Taking a Bite of Whole Foods

Whole Foods Market (Nasdaq: WFMI  ) may have a reputation for shares as pricey as its wares, but investors gave its stock a hefty discount after the natural and organic grocer reported its third-quarter earnings. However, some Fools might consider that reaction in poor taste. In many ways, Whole Foods is a revolutionary, shareholder-friendly company, with plenty of signs of growth ahead.

Third-quarter net income at Whole Foods increased 33% to $53.9 million, or $0.37 per share. Sales increased 18% to $1.3 billion, while same-store sales increased 9.9% (compared to a 15.2% increase in the same quarter last year, a difficult comparison). Profit margin also increased to 35.3%.

So why the panic on the Street? Whole Foods' sales came in a bit shy of analysts' forecasts, and it seems some analysts split hairs over its anticipated sales growth next quarter. Whole Foods previously expected sales growth between 18% to 21%, and the company stuck by its numbers in its most recent release.

During the company's conference call, founder and CEO John Mackey admonished analysts for focusing more on short-term numbers than long-term growth. Many of us Fools would agree, especially considering Whole Foods' notable transparency concerning its numbers and strategy.

Whole Foods and the big picture
Indeed, Whole Foods goes above and beyond the call of duty in reporting several metrics that emphasize long-term economic health. Among others, it reports the Economic Value Added metric, or EVA, which increased by $11 million to $20.6 million in the quarter, the largest amount this year so far.

Furthermore, while many retailers give only bare-bones data on same-store sales -- and some reduce or even eliminate such disclosures -- this Motley Fool Stock Advisor recommendation goes the extra mile by breaking down its comps growth according to the age and size of its stores. (When I wrote this commentary on the dangerous developing trend of unreported same-store sales data, I gave Whole Foods credit for reporting EVA, but I missed the extraordinary amount of detail it provides regarding its comps. Mea culpa on that note.)

My colleague David Meier used Whole Foods' abundant data to plot the progress of its same-store sales, observing that comps for older stores appear to flatten to a constant level around 7% to 9%, instead of continuing on the downward trend one might expect for many retailers' older stores. Although we all know that can't continue forever, David observed that given those indications, it's possible that Whole Foods' stores might have an incredibly impressive growth life of 25 to 30 years.

In addition, Whole Foods tends to remodel older stores to reflect its ongoing observations of what works. Such investments seem to generate incremental value by extending the life of older stores. That dynamic strategy, incorporating the company's experience to boost older stores' appeal, probably explains why mature Whole Foods stores continue to excel. Furthermore, the company manages to grow while retaining a strong balance sheet, with $397 million in cash and investments and $9 million in long-term debt. A smart competitor that generates good incremental returns on invested capital while maintaining a strong balance sheet bears all the hallmarks of a great business.

Competitive challenges
That's not to say there aren't risks at hand. The specter of Wal-Mart's (NYSE: WMT  ) growing influence in organics jumped out at me while I looked over Whole Foods' conference-call transcript. Apparently, Whole Foods has been "price advertising" in certain high-profile markets. In the past, the company has never been a big advertiser; it's long been distinguished by its customers' willingness to fork over for premium merchandise, and the impressive effectiveness of its word-of-mouth marketing.

Whole Foods said that it wanted to better communicate the value offered by its private-label products. The move emphasizes its hungry competition and its need to attract less affluent shoppers. Whole Foods is up against everybody from traditional grocers like Safeway (NYSE: SWY  ) to more specialized niche players like Wild Oats (Nasdaq: OATS  ) and privately held Trader Joe's. Whole Foods said it has every intention of competing on price for certain commodity items that might be available elsewhere (a certain brand of organic milk, for example), while charging higher prices for unique, premium goods. The company also pointed out that this strategy hasn't harmed its margins.

Mackey also said that investors should expect accelerated innovation over the next year or two, as Whole Foods works to further differentiate its stores and their customer experience. (One recent move seems highly complementary to Whole Foods' long-term strategy.) As he's often said before, Mackey noted in the latest conference call that competitors have often served as gateways to Whole Foods' own stores. In the past, consumers' exposure to small selections of organic goods in more traditional outlets has driven them on to Whole Foods, which has the selection and the values to back up its image of an organic, healthy lifestyle. It remains to be seen whether Wal-Mart's historic move into organics will have a similar effect on consumers.

In the checkout line...
Even with today's drop in price, Whole Foods still has a rich P/E of 46. That's probably too richly valued for many value-oriented investors, not to mention those nervous about macroeconomic trends and retail in general. However, I'd argue that this stock never looks cheap. Today might represent an opportunity to buy into a revolutionary, growth-oriented company headed up by visionary leadership, with a unique understanding of emerging trends that are increasingly important to consumers, ample room for future growth, and a history of practices that have proved extremely friendly to long-term investors.

Whole Foods Market is aMotley Fool Stock Advisorrecommendation. Wal-Mart is aMotley Fool Inside Valuepick. Whatever your investing style, the Fool has a newsletter for you.

Alyce Lomax does not own shares of any of the companies mentioned.


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