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Whole Foods: Not Quite a Z

In a previous column, I discussed a categorization scheme to help identify different types of companies based on the work of Bennett Stewart in his book The Quest for Value. Although the X, Y, Z scheme is not as well known as Peter Lynch's six company types (fast growers, stalwarts, slow growers, cyclicals, turnarounds, and asset plays), it can play a valuable role in understanding a company's investment story.

The X, Y, Z categorization method is especially useful when trying to value fast-growing companies that generate negative free cash flow. Often, a company masquerades as either a Y company or an X company but is really a pre-Z company. This Fool thinks organic-foods retailer Whole Foods Market (NYSE: WFMI  ) is a perfect example of this situation.

The problem is that CEO John Mackey would have you believe that the company's operating leases aren't contractual obligations. While we can debate the merits of GAAP and lease accounting, any Fool knows that operating leases are contractual obligations and should be treated as a financial asset. If that's the case, then Whole Foods has inked 21 years of leases, which, when capitalized, are valued at $2.8 billion using a 5.25% cost of debt. And that means Whole Foods' free cash flow to the firm (FCFF) is definitely negative -- and, therefore, it's not a Y company.

Add the growing lease obligations to the existing $1.65 billion in assets on the books, and now we get a better representation of the leverage Whole Foods is using. However, this Fool has a theory that while Whole Foods' operating leases are a financial obligation, as long the company can pay its rent, those leases can be treated as equity. If that's the case, then most of the $4.5 billion in invested capital should accrue to the shareholders.

With Whole Foods' enterprise value at $6.5 billion, the $2 billion market premium doesn't look so rich. Unfortunately, that still leaves us with only $32.50 in invested capital per share. Consider X company Kroger (NYSE: KR  ) , which trades close to its invested capital of $22 billion. Even competitor Wild Oats Markets' (NYSE: OATS  ) enterprise value of $533 million is less than its invested capital of $626 million.

Although Whole Foods' margins are significantly better than Wild Oats' and its growth looks insatiable, the company needs to either increase its margins or improve its operational efficiency to justify its current $47 share price. At a five-year 7.5% return on invested capital average, Whole Foods is still not meeting its cost of capital, which at 8% includes the capitalized leases. This means Whole Foods is not a Z company, either.

And this is rather a different picture from the 12.8% ROIC and $1.7 billion in invested capital that John Mackey presents. While this Fool is happy that Whole Foods recognizes the value of creating economic profits, I think it's foolish not to present the whole picture.

Hungry for some related Foolishness?

Whole Foods is aMotley Fool Stock Advisorselection. You can read the investment thesis by taking afree 30-day trialto Tom and David Gardner's flagship newsletter service.

Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.

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