Whole Foods Market (WFM) was not on my investment radar. I didn't look into the company as an investment until I was on a family vacation. We should all strive to work past our biases, but it seemed a store catering to middle and upper class customers would receive too much shareholder support to be attractive based on the fundamentals. This is a simple concept with people thinking more about the companies where they spend their money.
Whole Foods Market Used to be Expensive
My theory would've been right for years, but as shareholders know, prices came crashing down. Investors suddenly soured on Whole Foods Markets.
The company saw shares crash twice in the last five years. Once was spanning late 2013 to early 2014 and the other was around the middle of 2015. Those share prices didn't just decline, they cratered. We can tell at a glance that this wasn't strictly about earnings because the P/E ratio was flying along with the share price. The major problem is that trading at a grocery store at over 35 times earnings doesn't make sense. Seriously, the grocery sector is not undergoing some massive innovation that will cause profit margins to explode. If profit margins won't explode, how will earnings grow substantially? Revenue is also unlikely to climb suddenly since there is no catalyst for dramatically higher volume. Sure, investors might have believed more customers would shift to WFM, but that theory clearly failed.
Was There a Better Way to Value Whole Foods Market?
I believe there was a fairly simple strategy and I believe it is the metric that is providing support for WFM around current prices. That metric is EV to EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization). Take a look at the chart showing the last 5 years of the EV to EBITDA for 3 major retailers:
The two companies shown with Whole Foods Market are Target (NYSE:TGT) and Wal-Mart (NYSE:WMT). I added both of these companies to my portfolio in 2016. They are both dividend champions with excellent track records on revenue, earnings, EBITDA, and they both fell out of favor with investors. I wasn't interested in either of the retailers when share prices were high. It wasn't until investors scorned them and tossed their shares into The Bargain Bin that I started buying them.
Now I'm interested in Whole Foods Market. I'm not interested in it on any glamorous terms. I don't see the company as being incredible, or having some enormous fundamental growth in the near future. What I see is a company that investors frequently overvalued that is finally trading based on the fundamentals. There is a substantial possibility of a move higher in the share price over the next few years if those optimistic investors return. Meanwhile the downside risk should be substantially limited. I'll be doing more research on the companies plan for growth before I commit to this vision, since I want to be wary of any potentially terrible plans. Since WFM experienced a dramatic decline in the growth rate of same store sales, this topic will require thorough research.
It should be pretty obvious that Whole Foods Markets now trades only slightly above Target and Wal-Mart on the metric of Enterprise Value to EBITDA. Previously, they often traded around 9.5 - 19 times EBITDA. Even the hard shell off in the middle of 2014 did not bring them below an Enterprise Value to EBITDA ratio of 9. Some investors may be concerned about catching a falling knife, and there certainly is still some potential for Whole Foods Markets to decline further. At this point it simply appears that the upside is dramatically larger than the downside.
Since I'm evaluating Whole Foods Markets on the premise of Enterprise Value to EBITDA, it stands to reason I would want to follow the EBITDA margin to see you what kinds of changes the company is facing. Looking out across the last five years and using a rolling 12-month basis the EBITDA margins have come down for all of the retailers. For Wal-Mart they declined by about .7% and for Whole Foods Market they only declined by .4%, unless you're starting the comparison at about 1 year ago, in which case it appears that margins declined by more than 1%. Target also saw margins decline, though they were recovering since the middle of 2014. See the chart below:
The decline follows the theory of pressure on margins for retailers, but I think it may still be a little overblown. If margins continue at current rates it shouldn't be a problem, it is only if margins continue to deteriorate significantly further.
Favorable Macroeconomic Factors
Grocery prices have been under pressure. Margins for the retailers have been declining. This is precisely the point when many investors may think the macroeconomics will be working against Whole Foods Market. I disagree. We are finally seeing median household incomes increase. In inflation-adjusted terms those income levels were stagnant for years. For Whole Foods Markets to generate better leverage on fixed costs, they would stand to benefit from a slightly larger market share. Wages pushing higher indicates a larger portion of the population may be able to afford the relatively higher prices from shopping at Whole Foods Market.
If investors are scared of a falling knife, I can understand why they would want to avoid Whole Foods Market. On the other hand, if they are focusing on fundamental analysis and using metrics like EV to EBITDA, they may see Whole Foods Markets as a much more appealing investment. The company doesn't have two distinguished track record of Target or Wal-Mart. It doesn't have the same enormous reach. However it finally trades at similar ratios. The price to earnings ratio isn't there yet, but the EV to EBITDA ratios are there.
I'm going to wait on a assigning any ratings, because I want to look further into the strategic plans for Whole Foods Market. On the fundamentals, they appear to be reasonably priced. However, I need to check for any terrible development on the horizon. A solid value on the trailing fundamentals is a great starting point, but I still want to know more about management's plans.
Disclosure: I am/we are long WMT, TGT.
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.
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