Description

WFMI- Long. By the end of 2010, Whole Foods will be worth $60/share at 20x P/E, for 28%/year total return over 2.5 yrs (w. dividends). The market has missed increasing barriers to entry in the segment and the removal of the only viable competitor, making this a much more defensible business. Also, run-rate EBIT margins are penalized 160 bps by high growth. Finally, growth should be sustained by an excellent management group who think like owners and have developed a framework to keep the best employee crew in grocery.

Finally, on the flip side, the market wrongly focuses on whether a recession will greatly lower customer demand, and whether the market is already saturated. A 2.4% dividend yield helps sooth the wait.

Market Cap: $4.8B, EV: $5.5B
Run-rate end of 2010: Revenue: $12.3 billion, EBIT margin: 5.9%
Pre-tax ROIC: Mid 20s historically
Options: 17M struck at $49.

THREE BARRIES TO ENTRY – drivers of sustainable high ROC and margins

Barrier #1: Local economies of scale – drive cost and purchasing savings
Local market share matter (SG&A advantage)
WFMI has no real competitor in many markets after the other major natural foods company, Wild Oats (1/2 as many stores), was bought by WFMI in late 2007.

As an example of scale in other grocery markets, in Florida Publix has a much larger market share (2x) than Winn-Dixie, and this helps drive 7% less (28% vs. 21%) SG&A as a % of sales. Generally, market shares within a region can drive distribution synergies (SG&A), and individual store volume can drive gross margin scale (see next paragraph).

High Individual store volume creates virtuous cycle of fresher goods, more customers, and higher gross margins

Since almost 70% of WFMI sales are perishables, and WFMI has many varieties, you need high volume within a store to have a great selection and have it fresh. How many people have seen old seafood at a Winn Dixie, Wal-Mart (it’s really bad at WMT), Trader Joes, etc – you need volume to continually move your stock and keep fresh stuff coming in. This cycle feeds on itself: WFMI is popular so people shop there, volume is high so the seafood is fresh/rotates quickly, so more people shop there, etc. A virtuous cycle is hard to break since the subscale player will find it hard to toss out at spoiled items at a loss, which perpetuates the cycle.

Wild Oats, with lower sales per square foot at $473 vs. $708 for WFMI, made no EBIT 2003-2006, and the sole difference was COGS at 70%, vs. 65% for WFMI with no real SG&A difference. Interesting, Wild Oats wasn’t necessarily less concentrated regionally than Whole Foods, but instead just had subscale stores within those markets.

WFMI understands the importance of the two types of scale and is looking to have an overwhelmingly dominate position in the natural and organic food industries in their local markets. The Wild Oats purchase meant that in many markets, there is no effective competition, which caused the FTC to try to block the merger.

Also, referring back to the Publix example, their sales/sq. foot is $515 vs. $288 for WINN, which helps drive a 2% higher gross margin.

Purchasing scale: organic & natural is more local than hard goods grocery, and WFMI has set up purchasing for this particular market
20% of WFMI produce is sourced locally, and 78% of organic produce is produced by independent family farms (average organic milk farm has 66 cows). WFMI has 11 decentralized purchasing areas than can deal with the small suppliers common in this market, versus the large suppliers common in hard goods. Therefore, the centralized buying systems of mainstream grocery chains can’t compete.

Also, WFMI’s large buying allows it to economically source from small producers that smaller buyers would find cost prohibitive. Without hard data, I have heard that for many of these local suppliers WFMI can constitute greater than 50% of their sales. WFMI should be able to enjoy better pricing and economies of scale in this submarket.

From a farmer on a Business Week blog: “I work for an organic farm that supplies just a few specific specialty veggies for one nearby Whole Foods store. They pay our premium prices because our quality is much better than produce trucked in from further away. A centralized "professional supply chain" can't deal with small suppliers like us. That's why you can't buy real heirloom tomatoes or other top-quality ripe perishable produce (organic or otherwise) at Wal-Mart.”

My fiancé’s cousin runs a small (100 acre) organic vegetable farm in West Texas that only has two regular customers as no one else buys that type of product, or thinks it’s worth the effort to deal with such as small, small producer.

20% of produce might sound small, but remember that some people go to WFMI to buy stuff you can’t find elsewhere and so it has to be stocked.

Barrier #2: Network effects –employees, customers, and culture

• People want to be around other like-minded and cool people. Hourly wages of $16/hour, vs. ~$10 or less at other grocery stores help keep the cool ones.
• Also, shoppers like being around similar people, and for some people Whole Foods is a social experience, especially the stores with multiple eat-in options instead of the standard “check out and go home” format. Not unlike the Dairy Queen of small towns, where people go to hang out and congregate.

Culture: Local stores can choose what to stock and promote, as Mackey pushes for a “Hayekian discovery process” (Friedrich Hayek), in which a decentralized decision making process helps capture and use institutional knowledge of the local market. This not only provides a more customized experience, allows more community involvement, but also makes for a more satisfied employee base. Basically, Mackey said a socialistic, top-down management style that doesn’t work in an undefined industry (WFMI has mostly created the market), and so only by trial and error can the optimal solution be found.

Also, employees feel like owner-operators. The store employees I have talked to are happy and feel like they are part of something. 93% of option grants have gone to non officers (exec officers or regional presidents).

Culture may be a “soft” advantage that normally value investors don’t pay for, but an excellent culture can be a formidable barrier in an industry where most employees are low-paid youngins who might be just looking for a paycheck. You can’t just take a regular grocery store and turn it into a WFMI, much like can’t easily turn the local community college into Harvard (ok, I’m stretching).

Litmus Test
Highly successful grocery chains in the US include Wegmans, Publix, and HE Butt. I believe Whole Foods has the following traits in common:

1) Dominating market share. HEB is very careful about where it expands, always keeping within its boundaries (circle of competence).

2) Keep and retain the best employees. In Winn-Dixie vs. Publix in Florida, Publix store managers are usually 25 year veterans, own a ton of company stock, are kept for life, and are extremely loyal to the company. Try to ask a Publix store manager about their company – you’ll get 45 minutes about how they love their job and their company (and then try and get away). Contrast that to the hired guns at Winn-Dixie who own practically no stock, fear for their job, and watch the CEO get $14.6M in annual comp. Which store produces better managers and happier employees?

a. Compare this to WFMI executive officers – the most recent addition was 10 years ago and the regional presidents are all very tenured.

3) Private. This removes the incentive for short-term growth if the right people aren’t already on staff. Also removes incentive for short-term earnings tricks. Obviously WFMI is public, but they tend to act in a manner consistent with the long-term health of the company.

Frankly, the traits of successful grocery chains aren’t unlike the successful traits of many other businesses.

Barrier #3 – Change in organic labeling to advantage WFMI
Recently, WMT and others have cheapened the term “organic” by offering items with organic labels even though they are often barely organic. WFMI plans to differentiate the market and highlight product differences by introducing various tiered labeling systems. As the dominant retailer for most of the authentic/high end natural items, this will disproportionately benefit WFMI and play to its strengths as a dominate purchaser of artisan and high-end products.

WMT: A recent study said Wal-Mart is, "cheapening the value of the organic label" by sourcing most of its products from "industrial-scale factory farms and Third World countries," but also -- on multiple occasions and in multiple stores -- labeling non-organic food as organic with misleading in-store signs.” For the organic food from China filling Wal-Mart stores, the USDA has never made a trip there and relies on the word of Chinese surrogates. Also, Wal-Mart’s annual organic milk output per cow is a suspicious 20,000 pounds vs. 16,000 for most organic dairies. Books have lamented the industrialization of the organic food industry, and for those who care “mainstream” grocery stores don’t suffice.

WFMI tiered labeling system for animal products (2008 rollout):
Step 1: No Cages, No Crates
Step 2: Enriched Environment
Step 3: Pasture Based
Step 4: No Mutilations
Step 5: On-Farm Birth and Slaughter.

Why this could drive volume: Most people just aren’t aware of what happens to their food since it is out of sight, out of mind. For most people, if they are not reminded, they would rather save 50 cents on that carton of eggs. Now, it’ll be harder to say, “Honey, let’s save 50 cents and get the poultry that was mutilated and tortured in a cage, instead of the step 4 poultry.” This could be brilliant, could really bring these issues to the forefront of consumer consciousness in a way the PETA folks could only dream of.

Does this matter?
Large-scale industrial producers of animal proteins will find it hard to switch to the low volume, high-touch meat growing. First, it is a different process, so they have no inherent advantage over other entrants. Second, it is still a niche market, and it might not be worth the effort for something small, and when you are cannibalizing your existing business.

Also, grocery buyers of these items will find it hard to buy the new, kinder, proteins. Given the small size of many growers/producers, WMT would have to change their purchasing to local (where they are at a scale disadvantage), get the relationships, take volume from WFMI, and wonder if the small, holistic farmer would even sell to them. Also, is this even what WMT wants to do? CEO Scott of WMT has made comments that he sees WMT’s organic offering as organic on the cheap. “Well, we don't think you should have to have a lot of money to feed your family organic foods”

MARGIN STEADY-STATE
Steady-state margins for existing stores should be 1.6% higher than current reported EBIT margins (I value existing stores and new stores separately). First, 0.6% comes from a misunderstanding about store age. Stores become more profitable over time as sales increase, efficiencies are gained, and fixed costs are leveraged. The 10-K says WFMI stores are 7.9 years old, but that does not account for a change in store size - new ones 50K sq. feet vs. older ones at 20K sq. feet. An age weighted by store size gives closer to 6 years. Stores can be expected to gain ~60 bps of margin in 2-4 years as they more fully mature.

Also, the upfront expense from new store openings run through the I/S instead of being capitalized– EBIT increases 100 bps per year for the existing stores if take this out. Of course, it creates the same NPV over time, but it helps to adjust for to see the true economics. The 100 bps + 60 bps get you to 6.1% steady-state EBIT margin for existing stores vs. 4.5% total last year.

HIGH QUALITY FOUNDER AND CEO
With the exception of the well-known Yahoo message board posts, I consider Mackey an good CEO who has laid the framework for an excellent employee base

• Extremely well-read. An outspoken libertarian who knows a lot of subjects in a way Charlie Munger would be proud of. He quotes economists and social history with dexterity and incorporates his libertarian learnings into the business (see Hayekian discovery process and health care in this writeup)
• Independent – the worst thing Mackey could do is to bend to short-term earnings pressure and destroy a culture which might never come back. Long-term shareholders should be proud and grateful, because they need customers and employees to be well treated and well regarded, not abused to make an extra nickel in the quarter. In this way, Mackey thinks like a private owner.
• Good operator to date and well liked by employees. I especially liked how he set up health care accounts for employees – charge a $1000 deductible vs. a $10 deductible with other plans, and then give employees $1,500/year (dollars never lost, and roll over w/ interest) to spend toward deductibles or other related items, such as acupuncture, glasses, or whatever else. Employees now are very price conscious about going to say the emergency rooms for something trivial since no longer is someone else paying everything.
• Option dilution has improved – previously options were diluting existing shareholders by 5%/year. But, for 2006 and 2007 options issued = 1 to 1.2% of shares, and the company intends to keep dilution around this lower level.
• 2007 total CEO compensation (bonus, perks, options, etc) $162 thousand. According the April 6, 2008 New York Times list of 200 large companies’ CEO comp., Mackey had the second lowest (Steve Jobs/Apple #1, Warren Buffett #3).
• Contributes 5% to charity and is active in both local charities, and in helping new organic farmers get started. Important on many levels.

CUSTOMER RECESSION SENSITIVITY: probably less than generally thought
Some perceive that WFMI shopping is more consumer discretionary than a normal grocery store due to higher prices per calorie. However, I estimate that ~50% of customers shop WFMI based on lifestyle choices – environmentally friendly, natural products, etc (see categories in below chart called “Die Hard and Conscientious”). These customers see their lifestyle as an integral part of who they are, and won’t be going to Wal-Mart to save a few dollars.

The other 50% (I call them “Best Quality” shoppers), buy the best money can buy, but if their income went down or if a better shop opened next door, they might bolt. These guys don’t see natural foods as something that defines them as a person, and hence are much less loyal.

Categories of US shoppers

WFMI?	03 population	08 population	Growth/yr	Income	Category	Price sensitivity	Loyalty
Yes	2.0%	2.0%	0.0%	Any	Die hard organic lifestyle	Low	High
Yes	7.0%	10.0%	7.4%	$50K+	Conscientious	Low	High/Medium
Yes	11.0%	12.0%	1.8%	$60K+	Best quality	Medium	Medium/Low
Never	81.0%	76.0%	-1.3%	$35K	Best price	High	Low

Source: Nielsen, Whole Foods surveys, literature searches, my own category naming

A writer on a blog said, “I barely make $30,000 a year, but I am more than willing to shop for food that doesn't contain any preservatives, artificial colors/flavors, or PHOs. I'd rather be slightly poorer than say, diagnosed with some chemically-induced disease that could have been prevented by simply consuming "real" food, as nature intended. And I think my wheat and gluten-allergic friends would agree, too.”

The FTC, in their attempt to block the WFMI/OATS merger, said in a court document, “Shoppers with preferences for premium natural and organic supermarkets are not likely to switch to other retailers in response to a small but significant non-transitory increase in premium natural and organic supermarket prices.”

It’s worth noting that US citizens spend 8% of their income on foods, vs. 15% in Europe, and 20% in Japan. So, for a lifestyle choice, US citizens could in theory rearrange their spending habits.

Wild Oats purchase greatly reduced the threat of competition
Wild Oats had half as many stores as WFMI and was the only other competitor of any size. The FTC, in one of its rare recent attempts to block a merger, made public internal WFMI boardroom comments and emails:

1. Wild Oats “is the only existing company that has the brand and number of stores to be a meaningful springboard for another player to get into this space. Eliminating them means eliminating this threat forever, or almost forever.” – John Mackey, CEO

2. Buying Wild Oats "will greatly enhance our comps over the next few years and will avoid nasty price wars in Portland (both Oregon and Maine), Boulder, Nashville and several other cities, which will harm our gross margins and profitability" - Mackey

3. Wild Oats "may not be able to defeat us but they can still hurt us. Furthermore, we eliminate forever the possibility of Kroger, SuperValu or Safeway using their brand equity to launch a competing national natural/organic food chain to rival us ... . Eliminating (Wild Oats) means eliminating this threat forever" - Mackey

An organic/natural/premium grocery, and the feel and culture that goes with it, almost has to be started from a small store base and then expanded in order to get the proper people, culture, and procedures. Bringing in hired guns won’t work because of the lack of authenticity and passion for truly natural products. Also, starting a one-store chain and working up is much harder now with a dominant competitor in the industry.

Lesson for other CEOs: don’t e-mail anticompetitive comments, or have it on the Board’s transcript.

Market not saturated
WFMI sells only around 7% of the US organic food sold today ($1B of organic into $15B market). JP Morgan estimates that WFMI has 15% of the more inclusive category of natural foods ($46B). I don’t know how accurate those market estimates are, but as a reality check: By 2010, WFMI should be ~4% of total US grocery sales. Compared with the previously noted 20% of Americans that are receptive to something besides the lowest price, it seems reasonable that Whole Foods has lots of room to expand.

Also, growth is projected to remain near 10% for the category, which I see as reasonable given the change in organic categorizing, the better pricing of organic, and even just WFMI becoming available to more people as they open in towns they were not previously in. I understand that Whole Foods was unsure about how well a store in Omaha would do, but it has turned out to be very profitable and a good store.

Organic prices decreasing: (should help sales, at the margin)
CEO Mackey says organic prices have been increasing for years at lower than the rate of inflation as the industry matures and more suppliers come on line.

Valuation methods:
1) Sum of parts: based on DCF, 10% r, 3.5% terminal value growth

Current WFMI stores: $5,600 million
New stores: $2,320 million (20 stores/year, 2008-2017). $15.6M NPV/store
Wild Oats stores: $850 million
Total $8,770 million

Net debt -$750 million
Dividends/buybacks $400 million
Per share by 2010: $60/share
Present value/share: $47/share
Current Price/Value: 72%

2) P/E Ratio - 20x late 2010 run-rate earnings

3) CEO’s perspective:
In public forums, Mackey has said the stock got way too high when it hit $80, and he thinks a 25-30 forward P/E is correct (~$50/share today). It’s interesting to square those comments with how WFMI has distributed earnings. In late 2005, a $2 special dividend was declared when stock approached $80 ($358M in total 2005 dividends). When the price declined below $50, they switched to share repurchases ($100M/year for 2006 and 2007) to distribute excess earnings.

With Wild Oats remodeling and aggressive expansion speaking for free cash flow, WFMI can’t do too much of a share repurchase without taking on debt beyond a ~2x trailing net Debt/EBIT ratio. Mackey doesn’t seem the type to lever up and add the accompanying risks.

EBIT Margins: could they decline?
Margins are steadier/more reliable than most companies’ because of the previously discussed competitive advantages. Also, importantly, Mackey has said many times he does not try to maximize profits or minimize costs in order to create a balanced ecosystem where everyone is treated fairly, much the same way that some money managers charge lower fees, even when they could get away with much higher ones.

I would much rather have this setup than a company who has an ex-GE manager axing away, has Al Dunlap, or is being sold by a private equity firm fresh off massive cost cutting, since it allows for much higher longevity and creates a better environment.

For comparison, Publix has a ~7% EBIT margin and has similar traits.

Same-store sales growth:
Same-store sales increase implied in my estimates is 6-7% range for the next several years. I have absolutely no idea what same-store comps will be exactly, but I include them for discussions’ sake. My numbers are based on a historic growth rate for stores of certain age categories. I believe them reasonable due to the general market growth of organics/natural and the competitive advantages WFMI enjoys over competitors.

Risks:

• Recession: Mackey has said that if the economy slows way down, he’ll just slow store expansion.
• I could be wrong on how discretionary WFMI customers are.
• Other grocery chains could start a WFMI-type chain on a large scale. In addition to the previously mentioned reasons why this is tough, the market will always be somewhat of a niche and hence potentially more of a distraction than an opportunity for a large player.

Catalyst

None