Whole Foods Market Inc. Stock Could Actually Be Worth Less Than You Think

In 2013, Whole Foods Market (NASDAQ: WFM) started to report declining sales growth, and its stock price took a major hit. The stock was down as much as 40% through autumn 2014 as increased competitive pressure from dedicated natural food sellers like Sprouts Farmers Markets (NASDAQ: SFM), as well as big box, all-in-one retailers like The Kroger Co. (NYSE: KR), has led to less optimistic outlook about Whole Foods ability to continue growing at past rates in this new and more price-competitive environment. In response, Whole Foods changed its pricing strategy starting in 2014, increasing transparency and lowering prices on perishables. The stock nearly recovered to previous highs by early March of this year, yet it appears to be sliding again.

BMO Capital Markets, an analyst group, cut its price target for Whole Foods Market shares to just $54 on April 15, from its previous target of $58. Deutsche Bank has set a price target of $54 for WFM as well. Does Whole Foods really deserve BMO's target price cut? Actually, even this new lower price might be too high -- here's why.

Whole Foods shares are already at a premium
Whole Foods shares are trading around $49 now, priced at 31 times earnings. When compared with the industry, Whole Foods initially looks relatively fairly priced. With companies like Sprouts that also have a high P/E and gross margin, Whole Foods barely stands out.

Yet Sprouts is not the competitor that Whole Foods needs to worry about, it's the more established companies with many locations already, and a revved-up ambition for reaching the natural and organic food market that present a threat to Whole Foods and its share price now. When you compare Whole Foods to a company that fits that example, like Kroger, it's clear that Whole Foods is trading at a premium. 

Some Whole Foods earnings math
Let's estimate what Whole Foods' share price could be  by the end of this fiscal year ending September 2015.  Even with same-store sales growth declining, at a low of around 4% year over year last year, 38 new stores during the year helped Whole Foods to post about 10% year over year total revenue growth for fiscal year 2014 ended last September. The company has forecast 9% year over year revenue growth for fiscal year 2015. Even though same-store sales may fall a little more, new store growth expected this year and next should help to keep that growth going, so 9% each of the next two years looks pretty accurate.  This puts the fiscal year 2015 revenue estimate at $15.47 billion. 

Gross margin seems likely to contract from where its 35.5% at the end of FY 2014. Whole Foods has been lowering prices in its stores to combat rising competition, resulting in declining gross profit margin, down to its most recent 34.8% in the first quarter. At this rate of decline, we can expect around 34% by year-end fiscal year 2015 as the company continues to cut prices. In fact, management even stated in the 2014 fiscal year end earnings release that gross margins are expected to decline more in 2015 than in 2014. 

The resulting gross profit for fiscal year 2015 in the example here is now $5.879 billion. One way Whole Foods does seem to perform very well consistently is that it has kept its other costs steady, largely through extremely prudent capital management (the company has essentially no debt). So, leaving the net profit margin alone at 11.66%, we are looking at a 2016 net income of $685.4 million, or an EPS of $1.90.

Why the $54 price target could actually be too high
At a price of 31 times this 2016 earning estimate (WFM current P/E), the stock is then worth about $58.90. But the question is: In an industry with new, lower-priced competition, will Whole Foods investors continue to reward the company with a valuation of 31 times earnings? At just a small drop to 28 times earnings (still relatively high), Whole Foods' valuation is already down to less than $54. Twenty-two times earnings (Kroger's current P/E) would put Whole Foods share value at just $41.8.

Furthermore, if we account for the same math but use a lower gross margin (which is highly possible due to increased competition and the need for lower prices), things look even worse. At a gross margin just one percent lower at 33%, FY 2015 earnings per share could drop to just $1.65, and the stock price at those same price-to-earnings valuations would be $51, $46.20, and $36.30, respectively. A share buy back from the company could affect this calculation and send EPS higher, but there has been no hint of that in the near future, as the company's recent share buy back plan ended in the summer of 2014.

Are 800 new stores reason enough for a high valuation? Probably not
Two valuation questions at play above are: How much will competition continue to drop the company's gross margin, and will the market be confident enough in Whole Foods' long-term growth to continue affording it such a premium price-to-earnings ratio? As for same-store sales growth and gross margin, these numbers look very risky, especially since Kroger is expected to replace Whole Foods as the largest seller of natural and organic food in the country by 2017. 

As for new store expansion, Whole Foods high valuation comes from the belief that it can continue to rapidly expand its store count. The company has guided that it would like to eventually reach 1,200 stores, nearly triple how many locations it has now. The company didn't specify a timeline for this growth, but at its current growth rate, it could take about 20 years. An additional consideration is that Whole Foods is seeking to expand internationally, but again, with no real timeline or set plan for this, and with mounting competition there as well, this alone doesn't look like a reason to believe the stock can continue to climb with such high valuations.