The Allure of Whole Foods

Warren Buffett loves buying great businesses at fair prices -- something I strive for, as well, to improve my portfolio returns. With the recent fall in the stock price of Whole Foods (Nasdaq: WFMI  ) , I've been wondering if the organic grocer has become one of those situations, or if I am falling for a "song of the sirens."

The beginning, a very good place to start
A simple way to think about Whole Foods is that it's a fancy grocery store. I don't think that's quite accurate, though. Despite my dislike of the term, it's a lifestyle store, and that lifestyle is about natural and organic foods.

In my house, we've been slowly moving away from processed foods and toward organic. We've found that selection is one way Whole Foods differentiates itself from the likes of Kroger (NYSE: KR  ) , Safeway (NYSE: SWY  ) , SuperValu (NYSE: SVU  ) , and Wal-Mart (NYSE: WMT  ) on the traditional grocery-store side and Wild Oats (Nasdaq: OATS  ) on the natural and organic side. Not only does it carry natural and organic foods, but it has an excellent selection of them. And if you're looking to pinch a few pennies in the process, it has private-label goods, too.

A big differentiator is its prepared foods. There's plenty of selection for lunch, dinner, and dessert. You can eat there or take your choices home. It's an important way Whole Foods helps its customers maintain the lifestyle. The store is designed to be an experience, not just a place to buy food.

Movin' on up
Being a lifestyle brand allows Whole Foods to charge higher prices. Trust me -- my wife tells me its prices are high, and as a good penny-pincher, she would know. I think these high prices tend to reinforce the nature of and commitment to the lifestyle, which can create an advantage not unlike the one Starbucks (Nasdaq: SBUX  ) enjoys with its model.

New stores open with considerable fanfare. People are looking to be a part of the lifestyle and have pent-up demand that is released when a store is opened in a new area. In Greenville, S.C., the Whole Foods is relatively new, huge, clean, well-stocked, and packed with customers (and the smoked salmon dip is to die for). And by the looks of the performance metrics below, I think that's common wherever a new store is opened.

The numbers
Whole Foods has averaged 20% sales growth over the last five years, a combination of 8.1% in new-store growth and a very healthy 11.5% increase in same-store sales. From the margins in the table below, we see that the stores are gradually improving their productivity as well.

























Data provided by CapitalIQ.

Those are some impressive numbers.

What's not to like?
The answer is simple: return on invested capital (ROIC). Growth alone is not enough. Growth has to come from the most efficient use of capital possible, and that's why we always have to understand how much capital is used to generate that growth, as well as the returns that capital generates.

I'll give Whole Foods praise for using Economic Value Added (EVA) to evaluate its business decisions. However, I will criticize its neglect of operating leases in the calculations found in the investor-relations sections of its website. Operating leases, while not carried on the balance sheet, are still a form of financing, and a big one for Whole Foods. My estimate of the net present value of its 2006 lease obligations is about $2.9 billion, compared to $1.2 billion in plant, property, and equipment. As such, that capital has to be accounted for in the return calculations and the imputed interest added back to returns.

Here's what I found when I compared my ROIC calculation, which includes adjustments for operating leases, with what I found on the company's website.






ROIC from website






Calculated ROIC






Returns are flat and, while above the cost of capital, smaller than I expected. I like to invest in companies that have a competitive advantage and are able to turn that advantage into increasing ROIC over time. Whole Foods, I am sorry to say, does not appear to fit that mold. As the leader in its space, I am surprised it doesn't generate higher returns. Perhaps I am demanding too much, but I was expecting more.

Given the nature of economic returns over time (competition tends to force returns to decline toward the cost of capital), I am concerned as to how Whole Foods' will rise higher. Is sales growth going to increase faster? Are margins going to expand further? The future is going to be difficult, despite the incredible selection of products and the lifestyle Whole Foods helps its customers support. Supermarkets require lots of capital to operate, and I don't see why Whole Foods would be any different.

Foolish bottom line
We all want to pay a fair price for a great business. But that business has to generate high returns on invested capital, because those returns are what will drive the stock up in the future.

Whole Foods is a great business that looks like it is getting better on many operating fronts. But it requires lots of capital and, quite frankly, that capital is not earning enough to warrant my investment dollars. To me, this is just like the song of the sirens: The appeal of the song is very hard to resist (great story, great growth, great performance) but I fear that if I am drawn to the sound, my portfolio is likely to see poor results.

I am probably not making any friends by saying that. (1,474 of 1,614 investors rate Whole Foods an "outperform" in Motley Fool CAPS.) But like Odysseus' men, I am filling my ears with beeswax, because I am scared of smashing my boat into the rocks.

For more on Whole Foods, check out:

Whole Foods and Starbucks are both Motley Fool Stock Advisor recommendations. One of the beautiful things about The Motley Fool is that we don't have to agree. To see why Whole Foods was recommended, all you need to do is click here for your free 30-day trial. Wal-Mart is an Inside Value pick.

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He is currently ranked 619 out of 20,943 investors in The Motley Fool's CAPS stock-rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.

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