The dominant position of Whole Foods Market (NASDAQ:WFM) in the growing market for natural and organic foods has drawn plenty of attention over the past few years; while being respected as a market leader is certainly a good thing, the increased competition that inevitably follows has been a concern to investors in recent months. As a result of these concerns, Whole Foods has underperformed the market thus far in 2014.
After Whole Foods' second-quarter results included a decline in margin in comparison with the comparable quarters in 2012 and 2013, the market jumped to the conclusion that competition from growing specialty grocers such as The Fresh Market (UNKNOWN:TFM.DL), Sprouts Farmers Market (NASDAQ:SFM), and Natural Grocers (NYSE:NGVC) was starting to take a bite out of Whole Foods. The commitment of more established grocery chains such as Kroger (NYSE:KR) to focus more heavily on natural and organic foods has also fed fears of increased competition as well as an impending price war. The result of these competitive fears has been a dramatic decline in share price over the past year for all of the natural and organic-focused grocery chains:
Is it time to panic, or does Whole Foods have significant potential for long-term market outperformance?
Whole Foods' growth trajectory remains intact
As with any retailer, Whole Foods' revenue growth will come from two sources: new locations and comparable-store sales growth. As of its most recent quarterly earnings release, Whole Foods had 374 locations. In the near term, the company expects this to grow by 36-39 stores in fiscal year 2014 and 38-45 locations in fiscal year 2015. These aren't just casual projections; Whole Foods has a record 114 new locations in its pipeline that are already under contract.
Looking out to the longer term, Whole Foods constantly reiterates its long-term target of 1,200 locations in the United States. At almost four times its current number of locations (and excluding the opportunity to expand the company's international footprint), this highlights how early in its growth story Whole Foods is today.
New Whole Foods location in Albany, NY. Source: Whole Foods
On the comparable -sales front, Whole Foods has reported 18 consecutive quarters of positive comps in excess of 3%. This is an impressive illustration of the growing market for Whole Foods' products, even as competitors that range from The Fresh Market to privately held concepts such as Earth Fare have opened in close proximity to established Whole Foods locations.
Whole Foods projects comparable-store sales growth in the low 5% range in 2014, which indicates that competition from niche players as well as new focus from traditional grocery stores is not dramatically impacting Whole Foods' performance. The primary reason for this is simply the tremendous growth in the overall market.
In combination, long-term growth from 10% annual increases in total store square footage and 5% growth in comparable-store sales creates a robust growth picture on the top line.
Whole Foods co-founder John Mackey is known for pioneering conscious capitalism. He literally wrote the book on it! In addition to focusing on the customer, this approach also places significant emphasis on industry-leading treatment of employees. While qualitatively gauging the culture of a company can be difficult, Whole Foods is a rare instance where it is not.
Whole Foods prides itself on having been on Fortune's list of the top 100 companies to work for in 17 consecutive years. On Glassdoor.com, Whole Foods' rating of 3.6 is among the highest ratings received by large corporations. Employees also give an 83% approval rating to co-CEOs Mackey and Walter Robb, which again puts Whole Foods in elite company.
Why does this matter? Employee satisfaction leads to improved performance and less turnover. This translates directly into a correlation between highly rated CEOs on Glassdoor.com and stock market outperformance.
The recent decline in share price has resulted in Whole Foods trading at a trailing 12-month price-to-earnings ratio that is the lowest it has been in five years:
In contrast to this weakness in share price, the top-line growth thesis remains quite strong as Whole Foods expects double-digit growth in each of the next five years. While this valuation multiple remains higher than that of the larger, slower-growth Kroger, it remains well below The Fresh Market's trailing P/E of 32, Natural Grocers' P/E of 44, and Sprouts Farmers Markets' P/E of 83.
Whole Foods also has the advantage of a strong net cash position. With minimal debt and over a billion dollars of cash and short-term investments, Whole Foods has a combination of scale and financial flexibility possessed by neither the smaller grocery concepts nor the traditional grocers:
In addition to the healthiest balance sheet of the group (both in whole numbers and size-adjusted), Whole Foods is also generating remarkable free cash flow. During the first half of the fiscal year, Whole Foods invested $362 million in capital expenditures that primarily related to new stores and still managed to have $257 million of free cash flow left over to pay dividends, repurchase shares, and increase its net cash position.
A great long-term opportunity
A key factor that is often lost in the discussion of the ongoing trend toward healthier eating is that the overall market for natural and organic foods is expected to grow for the foreseeable future. So even if Whole Foods were to lose market share to a new competitor, the size of the overall market for healthier foods will likely increase sufficiently to support Whole Foods' overall growth despite the competitive pressure. This presents a situation where "a rising tide lifts all boats" and multiple competitors such as Fresh Market are also likely to perform well over the long term.
Whole Foods has plenty of room to grow, a management team with proven success, and significant financial flexibility to fund growth and return value to shareholders going forward. While competition will likely continue to increase over time, Whole Foods has successfully competed for years. With its recently improved valuation added into the mix, Whole Foods is a very compelling buy for long-term investors who can weather the day-to-day changes in the market's level of fear relating to competition.