Description

WFMI is a great company with a stock that has almost always had a rich valuation reflecting its excellent performance – until now.  For a trailing EV/EBITDA of 4.5 on depressed EBITDA (and an EV probably below what it would cost to rebuild the stores from scratch), you get the category leader in premium grocery, a well known brand, good management, a long growth path, and a company that has compounded per share sales, cash flow, book value, and earnings at better than 15% annually since going public in 1992.

 

Earnings and EBITDA at WFMI are chronically understated due to pre-opening costs and the multi-year maturity curve of new stores.  Earnings are also currently depressed due to costs associated with the Wild Oats acquisition, the England market, and most importantly, the U.S. economic downturn.

 

This last item is at least partly responsible for the multiple compression of the last few months, as investors have come to realize that Whole Foods is much less immune to the economic cycle than other grocers, despite a two decade track record that led people to believe otherwise.  Consumers are economizing, and this means fewer trips to Whole Foods and trading down to lower cost items.  This will continue to mean flat or declining comps for at least a few more quarters, and probably lower earnings in the near term.  And nobody knows just how long this down cycle will last.

 

But the down cycle will also mean that Whole Food develops better cost discipline, reduces risk taking, and solidifies its lead over weaker direct competitors  In other words, barriers to entry for direct competition will be higher than ever (though less direct competition from grocers such as Trader Joe’s, Publix, and Wegmans will obviously continue).  With new store growth slowing, Wild Oats being assimilated, and cost cutting efforts kicking in, Whole Foods’ earnings will be much higher a few years from now (so long as identical store sales stabilize and grow modestly again), and this may become obvious as early as the middle of 2009 when WFMI faces much easier comps.

 

Below I go into more detail on the valuation and various issues associated with WFMI.  I will not elaborate on Whole Foods’ company culture, high barriers to entry, excellent branding, extensive private label program, etc. as these are well known and were discussed in a prior write-up on VIC.

 

 

Valuation

 

For FY ending September 28, 2008:

 

EBITDA: 485 million

EBIT:  236 million

 

Basic shares: 140,286,000

Market Cap:  1,232 million

Debt:  929 million (includes capital lease obligations)

Enterprise Value:  2,161 million

 

EV/EBITDA: 4.5

EV/EBIT: 9.2

 

Average CapEx $/square foot since 2001:  $260 (approximately)

Total square feet on Sep 28, 2008:  7,737,700 square feet

Cost to build out current store base if at $260/sq foot:  $2 billion (lower bound)

 

Gross PP&E since company inception:  $2.8 billion (close to upper bound)

 

Cost to build current store base from scratch:  between $2 and $3 billion.

 

WFMI’s EV of just under $2.2 billion is probably below what it would cost to build the stores from scratch, meaning that a large grocer wanting a premium U.S. grocery presence would be better off buying WFMI than building from scratch.  Tesco comes to mind as an obvious acquirer as they have been trying (disastrously so far) to break into the U.S. market with their Fresh and Easy stores at a very high cost – buying Whole Foods would cost much less in the long run than sticking with their current strategy.  Carrefour also seems like a possible acquirer.

 

Projections

 

At the current stock price, an optimistic 5 year forecast is unnecessary to justify investment.  However, I think it worth sharing some results of a profitability (after store maturity) analysis I did a year ago which excludes Wild Oats.  My analysis assumed the following store maturity curve (which is based on publicly available data from Whole Foods and a bit of interpolation in order to force fit to 2006-2007 results):

 

 

Year    % growth      Sales(thousands)     Assumed Store Contribution Margin

 

1                                512                           1.0%

2          21.1%            620                           4.0%

3          11.3%            690                           7.5%

4          9.4%              755                           8.3%

5          7.3%              810                           9.0%

6          6.8%              865                           9.3%

7          6.1%              918                           9.6%

8          5.2%              966                           9.9%

9          4.1%              1006                         10.1%

10        3.7%              1043                         10.3%

11        3.8%              1083                         10.4%

12        4.2%              1129                         10.5%

13        4.5%              1180                         10.6%

14        4.6%              1234                         10.7%

15        4.4%              1288                         10.8%

16        4.3%              1344                         10.9%

17+      4.0%              1398                         11.0%

 

 

At the time I put this together and even as little as 6 months ago, these assumptions seemed pessimistic – now they look optimistic.  But regardless of what identical store sales turn out to be, the interesting part of the analysis is what happens when you plug these assumptions into a model that assumes Whole Foods stops building new stores.  The result (5 years later) is that:

 

Contribution margins rise 1.5%

Pre-opening costs drop from 0.7% of sales to nothing

G&A drops by 0.4%

 

Bottom line:  Operating Margin improves by 2.6% in 5 years just from the natural maturity of stores, the absence of new store opening charges, and the G&A associated with new store openings.  Again – this assumes the store maturity curve listed above, and given the amount of guesswork that went into it, a range of 2% to 3% operating margin improvement is more appropriate.

 

The cash flow characteristics are even better in this runoff scenario.  The store base is mostly new, and grocery stores typically require CapEx far below D&A for at least a decade after being built.

 

So, the only way net income percentage doesn’t go up over the next few years is if comps turn negative for many years, which I think is unlikely.  Based on the combination of slowing new store builds, Wild Oats integration, fixing (or terminating) the stores in England, and the maturation of recently built stores, I believe operating earnings will roughly triple in 5 years.  Combine that with multiple expansion from record low levels, and WFMI stock should do quite well for those holding on for 5 or more years.

 

An aside:  I was considering buying Whole Foods stock for $30-$35/share last year but declined based on this analysis, as the implied stock value was something like $50-$60 by 2015 assuming typical grocer multiples – not very appealing given the risks from Wild Oats,  the economic slowdown, and the aggressive store build-out with rapidly rising CapEx per square foot.

 

WHY THE STOCK IS DOWN (Well – at least the drop from 80 to 16 . . .)

 

2007 Comps:  WFMI same store sales have been decelerating for the last 8 quarters and will continue to get worse for at least another two quarters.  Reasons given by management for the deceleration during 2007 included tough comparisons due to three consecutive years of higher than average double-digit comps, stronger competition, a higher degree of cannibalization, and selective price cuts.  Another reason (not explicitly stated by management) is that new stores are starting at substantially higher revenue per square foot level than historically, but then not growing as fast in years 2-5.

 

2008 Comps (Macro factors):  In addition to the same factors as 2007, there are also macro factors impacting WFMI and nearly all other U.S. grocers:  higher gasoline prices (first half of year), rising unemployment (second half of year), and declining home values are causing shoppers to develop more frugal shopping habits.  Perhaps the biggest concern of investors at this point is that economic headwinds will mean declines in traffic, sales, and profitability that last years, not quarters.  As discussed below (see “Image”), Whole Foods is attempting to change its image to capture more of the value-oriented business.

 

Competition:  Of the reasons for the decline in comps, the biggest long-term concern among investors, including myself, is the increased competition.  Privately owned retailers like Wegman’s, Publix, and Trader Joe’s continue to include organic foods in their merchandise mix while executing well and opening new stores.  Several public retailers such as Safeway and Krogers have finally begun to make the investments necessary to compete for at least a portion of Whole Foods shoppers.  Tesco’s entry into the U.S. market with its Fresh and Easy concept could be adding to competitive pressures (and maybe Wal-mart will too with a clone of this concept), though the launch has been so disastrous that I wonder if Tesco will soon give up and shut it down. A number of independent cooperative food grocers have created a joint purchasing contract with UNFI which has enabled many of them to become more price competitive.  And in certain local markets, small chains have become quite competitive, if not outright superior (i.e. New Seasons in Portland).

 

While improvements and expansion from competitors will continue to limit Whole Foods’ pricing power, the company has done a remarkable job of reinventing itself and staying “ahead of the curve” to maintain its qualitative edge over most competition.  For example, in recent years Whole Foods has placed an ever greater emphasis on perishables, especially deli – while competitors struggle to catch up.  I believe that Whole Foods’ culture of innovation and smart risk-taking will keep it always a step ahead of really good privately-owned competitors and several steps ahead of its public competitors.  It already has the highest dollar sales per square foot among grocery chains which provides them a huge, nearly insurmountable advantage when it comes to perishables (the high rate of inventory turns means perishables are fresher than competitors’ and WFMI can offer greater selection).

 

Liquidity:  The Wild Oats acquisition combined with an unusually high number of new store openings in the past year has weakened WFMI’s balance sheet and liquidity position.  This risk has been mitigated by the recent capital raise, and it is further mitigated by the very large discretionary portion of CapEx.  New stores can be delayed as needed and in many instances can (and have been) canceled.  The company can also stretch payables if needed.  After the recent capital raise, I consider liquidity risk to be very low.

 

Image (High quality incompatible with Value Pricing?):  Some fear the brand could be permanently damaged by WFMI’s increasing emphasis on price and value in a bid to retain its customers in economically challenging times.  Alternatively, some believe that Whole Food will never be able to convince shoppers that it is possible to find low prices in their stores, in spite of the extensive private label program already in place.

 

I was on the board of a natural/organic cooperative grocer for several years that did a similar transition and the impact with customers was very positive.  The effort ramped up a low-key program already in place called “basic pricing,” by advertising heavily, developing a clear logo, doing free workshops on low cost meal preparation, and writing frequently about the program in newsletters.  At first, most customers refused to believe that this co-op could be price competitive but after 9 to 12 months, a gradual shift in perception began which resulted in increased sales and increased loyalty.  The low priced leader (for natural/organic packaged goods) in town noticed stalled sales growth as some customers who used to buy their produce/deli at the co-op and most packaged goods at the low priced leader shifted their shopping more towards the co-op.  Importantly, during the past few months of 2008, this co-op continues to see high single digit year-over-year revenue growth.  Customers continue to perceive the store as having the highest quality, and for the most part now believe that certain items (the ones with the “basic pricing” logo) can be purchased for the same price or less at the co-op as elsewhere.

 

Assuming Whole Foods executes well on its own re-imaging efforts, I would expect to see a positive impact by 2010, as existing customers will be shifting some purchases from other stores towards Whole Foods (in the words of WFMI’s Walter Robb, turning some partial basket shoppers into full basket shoppers).  Given that Whole Foods shoppers are predominantly “partial basket shoppers,” the opportunity is large.

 

Wild Oats acquisition uncertainty:  Whole Foods certainly paid more than they should have for Wild Oats, one of the few errors this company has made over the years but by far the costliest.  And for whatever reason, the FTC continues to attempt to penalize Whole Foods in some fashion for the Wild Oats’ merger which is costing the company dearly in legal fees ($15 to $20 million expected for next fiscal year).  The FTC is not expected to prevail but it is a costly distraction.  More importantly, Whole Foods’ track record for integrating acquisitions over the history of the company is superb, including the large Fresh Fields acquisition over a decade ago.  Re-branding to Whole Foods and sharing best practices has usually resulted in improved execution over several years time, with most stores eventually attaining Whole Foods’ standards.

 

Valuation:  Starting from such a rich valuation (1997 through 2007) left lots of room for the stock to fall if WFMI ever encountered hard times.  They finally have . . .

 

Other Concerns:

 

The single biggest risk for Whole Foods is the same as any other retailer – that sales will go into a steep decline that lasts many years.  There is a possibility that Whole Foods’ incredible run of the last 20 years was just as illusory as the growth in asset prices over the same time frame.  While there is no doubt a portion of Whole Foods’ business that will go away forever (want to buy some SUPER DUPER HIGH QUALITY GOURMET deli items for $30/pound?), this is still a grocer, and people still need to eat.  Many people in the U.S. want to eat healthy diets, and that won’t change.  What will change is that consumers will figure out how to do it less expensively (i.e. using bulk foods), and that will obviously mean lower revenue per store.  The revenue per store will stabilize at some point in the next year or two once consumers have finished changing their shopping/cooking/eating habits to adjust to the new economy.

 

Whole Foods’ CapEx spending per square foot of new stores doubled from 2001 through 2007, as the company was not much focused on containing CapEx costs.  This has shifted as management announced an intention to reign in new store CapEx costs in the Q3 CC.  I see this as more of an opportunity than a threat, as the cost savings opportunities are plentiful.

 

Some analysts are very critical of WFMI’s plans to continue to build stores, while raising capital at a very high cost (Q4 CC).  These analysts believe WFMI should stop building new stores altogether until the economy improves.  I happen to agree with management actions, not the analysts.  Management is trying to run the business as much as they can with the long view in mind, even if it means making decisions with non-optimal short term results. Management has raised their hurdle rates (and lowered assumptions) for ROI on new stores, while also considering the costs and potential legal battles of getting out of leases.  I personally like managements that prioritize the long term over the short term, though I know many would differ with me on this.

 

The Capital Raise

 

The preferred stock issuance was an unfortunate necessity.  It is not included in the valuation section because it happened after the end of the quarter.  While the conversion feature is 17% dilutive, the conversion price is $14.50/share, so the stock price can increase 65% before any conversion occurs (so the risk/reward slope is better now than it will be when the stock price is at 14.5).  The only thing good that can be said about it is that it essentially eliminates bankruptcy risk and has provisions which provide for some financial flexibility should conditions deteriorate further.

 

I don’t think the mistake was issuing these preferred shares – I think the mistake was buying Wild Oats with cash.  Whole Foods would obviously be in far better shape had they not purchased Wild Oats – which, incidentally, I wrote up as a short idea for VIC on 12/11/06.  In retrospect, I nailed the fundaments just fine and OATS would have been bankrupt or close to it by now had they not been acquired by WFMI.

Catalyst

Much easier sales comparisons by middle of 2009
Increased unit sales from educating customers about lower cost merchandise (2010?)
Improvement in Wild Oats stores – ongoing
Fewer store openings means higher earnings as stores mature, pre-opening costs decline
Acquisition by Tesco or Carrefour is possible
The economic recovers (2017?)