Whole Foods Market (Nasdaq: WFM ) announced first-quarter earnings last week, and they were nothing short of fantastic. The market has since responded by continuing a rather epic run over the last few months. Whole Foods is definitely a high-quality business, and the stock has been one of my best-performing CAPS positions, but is its price justified? I'm arguing no, and I've decided to end my CAPS pick. Read on to find out why.
The bull case
There are many good reasons to own Whole Foods. A big one is that the company has been growing net income at an almost 20% annual clip for the last 10 years, while more conventional grocers like Safeway (NYSE: SWY ) and Kroger (NYSE: KR ) have been essentially flat.
This massive outperformance is due to two simple factors. First, Whole Foods generates far higher sales per square foot than the competition. For 2010, Whole Foods generated sales per square foot of $804, far higher than the industry average of $613.
If you think this is just because Whole Foods sells more premium merchandise, think again. The Fresh Market (Nasdaq: TFM ) , which operates around a similar concept, only managed $481 per square foot in 2010. The only grocer that seems to outsell Whole Foods is the shadowy Trader Joe's, which is estimated to achieve twice the sales per square foot of Whole Foods, but is sadly not a public company.
Whole Foods also keeps a higher margin on those sales. At 3.5%, Whole Foods' profit margin may not seem impressive, but it is the highest in the industry (except perhaps Trader Joe's).
Compare this to the big three -- Safeway, Kroger, and SUPERVALU (NYSE: SVU ) -- all of which may experience a loss in any given year, notably SUPERVALU, which has been flirting with bankruptcy for several quarters now. Some of SUPERVALU's losses are just accounting gimmicks -- the company has been impairing its intangible assets heavily -- but revenues have fallen in almost every quarter for the last five years, with no sign of improvement.
The bear case
So if Whole Foods is the best in class, why would I want to drop it? Well, for the same reason some people prefer not to shop at the stores -- it's expensive, by almost every metric.
Price-to-earnings ratio? It's almost 40, second only to The Fresh Market, whose off-the-charts 142 seems best explained by its small size, its recent IPO, and investor demand for a second chance at a young Whole Foods. The average P/E for the grocery sector is about 16, making Whole Foods nearly three times more expensive than its peers.
The bulls will say the P/E is a flawed metric because Whole Foods is growing so fast, a trend that is likely to continue. According to the Organic Trade Association, organic food sales have grown about 13.4% annually for the last nine years, while conventional food sales have remained largely flat. Whole Foods is better positioned to take advantage of that trend than most competitors.
But the price-to-earnings-to-growth ratio begs to differ. A company with a PEG ratio of one is considered fairly valued, whereas one with a higher ratio is considered more expensive than its growth rate warrants. At 1.38, Whole Foods is moderately overvalued, especially considering that the grocery industry itself appears slightly undervalued with an average PEG of 0.93.
A bull might say these are both flawed metrics because they use earnings, which are easily manipulated. They could point to SUPERVALU, whose worrisome earnings losses run contrary to its more healthy free cash flows. But even if we use the enterprise-value-to-free-cash-flow ratio, Whole Foods still sits at 24 compared to an industry average of 21.6, and far less than the big three supermarkets, which average just north of 15.
Both sides now
I'm not arguing that you should go out and short Whole Foods just because its valuation metrics are high. That would be akin to buying shares of a lousy business just because the metrics say the stock is cheap -- a situation known as a "value trap."
It wouldn't be unreasonable for Whole Foods to start growing fast once the economy does, especially given its strong performance during these hard times. But I just don't think there's much opportunity in the stock right now, and rather than hold on and hope, I'm going to close my CAPS position and wait for a better re-entry price.