Wednesday, November 20, 2013

Whole Foods Still Isn't Good Value

hings usually turn nasty when growth stocks stumble, and specialty grocer Whole Foods Market's  latest fourth-quarter results were bad enough to see the stock initially marked down more than 10%. The market obviously believed the company's problems to be industry-wide issues, because sector rival The Fresh Market  was sent down nearly 7% in sympathy. Is the market right to conclude it's an industry issue? And is this a short-term buying opportunity in a long-term growth story?

What went wrong with Whole Foods?
As with all retailers, the key metric to follow is comparable-same-store sales. Unfortunately, Whole Foods managed to miss estimates and reduce guidance for 2014. Its previous outlook was for comparable-same-store sales of 6.5%-8% in 2014, but the weakness in the fourth quarter caused management to lower projections to 5.5%-7%.

Source: company presentations
Moreover, according to management on the conference call:

This change in trends ... ... were seen in both transaction count and basket size and was broad-based across geographies, departments and storage classes.

Why it's a short term issue...
Naturally, analysts were all over the issue during the conference call, but management failed to give a definitive view. In fact, they cited a number of reasons:

  • Strategic price-matching initiatives

  • Cannibalization of existing Whole Foods stores, with Boston specifically cited

  • Weakness in consumer sentiment

  • Increased competition

The first three reasons might make you think this is just a temporary dip in fortunes. For example, the pricing initiatives made at the end of the third quarter did affect sales, but according to the company they will drive growth in the long term.

Furthermore, cannibalization is an issue that can be addressed by better selection of new store locations. As for consumer sentiment, this could turn out to be a short-term issue related to fears over the government shutdown, among other factors.

This viewpoint is strengthened when looking at what Starbucks  recently reported on its trading conditions. The coffee shop is always compared to Whole Foods because both companies tend to serve an aspirational clientele. Indeed, the companies have ties because Starbucks is now retailing some of its products in Whole Foods locations. With Starbucks recently reporting 11% growth in the US and its strongest comparable growth in Canada in more than three years, it was reasonable to think that Whole Foods would report good numbers.

...and why it isn't
Foolish investors might like to think this is a merely a blip in the Whole Foods growth story, but there are three reasons why they should be concerned.

First, back on Aug. 28, The Fresh Market only reported 3.4% comparable-same-store sales growth, a figure that is noticeably lower than the mid-point of its long-term target of 3%-5% growth. Another worrying sign was that its new store productivity (the ability of new stores to generate revenue per square foot compared to existing stores) was only 79% in the quarter, where its target range is 80%-90%. Both figures are indications of an increasingly competitive market.

Second, the strategic price-matching initiative was made in order to "address a couple of competitors in particular," according to Whole Foods CEO Walter Robb. Again, this is a sure sign of encroaching competition.

Aside from the other specialty grocers, mainstream grocers like Kroger    have been targeting the organic- and natural-food market. For example, Kroger launched its Simple Truth brand in 2012, and executives are now disclosing that it's close to being a $1 billion brand.

Finally, the Starbucks analogy is not necessarily a good one. While it's true that Starbucks and Whole Foods offer a high level of service and retail satisfaction, there is a key difference between them. Starbucks sells its own branded products, while Whole Foods sells products that can be bought at Kroger or elsewhere. This leaves Whole Foods a lot more susceptible to competition, particularly in a highly competitive category like food. When Starbucks' customers are in the shop, they might not tend to make price comparisons because they can't buy Starbucks products elsewhere.

Where next for Whole Foods?
All told, this doesn't look like a short-term issue for Whole Foods or even for The Fresh Market. On the other hand, investors shouldn't conclude that it's all doom and gloom from here on out. Most retailers would envy Whole Foods' updated forecast of 11%-13% sales growth in 2014, and the secular trend towards healthier and more organic food doesn't seem like it will end anytime soon.

However, the stock simply isn't priced for any sort of future disappointment. Even at a price of $57 per share, the stock still trades at a P/E ratio of more than 33 times forward earnings. Given the downward pressure on its comparable-same-store sales, it doesn't look like a compelling value play.

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