Distractions at Whole Foods

Motley Fool Stock Advisor selection Whole Foods Market (Nasdaq: WFMI  ) reported fourth-quarter and full-year fiscal 2005 results Wednesday after the market closed. The specialty grocer turned in another strong quarter of revenue growth, but earnings took a big hit, and a couple of items in a recent press raised concerns about whether management is becoming increasingly distracted by its efforts to prop up its share price.

For the quarter, sales increased 20% year over year to $1.1 billion, driven by 12% growth in weighted average square footage and 13.4% growth in comparable-store sales. For the full year, sales rose 22% to $4.7 billion, and the company increased sales guidance for next year to 18%-21% from a previous estimate of 15%-20%.

But net income and earnings per share for the quarter fell significantly. Net income plunged 68% year over year, from $28 million to $9 million, and diluted EPS fell from $0.43 from $0.13. The profit decline was driven by lost sales associated with Hurricane Katrina, non-cash stock-compensation charges, a one-time increase in the effective tax rate caused by a change in its option program, and an unexpected 31% increase in general and administrative expenses. Investors didn't like the news, sending the stock down 7% in Thursday's midday trading.

Despite Whole Foods' Q4 profit drop, I've often written about this company's large economic moat, great business model, and outstanding returns on capital. For the full year, it generated $411 million in operating cash flow on the $4.7 billion in sales. Despite the continued reinvestment of capital to grow the store base, the cash flow exceeds the capital requirements. As a result, the company announced that it will return some of its excess cash to shareholders, through a combination of a one-time $4-per-share dividend, a 20% increase in its quarterly dividend, and a $200 million stock-buyback plan.

It's the kind of business that BerkshireHathaway's (NYSE: BRKa  ) (NYSE: BRKb  ) chairman Warren Buffett loves to own. As he has written, "The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. . Unfortunately, [this] type of business is very hard to find."

One of the reasons I was initially attracted to Whole Foods was management's stated commitment to metrics such as return on invested capital and economic value added. A focus on ROIC and EVA ensures that management employs capital only at high rates of return, which in turn ensures growth over the long term in the intrinsic value of the business.

But the most recent press release contains some items that may suggest excessive internal concern about the company's share price, which I have argued looks overvalued -- particularly when compared with other leading retailers like Costco (Nasdaq: COST  ) and Wal-Mart (NYSE: WMT  ) .

First, the company announced that it will split its shares two-for-one. To me, this is a clear indication that it is focused on something other than intrinsic value. As David Gardner clearly explained back in 2000, stock splits do nothing to improve shareholder value, ROIC, or EVA.

Second, the company announced that it accelerated the vesting of option grants to employees. Because of rule FASB 123(R) from the Financial Accounting Standards Board, it will have to start expensing options starting next quarter, and rather than expense options grants as they naturally would vest (as the company should have done a long time ago), it decided to accelerate the vesting of all options grants now, while expensing is still not required.

Purely from a strategic perspective of using compensation as a work incentive, accelerating options vesting makes little sense, and I doubt that the company would be doing this had the FASB regulations not come into play. A company's compensation system is a key part of its strategy to drive value; changing it to avoid an accounting hit to earnings looks a lot to me like trying to prop up EPS and the stock price. Again, the question to ask is: How does manipulating options accounting drive ROIC or EVA?

The strategy and business model of this company are great, and what management says about EVA and ROIC really resonates with me. But some of its latest announcements make me think that the company is getting increasingly concerned about how to maintain the momentum in a stock that's had a massive run-up and may now be on shaky ground based on fundamentals.

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Whole Foods and Costco are bothMotley Fool Stock Advisorrecommendations.

Fool contributor Salim Haji lives in Denver, where he shops at the Whole Foods near his house. He also owns shares of Costco and Berkshire Hathaway. He does not own shares in any other of the companies mentioned. The Motley Fool has a disclosure policy.


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