A disappointing 2015 continued for natural foods grocer Whole Foods Market (NASDAQ:WFM) as it reported higher fiscal-fourth-quarter revenue but lower profit after the markets closed on Wednesday. The company's top line grew 5.6% to $3.4 billion. Yet net income declined versus the prior year by 56% to $58 million. Earnings per share decreased by roughly the same percentage to $0.16 per diluted share, in comparison to the $0.35 earned in Q4 2014.
Below I'll review a few important highlights from the report, as well as significant announcements the company made in conjunction with its earnings release.
Comparable sales turn negative
Whole Foods' comparable-store sales decreased by 0.2% during the quarter, marking the first "comps" decline in over five years. While the company had indicated to analysts in late July that comps were in a weak trend at the outset of the fourth quarter, the negative result nonetheless jarred investors, who were expecting at least a flat or slightly positive number.
Partially in response to this outcome, Whole Foods' stock tanked in after-hours trading, losing as much as 7.5%. In guidance for 2016 issued Wednesday, the company indicated that comps might essentially remain flat next year.
Gross margin weakened, but overhead was softer yet
Since the company has been making price investments all year to remain competitive with encroaching competition in the natural foods category from the likes of grocery giant Kroger Co (NYSE: KR), gross margin was widely expected to decline a bit this quarter. Whole Foods' gross margin indeed slipped nearly one percentage point, to 34.5%.
More surprising was the company's selling, general and administrative expense, often referred to as "overhead." Selling, general and administrative expense surged 10.5% as a percent of total revenue, to 31.4%, versus just 28.4% in the comparable quarter. If shareholders were wondering why management made the decision to reduce its workforce by approximately 1,500 employees during the quarter, the answer is now evident. The company is undoubtedly hard at work to control unnecessary costs in future quarters, in the face of slowing revenue.
Buybacks, dividends, and indebtedness
Along with Wednesday's earnings, management introduced new initiatives aimed at appeasing shareholders. The company announced a $1 billion share repurchase program, which will expand the current existing authorization to $1.3 billion. Whole Foods' board also declared a dividend increase of 4%, beginning with the Jan. 26, 2016, payment, which brings the total quarterly dividend to $0.135, for a yield (at today's post-closing level) of approximately 1.9%.
These shareholder-friendly actions were supplemented with a change in the company's capital structure. After expressing an aversion to debt after borrowings reached nearly $1 billion between 2008 and 2009, management has kept the company mostly debt-free for several years. But Wednesday Whole Foods announced that it has entered into a $500 million revolving credit facility, and plans to borrow an additional $1 billion before the end of the first quarter of 2016.
In its press release detailing the buybacks and debt, Whole Foods stated the following:
Proceeds from any debt incurred would be used for general corporate purposes, including the repurchase of stock. The Company's intent is to spend the majority of the $1 billion buyback authorization in the first half of the fiscal year and expects the combined effects of the additional indebtedness and future share repurchases to be accretive to earnings per share in fiscal year 2016.
To condense this statement in conjunction with the information I presented directly above it, the company will borrow $1 billion in Q1 2016, to complete a $1 billion buyback by its fiscal midyear, which will increase earnings per share by decreasing the number of shares outstanding.
For stable, mature companies with great cash flow, this is a common enough bit of financial engineering which is often well-received by shareholders. Fewer shares outstanding means that existing shareholders get a greater piece of future earnings.
Yet Whole Foods' stock certainly didn't pop on this news. In fact, the indebtedness probably factored in the stock's after-hours decline. Investors have a tantalizing question they want answered: Can Whole Foods return to being the phenomenal growth company it used to be, or even a semblance of the same?
Leveraging the balance sheet to juice earnings per share doesn't address this question at all. The action has a bit of tone deafness about it, and this from a management team that previously seemed focused on reinvesting profits into the business. But perhaps the buyback tacitly provides its own answer on management's assessment of the company's growth prospects.
An extremely mixed message
To be fair, in today's release, CFO Glenda Flanagan pointed out that the new debt lowers Whole Food's cost of capital, while preserving financial flexibility for future growth. This is true, but the cost of capital for initiatives which truly expand the company will only be decreased within the portion of the $500 million credit facility which gets utilized. As I pointed out, the $1 billion is simply being borrowed to buy back shares.
Whole Foods currently has a weighted average cost of capital hovering near 8%, and it's reasonable to assume that the short-term financing cost on the credit line may be half of this percentage or even less. So Flanagan is correct to point out the benefit of the credit "revolver."
But it may have made more sense to shareholders for the company to have flipped its plans, and authorized a $500 million buyback, while setting aside $1 billion at a lowered cost of capital to ramp up store development (including the new "365" concept stores due to launch next year).
In the absence of comps expansion, this would have sent an unmistakable signal to the market that the company was serious about resuming its profile as a growth company. The prioritization of Whole Foods' new debt sends an extremely mixed, even confusing, message to shareholders. That message is, the company sort of thinks it can grow, but just in case, it's hedging its bets by doing what it believes will really please shareholders, while manufacturing the ability to point to increased earnings per share next year.
Given the nearly 29% swoon of the "WFM" symbol year-to-date, and the immediate reaction Wednesday, it's clear that investors wanted to see firmer conviction from company executives. Instead, stockholders appear dismayed that Whole Foods' capital is being returned to them instead of getting plowed into an investment such as square foot expansion. At any rate, what's done is done. Time to tap that credit line for a constructive purpose.