Friday, December 21, 2012

How Much Longer Can Whole Foods Keep Growing?

Whole Foods Market (NASDAQ: WFM) is one of the stocks that is going to give emotional investors sleepless nights. On the one hand it’s starting to look expensive in relation to its growth prospects, particularly with competitors making plans to encroach on its market area. On the other, its growth prospects are starting to make it look cheap on a long term basis. I happen to like both sides of the argument, hence the uncertainty. I don’t buy stocks that I am uncertain of, but I’m sure others will have more concrete views.

I wanted to articulate some of the salient points so investors could make their own minds up.

A Smaller Piece of a Bigger Pie?

The sub-heading is why the proposition is so tricky at Whole Foods. More often than not, any analysis of a company usually involves trying to find its value proposition within a particular point of a cycle that most companies go through.  I’ll try to elucidate. The cycle typically runs a bit like this: high growth nascent industry phase, growth phase as company matures, GDP (plus a bit more) growth phase as maturity sets in and competitors enter, GDP (or less) growth phase as the company matures.

Of course this type of conceptual thinking is usually expressed rationally in a discounted cash flow analysis and the question is always “am I paying the right price for the stock?” The best answer usually lies within a better understanding of where the company is in the cycle. So what does it all mean for Whole Foods?

Well, usually a company is involved in fighting for a bigger piece of a relatively smaller pie in the future. Competitors enter and it gets that much harder to retain or grow market share. However, with Whole Foods I think that its end markets will accelerate in the future so that we will be in an elongated position within the second growth phase of the cycle.  The pie will get bigger and Whole Foods can still generate growth even with a smaller piece.

A quick look at some of the key metrics suggests that quarterly gross margin comparisons are still favorable while same store comparables remain in the 8%+ range.

So far so good, and there are no real signs of slowing growth in the metrics yet.

Bigger Pie

Long term, the trend towards organic, ‘healthy’ or non-GM foods looks assured. I use inverted commas because I’m not someone who views GM foods as being unhealthy, but I am a cynic when it comes to the unfailing ability of the media and celebrities to discuss important subject matters that they know nothing about. Scare stories involving health issues are particularly prevalent and few more so than GM foods.

Another favorable trend will be that of increasing discretionary spending by wealthier career women. I wouldn’t underestimate this trend. Indeed, in the recent conference call Whole Foods outlined that 20% of its customers do about 75-80% of its business. This is a kind of devotion only usually inspired by Scientology or other cults. In addition marketing data suggested that they gained 22% in new customers in the quarter.

In a sense, this is why Wal-Mart (NYSE: WMT) and Costco (NASDAQ: COST) don’t appear to be making inroads yet, despite their expansion into the food category. Shoppers like the Whole Foods retail experience and the feeling of ‘being healthy’ by eating there. They don’t get this at Wal-Mart or Costco, even if the food is exactly the same. Moreover, if Wal-Mart and Costco are expanding their food operations, it will squeeze the traditional mass market grocers who will then try and find other areas of growth, and this could mean trouble for Whole Foods.

A Smaller Piece

With that said, I’m simply not ready to cast aside everything I’ve ever learned about market forces. The big box retailers may not offer the same retail experience to a typical Whole Foods customer, but traditional grocers like Kroger (NYSE: KR) and Safeway (NYSE: SWY) have a footfall of customers who probably also shop at Whole Foods.

Kroger in particular has management that has demonstrated that it is willing to go to every length to wring every sale it possibly can out of its customers. At some point, the sheer weight of footfall will start to tell, and they will both start to grab meaningful market share.

Moreover, while the devoted will still stay, the newly acquired customers may prove fickle amidst the temptation of every food retailer chasing the ‘health’ angle.

Where Next for Whole Foods?

If you strip out the amount spent on new stores the FCF/EV yield is 4.5%, which is a surprisingly high number for such a highly fancied stock. However, I think it does imply that Whole Foods needs to hit its earnings targets over the next few years.

There is little margin for error here, and any slowdown in comparable same store sales growth and this stock will get hit hard. If so, the stock will be worth a look because its end markets look good. However, I would rather buy it when the market is pricing it as I see it, rather than as a bigger piece of a bigger pie.

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