Source: Whole Foods Market
The past year has been a rough one for Whole Foods Market (WFM). In July, the company admitted to overcharging customers on pre-packaged foods. A month later, the company looked rather silly when it tried to sell $6 water laced with asparagus stock. Just before the end of September, Whole Foods announced it was laying off 1,500 employees, a blow to its reputation as one of the nation's top employers.
Whole Foods' most recent quarterly performance was also disappointing. The effect of increased competition in the organic and natural foods market was apparent as the company's same-store comparable sales fell 0.2%, its worst performance since the Great Recession. Gross margins declined by 96 basis points to 34.5% -- a level not seen since 2011. To pour salt in the wound, shareholders saw the market value of their once beloved grocer decline 34% in 2015. Depressed yet?
Despite management's missteps and the company's recent struggles, Whole Foods still has a tremendous market opportunity in front of it. According to the Organic Trade Association, consumer demand for organic products has increased by a double-digit percentage every year since the 1990s, growing from $3.6 billion in sales in 1997 to over $39 billion in 2014. Additionally, 51% of families are buying more organic products than a year ago. A Consumer Reports survey showed 84% of people buy organic food sometimes and 46% purchase organic at least once a month.
The trend toward healthier eating is increasing, and Whole Foods is looking to take advantage of this development. The company sees potential for more than 1,200 locations in the United States. At 433 locations today, Whole Foods still has a long runway of growth in front of it. And with 111 leases signed and a run rate of 30 to 40 store openings per year, Whole Foods is on pace to achieve its growth goal.
However, the market doesn't seem to agree, even though, despite slowing revenue growth and margin compression, Whole Foods is still outperforming the competition in key financial metrics.
|
Operating Metric (TTM) |
Whole Foods Market |
Industry Average |
|---|---|---|
|
Revenue growth |
8.4% |
5.3% |
|
Operating margin |
6.2% |
5% |
|
Return on capital |
13.4% |
10.9% |
Source: S&P Capital IQ
Moreover, the company's price-to-sales multiple is similar to its peers and moved lower only during the 2008 to 2009 great recession. The price-to-earnings ratio is also well below recent lows.
| Metric |
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
Industry Average |
|---|---|---|---|---|---|---|---|---|---|
|
Price-to-earnings |
24.4 |
35.9 |
26.0 |
33.8 |
38.7 |
39.8 |
24.4 |
21.4 |
17.7 |
|
Price-to-sales |
0.4 |
0.5 |
0.7 |
1.2 |
1.5 |
1.7 |
1.0 |
0.7 |
0.7 |
Source: S&P Capital IQ
Despite slowing growth at the individual store level, Whole Foods is still growing its footprint throughout the United States. If Whole Foods grows its store base at a pace of 35 locations per year, maintains its current store revenue of $715,000 per week with zero same-store sales growth, and continues to trade at current, depressed multiples, the stock appears undervalued on a price-to-sales basis.
|
New Stores Per Year |
Store Count in 5 Years |
Total |
P/S Ratio |
Market |
Annual Return |
|---|---|---|---|---|---|
|
30 |
583 |
$21,676 |
0.6 |
$13,006 |
3% |
|
35 |
608 |
$22,605 |
0.7 |
$15,824 |
7% |
|
40 |
633 |
$23,535 |
0.8 |
$18,828 |
11% |
|
45 |
647 |
$24,055 |
0.9 |
$21,650 |
14% |
Source: S&P Capital IQ and author estimates
A major factor cited by Whole Foods bears is continued margin compression from competition, especially from retailers known to win on rock bottom pricing. In 2015, the company had net profit margins of 3.5%, its lowest level since 2011. If Whole Foods continues to grow its store base at an average of 35 locations per year (with zero same-store sales growth) and incurs a further 25 basis point decrease in net profit margins, the stock is still slightly undervalued. Given these assumptions and no change in share count, earnings are projected to come in at $2.15 per share. Below are potential returns if it is able to achieve this performance.
|
|
Price-to-Earnings |
Price Per Share |
Annual Return |
|---|---|---|---|
|
Pessimistic |
16 |
$34.44 |
1% |
|
Most likely |
19 |
$40.90 |
4% |
|
Optimistic |
22 |
$47.36 |
7% |
A range of 1% to 7% returns is not significant. However, if you add in a 1.5% dividend yield and a $1 billion share buyback program, potential returns become more attractive. If management can outperform these conservative assumptions, returns can be even more substantial.
The market is also pessimistic about Whole Foods' ability to improve its individual store performance. While the company's recent struggles can be attributed to negative press and increased competition, Whole Foods is also a victim of its own success. As co-CEO John Mackey said in the company's fourth quarter investor call, Whole Foods has enjoyed high single-digit comparable-store growth for the past 20 years. With sales of about $1,000 per square foot, Whole Foods has some of the highest-performing supermarkets in the country, leading to higher hurdles and more difficult year-over-year comparisons.
Whole Foods' high-growth days may be behind it, and the market is punishing the stock accordingly. I have confidence that the negative publicity will be forgotten and Whole Foods' management will be able to regain sales momentum. However, even if it struggles to grow at the individual store level, Whole Foods' new store growth alone will make this company a successful investment. A turnaround with its existing locations will just be icing on the gluten-free cake.
