How much is a penny worth? To Wall Street, almost one-tenth of a share's value. At least that was the case when Whole Foods' (Nasdaq: WFMI ) first-quarter earnings came in a single cent shy of the Street's average estimate on Wednesday. Despite reporting strong results -- revenues were up 22% to $1.7 billion, net income increased 26% to $58 million, and comparable-store sales grew 13% -- the specialty grocer watched its stock fall by almost 10% in Thursday trading.
For those of us who have a long-term outlook in our analysis of Whole Foods, missing analyst estimates by a penny is inconsequential. In fact, the resulting drop in the share price is a welcome event, particularly when combined with the continued strengthening of the underlying business. For me, yesterday's fall is simply accelerating the inevitable convergence between intrinsic value and stock price -- two items that, as I have argued, have recently diverged as Whole Foods shares have shot up 74% in the past year.
Though I have raised questions in the past about whether company executives were starting to get caught up in the frenzy of Wall Street, the two most recent filings -- the quarterly report and the 2006 proxy -- indicate that Whole Foods does remain focused on the long-term health of the business.
In addition to the strong headline financial results for the quarter, three things caught my eye. First is the increased emphasis this quarter on economic value added (EVA), a key measure of long-term returns on invested capital. While Wall Street is obsessed with quarterly earnings-per-share targets, long-term value creation is driven by earning consistently high returns on capital, of which EVA is an excellent measure. EVA is less well understood and harder to explain than EPS, but it's a much more accurate metric of shareholder value creation over the long term. For the quarter, EVA increased nearly 50% to $16.3 million.
Second is a brief comment that CEO John Mackey made on the conference call regarding continued growth in the private-label business. SKU counts increased 12% year over year, and private-label sales increased to 16% of grocery and nutrition sales. In my mind, increasing the share of private-label products is critical to building Whole Foods' long-term competitive advantage. After all, Wal-Mart (NYSE: WMT ) , Costco (Nasdaq: COST ) , and Safeway (NYSE: SWY ) may be able to stock the same brands of organic products as Whole Foods, but developing a line of competitive private-label offerings will be much harder to replicate.
Third, and perhaps most importantly, is the section in the proxy report on executive compensation. Mackey was paid cash compensation of $436,000 in 2005, or about 14 times what the average hourly worker at Whole Foods was paid. This is particularly notable in the broader context of excessive executive pay in the U.S. According to the Economist magazine, the ratio of CEO compensation to the pay of the average production worker in 2004 jumped to 431-to-1 from an already egregious 301-to-1 in 2003. Whole Foods' compensation philosophy is a key driver of the company's culture and the productivity of its employees. A strong, loyal culture characterized by highly productive employees is not only critical in a customer service-intensive business, but it's also extremely difficult for a competitor to replicate. Every year that Whole Foods continues to buck the trend of overpaying its executives, the moat around its business gets deeper and wider.
Warren Buffett, chairman of Berkshire Hathaway (NYSE: BRKa ) (NYSE: BRKb ) has said that in the short run, the stock market is a voting machine, but in the long run, it's a weighing machine. Popularity is ephemeral -- should Whole Foods continue to lose votes in Wall Street's popularity contest while the fundamentals remain solid, the stock will once again trade at a price closely matched to intrinsic value, or perhaps even at a discount, as it did no more than a couple of years ago. When that happens, the opportunity to own a piece of this great business at a decent price will re-emerge. I'll be buying.
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