Why Wall Street Is What's Wrong With Whole Foods

Source: Wikimedia Commons

It seemed like a short time ago that supermarket chain Whole Foods Market (NASDAQ: WFM  ) was the darling of Wall Street. As the company cemented its brand image with consumers as a high-quality, premium grocer, analysts fell in love with the growth story. And, as happens so frequently, those analysts quickly raced to one-up each other's earnings estimates.

Unfortunately, that game usually ends the same way. A company can only grow so fast, and that's particularly true when it comes to a grocery chain. When expectations keep ratcheting higher, analysts set themselves up for disappointment. That's exactly what happened when Whole Foods released an earnings report that was actually solid in terms of its core business performance. Nevertheless, management provided an outlook that was less than perfect, which sent the stock crashing.

Still, despite the obvious disappointment over Whole Foods' results, it's still in a much better position fundamentally than many other grocers, including Safeway  (NYSE: SWY  ) .

What's wrong? In a sense, nothing
Fundamentally, Whole Foods isn't a broken company. Far from it. In fact, Whole Foods produced growth across most metrics important to a supermarket chain. It racked up $3.3 billion in sales, which set a company record. It also signed nine new leases, bringing the total development pipeline to 114 leases, which is also a record.

Even if you strip out the benefit to sales from opening new locations, Whole Foods' results look good. Comparable-store sales, which measure growth at locations open at least one year, rose 4.5% year over year. On a per-share basis, management is still creating value for shareholders. Whole Foods' diluted earnings per share were up 4% over the first half of the fiscal year. Compare these results to Safeway's. Safeway lost $83 million in the most recent quarter, and its operating profit was cut in half.

What really upset Wall Street was the fact that Whole Foods cut its outlook for the remainder of the year. For the full fiscal year, management expects $1.54 in earnings per share, down from previous expectations of $1.61 per share. In terms of growth, the company projects at least 5% same-store sales growth and about 4.5% earnings growth. This is down from its previous forecast of 5.8% comparable sales growth and 9.5% earnings growth.

Can't fault a company for its stock valuation
Comparable-store sales growth should still hold up, which reflects continued brand connection with shoppers. The sharp reduction in profit expectations is due mostly to an increased investment in expanding the store count and square footage. Recall that Whole Foods purchased seven stores in the Chicagoland area from Safeway earlier this year as part of its strategic initiatives. What's important to note is that even with the slashed guidance, Whole Foods should still post growth year over year. And, an expanding store count is a costly, but necessary, part of any growth strategy.

Where Whole Foods went wrong was its valuation, which management has no control of. Prior to releasing earnings, Whole Foods was priced to perfection, trading for about 32 times trailing earnings. This means that the company had very little wiggle room, and any disappointment was poised to send its stock crashing. Unfortunately, that's exactly what happened when it reduced its full-year outlook.

Foolish Bottom line: Wall Street got ahead of itself
Whole Foods is a profitable company that is growing its store count. There's nothing wrong with it from a fundamentals perspective, but the stock is a different story. After collapsing 18% post-earnings, Whole Foods is more modestly priced at 25 times forward earnings. For a growth stock, this is not unreasonable. But still, you should expect continued volatility.

The grocery industry is highly cost-intensive and very competitive. Whole Foods still expects rising same-store sales and profits this year, so it's not like its growth story is no longer intact. And, Whole Foods does pay a dividend, which provides a slight margin of safety. With such a high valuation, however, expect the bumpy ride to continue.

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