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Whole Foods Second Quarter
Board: Whole Foods Market, Inc.

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By rakapu
May 16, 2007

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To rehash the highlights (or lowlights): sales were $1.46B, up 11% annually but missing analysts' expectation of $1.49B and down sequentially. Net income was $46M, down 11% annually, down sequentially, and missing analysts expectations of about $52M. Obviously, missing the expectations is what has hurt the stock the most (down about 10% in pre-market trading as I write this). Comparable store sales slowed to 6%, from 11.5% a year ago, but that is still an impressive number for a retail store.

I'm long Whole Foods. So does this "blip" give me a chance to lower my average cost (currently somewhere in the 50's), or is it a red flag that tells me to reconsider my long position?

First, let's look at why Whole Foods had a down quarter. In their press release, they mainly cite costs related to new store openings. In fact, this quarter, Whole Foods had $42M is depreciation charges (non-cash) as compared to $35M for this quarter in 06. If you were to add that $7M difference back in, you'd just about hit expectations. In fact, gross margins this quarter were nearly the same as last year (35.2% vs. 35.3%), so maybe the business they are doing isn't all the different than it has been in the past, other than spending money on expansion and a little bit of competitive pressure (i.e. the drop in comps).

Long term, that may be fine. If you are long Whole Foods (like me), you trust that they will continue to have a competitive advantage with their model. You also have to trust in Mackey and the rest of the management and their expansion plan. The fact that they use EVA as a key factor in decision making leaves me feeling good about their assessment of what to spend money on. However, that doesn't mean Wall Street will treat the stock well for the next few months or even years. It appears their capital expenditures are continuing to soar, and that'll be hitting their bottom line over the next several years, offsetting new store growth.

For example: this quarter, Whole Foods spent $77M on new store openings, compared to $101M last quarter, but in the year-ago quarter, they had spent only about $33M on new stores (I'm estimating that number slightly, don't have the 10-Q in front of me). That's a huge increase since last year, and double their current depreciation charges. So the new store spending will continue to hit earnings for a while to come.

How do we value this? I always have a much harder time valuing growth than intrinsic value. To start with, let's add back in all of the new store spending over the past 2 quarters to owner earnings (NOPAT + DnA - CapEx + New-store-CapEx). This would give us a run rate of about $180M annually. Accounting for on-hand cash and debt, I'll then use a 6% growth rate for 10 years (as this is a conservative estimate for their comp sales growth, which would be what they'd grow if they stopped spending any money on expansion). This most conservative valuation would be $21.50 per share.

We could loosen things up a little bit, and say that they have already spent money on new stores, so let's expand the growth rate in the first 5 years to 12% (roughly what the sales grew this year), then leave it at 6% for year 5-10. In this model, they'd get the growth they've already committed to, but stop spending on any more growth. This bumps up the valuation to $27.10.

Obviously, even at today's beaten up prices, the market is pricing in a lot of growth to the company. In fact, the market is currently pricing in 20% earnings growth, and without taking into account the CapEx it'll cost to create that growth, so it's really pricing in something more like 25-30% growth. In fact, Mackey thinks this is possible, given their plan, stated time and again, is to have $12B annual sales by 2010. Still, I expect the market to punish Whole Foods a while longer for their increased spending and slightly-slumping competitive edge. I think I'll hold out a while longer to add to my WFMI position, probably if the stock sinks below $40 to the $30-35 range. At this value, the stock would actually represent a value (!!!) given their growth plan.

Comments are appreciated.

Ron


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