Whole Foods Market (WFM) is set to report earnings after the market close on November 7th. It is currently trading at $97.30, more than 4% off of its all-time high set in October. The stock is trading at a very high forward PE multiple of 33.8 and has a PEG ratio of 2.2 -- expensive by any measure, and implying a growth rate of 15%-16%. Yet I am long Whole Foods and will remain so for the foreseeable future, as the company is poised to continue to increase revenue while expanding margins.
Whole Foods is a juggernaut in the natural and organic foods space, and I believe its top-line growth will continue to increase at 9%+ per year. Its LTM revenue according to management in Q2 was $11 billion, up 9% YOY -- in line with its 5 yr. CAGR. The market research publisher Packaged Facts, projects U.S. retail sales of natural and organic foods and beverages to exceed $78 billion by 2015, up from $39 billion in 2010. Whole Foods' revenue was $10.1 billion at YE 2010, or ~26% of the natural and organic foods market. This implies that if it grows revenue 15% to 16% per year through 2015, its share of the total natural and organic foods space would decline by about 3-5 percentage points.
A small decline in market share does not seem unreasonable, as one would logically expect other large retailers to move aggressively into this growing market. According to the Economist, Walmart has been "reaching for the yuppie dollar" by offering organic and "all natural" products as far back as 2006. However, I think it is also possible that Whole Foods could gain share in the space, or that the size of the natural and organic foods pie could grow faster, and become even larger than currently projected. Given that Mayor Bloomberg has successfully restricted the sale of large, sugary beverages in New York City, it is very possible that concerns over obesity, hormones and genetically modified food (see California Proposition 37) will be a huge boon to the natural and organic foods market. As of August, there were 316 stores in the U.S and management believes they can build 1,000 with its revised strategy.
In addition to driving top-line growth, Whole Foods is working efficiently to increase margins by reducing costs and investing in lower prices to drive volume. Whole Foods has developed a smaller footprint that enables it to expand aggressively into small markets, including cities like Des Moines, IA (pop. 570K), Wichita, KA (pop. 350K) and Lincoln, NE (pop. 250K) - while maintaining comparable rates of return to existing locations. Although reduced-sized stores do not carry the same depth of selection as the larger ones, Walter Robb, co-CEO, states in this video feature in Business Week magazine that a reduction in store size typically leads to a smaller selection of each type of product, rather than the removal of entire product categories. What is missing from the smaller stores are some of the dine-in restaurants, cooking classes and other ancillary services that Whole Foods has added in recent years - as well as the additional square footage and labor costs required to operate them.
Whole Foods' growth vehicle of choice is a store of 38K - 40K sq. ft., rather than the 50K-70K sq. ft. prototype it was building five years ago. The result is accelerated new store growth and an increased return on invested capital (ROIC); Robb has said that Whole Foods has been able to increase ROIC to close to 15%, compared with 6% in 2007. According to Retailwire.com, the six new stores opened during Whole Foods' fiscal first quarter ended Dec. 31, averaged 38K sq. ft. and produced 29% higher sales per sq. ft. ($776) versus the prior year's new openings. New stores also produced about 450 basis points higher store contribution versus the prior year's class, and in many cases benefited from lower build-out costs, lower rent, and lower utilities and taxes.
Smaller stores also allow the company to invest in lower prices. In a speech in June, John Mackey, co-Founder and co-CEO, said "We're going to continue to try to make ourselves more and more competitive on a price basis, and that's the great thing about leveraging occupancy costs [with smaller stores] - it gives us more wiggle room to be more aggressive on price." The company's focus on price appears to be paying off. In September, Wells Fargo Bank said it found during a study that Whole Foods' prices beat those of Safeway (SWY) by 7% on a basket of 100 items. The study also found that Trader Joe's prices were 4% lower than those of Whole Foods, but Whole Foods beat Sprouts Farmers Market by 3%, The Fresh Market (TFM) by 14% and Amazon Fresh (AMZN) by 27%, in addition to Safeway. The lower prices are also partly a result of a decentralized management structure that empowers regional managers to set prices based on market demand.
Whole Foods is a great long-term investment because it is positioned to benefit enormously from secular trends around healthier living and eating, and its management's execution of revamped development and pricing strategies. Additionally, Whole Foods has roughly $1.5 billion in cash on its balance sheet for investment in growth and/or an increased dividend and the long-term prospects of international expansion. In a presentation given by Robb in August, he said Canada has the potential for $1 billion in revenue over the next 10 years; currently there are only seven stores in Canada with four in development. I believe the Canadian market could present a huge opportunity for natural and organic products -- after all, it is home to Lululemon (LULU) -- and there is currently zero upside from international growth baked into the stock.