Still, I think it is priced well above TJs.
I have bought sushi for lunch at TJs -- at least as good at WFs but almost half as expensive.
Yes, much of the Whole Foods stuff is better. Some of it TJs does not even carry, like the high end meats.
But for more and more people, they will do without the really high end stuff and find healthy food at TJs for much less.
Personally, every once in a while I will pick up $20-$30 per pound fish to cook at home. But other than that I have no need to go into WFs anymore.
On Aug 03 11:06 PM Dave Y wrote:
> My shopping experience at WF is quite different . Forgive the grocery
> metaphor but comparing TJ to WF is apples to oranges. When I shop
> at TJ I spend far less than half my WF bill because they have very
> few things that I want. Virgil's Root Beer is consistently cheaper
> there (I'll give you that).
>
> I find the 365 wines just fine for my palette and pocket. The 365
> organic label and bulk items are the core of value shopping at WF.
>
> On these items WF can compare favorably with anybody.
>
> Yes, you will find wild caught salmon for over $20/lb. Again there
> is no comparison to farm raised salmon in most any restaurant.<br/>
>
> Just because WF carries a lot of ultra high end items they get the
> the prohibitively expensive label. We too quickly delude ourselves
> into thinking we can't afford food without pesticides, antibiotics
> and steroids. Our grandparents didn't settle for less. Why should
> we?
It is easy to think in just all or nothing terms and conclude that a grocery store that is high-end focused will suffer indefinitely. That rules out that most of us aren't losing our jobs, aren't facing soaring mortgage costs, etc. As I stated in the original article, I believe that a lot of bad is now priced into the stock. The company, in my opinion, has finally adapted to the tougher environment. While the cost is permanently lower margins, the company can still grow significantly over time.
A lot of what they are doing is pure marketing to convince consumers WFMI is affordable. Other parts may be real re-positioning. The problem is that they need to move towards a TJ emphasis on value. TJ kills them there. TJ knows where to find the stuff that is good and has value. WFMI's buyers seem less capable of this.
It will be fun to watch. Not an encouraging WSJ story today, but WFMI holds up.
On Aug 04 09:08 PM Alan Brochstein wrote:
> We can argue all we want about what people want, how much they are
> willing to pay for it, etc. Yes, there is clearly something cheaper
> at TJs and something better but more expensive at WFMI. I have been
> shopping at WFMI for 14 years and know the company very well as a
> customer. I don't shop there exclusively, and I actually prefer
> Central Market (owned by a great perhaps the best supermarket chain,
> privately held HEB). I have no bias one way or the other - I shop
> at Kroger, Randall's (Safeway), and HEB. I have always been fascinated
> by the grocery business. This much I can tell you - Whole Foods
> has moved even more towards the "value" orientation. They have always
> offered tremendous value in their 365 private label, and their prices
> on a like for like basis have always been somewhat competitive.
> Dave Y is correct in his assessment about why the company gets its
> "expensive" reputation.
>
> It is easy to think in just all or nothing terms and conclude that
> a grocery store that is high-end focused will suffer indefinitely.
> That rules out that most of us aren't losing our jobs, aren't facing
> soaring mortgage costs, etc. As I stated in the original article,
> I believe that a lot of bad is now priced into the stock. The company,
> in my opinion, has finally adapted to the tougher environment. While
> the cost is permanently lower margins, the company can still grow
> significantly over time.
It is easy to find competitors such as the one you mention that can compete with PART of what they do, but they tend to either not offer one-stop shopping or don't have the service level that customers value as well. I disagree with you about value, and this is coming from someone who has been a customer for 14 years. We even buy our laundry detergent there. I NEVER thought that I would be able to buy a staple like that, but there are so many affordable staples that they do offer (again, higher quality than mass-marketed products). In this case, though, the per-use is both cheaper and better than Tide, etc.
If I am wrong about WFMI, the stock will go up, because I will be eating a lot of the 365 beans!
I guess that for those looking for organic/high quality but that have to pay attention to their expenditures, Trader Joe's does better at stocking its shelves with affordable, interesting, healthy items. (No, TJ's does not have some of the high-end stuff.)
WMFI can try to compete with its 365 items, but I do not think that they are enough when compared to what TJ offers.
Personally, I will continue to use Whole Foods for meats and certain produce/vegetables. I am trying to find as much as TJ's as I can for purely monetary reasons.
On Aug 05 05:37 PM Alan Brochstein wrote:
> I bought the stock pre-market today and then sold it, too early (22.35).
> After they reported, I purchased stock below 20. My guess is that
> it pulls a COH or SBUX and has an ok day tomorrow.
>
> It is easy to find competitors such as the one you mention that can
> compete with PART of what they do, but they tend to either not offer
> one-stop shopping or don't have the service level that customers
> value as well. I disagree with you about value, and this is coming
> from someone who has been a customer for 14 years. We even buy our
> laundry detergent there. I NEVER thought that I would be able to
> buy a staple like that, but there are so many affordable staples
> that they do offer (again, higher quality than mass-marketed products).
> In this case, though, the per-use is both cheaper and better than
> Tide, etc.
>
> If I am wrong about WFMI, the stock will go up, because I will be
> eating a lot of the 365 beans!
I like you have been short WFMI since the stock was in the mid 40s. I covered 1/2 my position @ 29 and I still have 1/2 of it left.
Since your arguments (both long and short) were based a lot on PE I don't know why you would by more after hours @a little less than 20. Given WFMI new guidance of .94 earnings a stock price of 20 puts the PE at 21.28, seems significantly higher then their peers, and one that I have a hard time justifying since they just guided their growth rate down from 25-30% to 6-10%.
So if before the report you were hoping for :
"After the report I believe that the PE ratio, though, could rise to 20X as growth begins to pick up again over the next year"
Why would you jump @ a PE over 21, above where you hoped it would go, with the growth rate not rising but getting sliced down to 1/3 of what it was projected be?
I am looking for a bottom to cover the rest of my shares and think I'll find it somewhere below 18. I am interested to know why you think this is a good buy at 20 after that atrocious report which was worse than I or I'm sure you anticipated.
random user, I didn't mean to imply that I was looking for a magic PE. Frankly, I don't pay that much attention to PE when stocks have seen their margins get hammered. I wasn't that surprised by the chop to earnings, though the extent may be greater than I thought. In the original article, I indicated that the earnings estimates were too aggressive. I don't think you see below 18. I am a better analyst than trader, but not such a bad trader. I did buy a little last night, but a lot this morning, some as low as 18.25.
You ask a great question - "why is it a good buy at 20 after that atrocious report", and yes, it was worse than I anticipated. They cut the dividend, which is smart. They are scaling back near-term expansion, which is smart. They are setting what I believe is realistic expectations (low single digit s-s-s). This is all stuff that should excite a value investor, the kind of guy who likes to dig in the garbage can. I generally don't play that game, but I believe that the WFMI franchise is actually quite valuable and many investors have been looking to establish new positions. We have already seen a lot of the growth investors flushed out over the past year. I stick to my expectation that the stock can see 28-30.
I absolutely love going from short to long on a story. Rarely can one do that successfully on a dime. It also doesn't always work. In the case of WFMI, I came into the report with no position, so I wasn't married to it one way or the other. I guess I had a bias to want to own it, so that may be ther fly in the ointment. I think I addressed your question, but big picture, I was hoping to buy bad news. I actually feared that I might have to pay a HIGHER PRICE, as what happened with SBUX. In this case, I have a feeling that a lot of investors who care about dividends had to run for the hills...
Are there better investments? Certainly for the intermediate to long-term. This is called playing the dead-cat bounce, which I think can yield say 20 (a 25% short-term return). My one-year out view is something a bit higher, but, as you said, not the "best" long.