Friday, January 29, 1999

Whole Foods Market
(Nasdaq: WFMI)
Phone: 512-477-4455
Website: http://www.wholefoods.com
Price (1/28/99): $32


The nutty-crunchy "think global, act local" attitude of natural foods retailer Whole Foods Market (Nasdaq: WFMI) makes for such a swell work environment that the company has landed on Fortune's best places to work list in each of the last two years. Yet there's a downside to giving local stores considerable autonomy.

Whole Foods shocked investors January 13 with the news that Q1 earnings will be just $0.45 to $0.50 per share, well shy of the consensus $0.58 per share estimate. While sales should come in on track at $455 million on a 6.4% comp-store sales increase, salaries and benefits ran over budget as store managers just didn't stick to plan and the decentralized management structure didn't catch it in time. As a result, selling, general and administrative (SG&A) expenses will be 50 to 100 basis points higher than the year-ago period.

The company is also building its infrastructure to support 29 stores currently in development -- the most ever. Plus, it's paying its apocalypse-not-now Y2K remediation costs, which will run about $0.6 million for the quarter and $2 million for FY99.

Chairman and CEO John Mackey said in a press release, "We expect to get expenses quickly back in line and do not think the first quarter is reflective of our ability to deliver strong earnings growth for our shareholders in the future." Nonetheless, Bloomberg reported that Mackey told investors on a conference call to expect EPS growth for the last three quarters of the year to come in at just 8% to 14% versus earlier guidance calling for 18% to 22% growth.

The Q1 warning led a host of analysts to cut their ratings on the grocer, dropping the stock from $44 1/2 to $33 1/2 per share in one day. Just like that, last year's Double became this year's Trouble.


With more than 87 stores in 19 states, Whole Foods is America's largest chain of natural foods supermarkets. It features organic produce that's free of chemicals and preservatives, hormone-free meats, cruelty-free cosmetics, and environmentally friendly household products. Its Amrion subsidiary, acquired in September 1997, develops and produces nutritional supplements and homeopathic medicinal products, which are sold in Whole Foods stores and by direct marketing.

Whole Foods added 12 net new stores last year. It plans to end FY99 in September with a total of 96 stores, on its way to 200 stores by 2003. The average store is 24,000 square feet, but newer stores fall into the 30,000 to 50,000 square foot range. The stores include such amenities as juice and coffee bars and even in-store massage therapists.

The company has grown rapidly, from just $93 million in sales in FY91, partly thanks to the acquisition of New England's Bread and Circus, North Carolina's Wellspring Markets, California's Mrs. Gooch's, and the 22-store East Coast chain Fresh Fields. The company believes its FY98 average of $670 in sales per square foot is tops among conventional groceries and large-store natural foods retailers.

Its main natural foods competitor is Wild Oats Markets (Nasdaq: OATS). Still, there are less than 100 competing supermarket-sized natural food stores in the U.S. -- total. In 1997, the overall retail market for natural foods was pegged at more than $14.8 billion, while the market for vitamins and nutritional supplements was more than $9.3 billion.

Insiders own 5.2% of the stock. Long-time president Peter Roy retired in October and was replaced by Chris Hitt, formerly president of the firm's Mid-Atlantic region. The company donates 5% of after-tax gains to not-for-profit organizations.


Income Statement
12-month sales: $1,389.8 million
12-month income: $45.4 million
12-month EPS: $1.64
Profit Margin: 3.3%
Market Cap: $890.24 million

Balance Sheet

Cash: $63.7 million
Current Assets: $184.1 million
Current Liabilities: $91.0 million
Long-Term Debt: $173.4 million

Price-to-earnings: 19.5
Price-to-sales: 0.6


Over the last three years, Whole Foods' results had improved steadily. Gross profit margins increased from 31.7% in FY96, to 32.9% in FY97, to 33.7% in FY98 thanks to greater buying power and private-label initiatives. Similarly, SG&A expenses as a percentage of sales fell from 28.1%, to 28%, to 27.7% over the same three-year period. Same-store sales growth led the way, increasing 5.4% in FY96, 8.3% in FY97, and 11% in FY98.

The Q4 results also didn't offer a lot of reason for worry. Sales rose 21%, gross margins increased 22%, pro-forma EPS (excluding one-time charges) increased 21%, and same-store sales increased 8.5%. On the other hand, all of these numbers were below the growth rates recorded for the previous nine months, suggesting some modest slowdown.

Also, the December quarter brought turmoil to other makers of vitamin supplements. For instance, Rexall Sundown (Nasdaq: RXSD) got crushed on an earnings warning that seemed related to General Nutrition's (Nasdaq: GNCI) move to cut vitamin prices in August.

Whole Foods has exposure to such price pressures, but it's hard to determine just how much since the company doesn't break out vitamin sales in its stores. Yet, the direct marketing component of the Amrion business accounts for 5.9% of Whole Foods' total revenues and 12.4% of operating profits.

Still, the shares already seemed to have discounted such looming price pressures, after slimming down from last spring's high of $70. The market took the Q1 warning as a surprise because, ultimately, it was.


The board recently authorized the repurchase of up to $25 million worth of stock. "We believe that our stock price is particularly attractive," said CEO Mackey in the press release. That's a modest vote of confidence.

With the consensus earnings estimate for FY99 cut to $1.78 per share, the stock now trades at about 18.5 times forward numbers. That's a slight discount to the analysts' long-term growth projection of 21.4%. Moreover, as the leading consolidator in a relatively high-margin and rapidly growing niche of the supermarket industry, Whole Foods has traditionally traded at a premium to its growth rate.

And, it probably should. The other day, a friend and I drove past the company's new Atlanta location currently under construction. My friend gets giddy over good grocers and knows Whole Foods well from Dallas. She shrieked with joy and reeled off a list of the friends she had to tell about this new arrival. It's hard to quantify that appeal, but Whole Foods clearly has a reputation for quality products and community involvement that inspires customer loyalty.

And the company is also reaching beyond those communities. On March 22, Whole Foods will launch its online store with 6,000 stock keeping units (SKUs). Management hopes the venture will be profitable within two years. E-commerce could prove a sweet fit given that the Web likely appeals to many of Whole Foods' core customers who have upscale tastes, a hunger for health-related information, and a willingness to build a feeling of community.

The consolidating and low-margin supermarket industry will no doubt see new pressures as Wal-Mart (NYSE: WMT) reaches for a bigger slice of the pie and the traditional chains broaden their product selection to appeal to more health-conscious and gourmet consumers. Still, Fools should take a close look at the Q1 results to be released February 16. This appears to be a case where the market has discounted a short-term disappointment at the expense of a longer-term growth story.

-- Louis Corrigan