"Great Deals" at Whole Foods - What about the stock?

I just returned from Whole Foods and feel compelled to reverse my long-term publicly-expressed bearishness on the stock.  I first shared my negative thesis in March 2007 in an article that generated some disagreement.  The main points of the article:

• EPS growth would fall short of 20% projections
• OATS merger made little sense and was risky
• Increased competition was a real threat, especially in light of weakening economy
• My belief that the firm needed to cut prices to maintain or grow same-store volumes
• Too high of a valuation for "value" investors

I concluded that "the PE has come down, but it is still a healthy 28X, about double the S&P 500. RPS and EPS are decelerating. With increased competition, a risky merger that will devalue its pristine balance sheet and clearly slowing growth, this stock doesn’t justify its current valuation."  I followed up that original article in July (where I was also quite negative on SBUX) and then twice in November (before FY07EPS and after FY07EPS). 

When you contribute as often as I do, you are bound to get one or two right and one or two very wrong (which I have!).  My point is not really to pat myself on the back for nailing this one for seemingly all the right reasons, but rather to determine if what I had projected has played fully out leaving the stock quite possibly now undervalued.  The stock did fall more than I ever anticipated, but the results did too.  When I wrote that first article, analysts had expected the company to earn $1.69 per share in Fiscal 2008, which is now almost complete.  With two quarters to go (they report Q3 8/5), analysts now expect the company to earn just $1.16. The FY09 estimate has declined from $2.04 to $1.59 in those 17 months as well.

As you can see in the chart below, the PE has plunged as well:

Download wfmi_072708.jpg

As I mentioned, what I saw at the store today made me think a little more urgently about what I already believed to be the case:  The stock is done going down.  I will share the advice that I gave a friend of mine on Friday:  Double up on your shares and hold the extra shares for at least 31 days (to then take the tax-loss on her existing shares).  This was the same friend who I had warned back in November 2006 not to buy the stock.  WFMI has gotten very serious about offering better value to its customers.  I never believed that the company was overcharging, but the competitive environment and the very tough economy necessitated changes.  The company goes out of its way to highlight "great deals" throughout the store.  It has started coupon advertising in the local newspaper to encourage customer traffic.  It has implemented several brand new loyalty card programs (though, unfortuntely, paper-based), rewarding customers for frequent purchases of coffee, flower bouquets, vitamins, fresh bread, etc.  No doubt any analyst worth his weight in salt will recognize that these programs will come at a cost of permanently lower margins, but that is reality.  In a nutshell, I recognize that the company is facing reality.

So, what about the numbers?  I don't profess to have a long-term model or to be in a position to suggest that the earnings aren't still going to be under pressure.  Valuation, though, has become much more realistic, with the PE now at 15X, the lowest in history.  While the balance sheet isn't as nice as it used to be, it's not so bad either relative to peers in the industry (grocery stores, restaurants and high-end retailers).  Here are some representative PE ratios:

• Kroger (KR): 13.4
• Safeway (SWY): 10.8
• Panera Bread (PNRA): 18.7
• Cheescake Factory (CAKE): 12.0
• Coach (COH): 11.1
• Costco (COST): 19.0
• Starbucks (SBUX): 16.1

The point is that one certainly isn't paying up a lot for WFMI any longer.  Another consideration is that the company is generally a significant cash-flow generator.  It has ramped up Capex lately due to expansion and the Wild Oats merger, but that will slow again.  The company already pays a large dividend (3.55% yield), but its payout ratio is a rather high 69%, so I don't expect the dividend to grow significantly faster than earnings.  The company could, however, use FCF to repurchase stock in FY2010, which would be a first.  Unlike SBUX, which is clearly saturated, WFMI can still grow "organically" as well.  My belief is that their expansion strategy should be more measured until there are clearer signs of better in-store productivity.  This next chart shows that the company has seen tremendous margin erosion, though its returns on capital are still respectable.  The valuations, using Enterprise Value, highlight again how inexpensive the stock has become:

   

Download wfmi_072708_margins_and_valuation.jpg

As I previously stated, margins are not likely to ever be as high as they were.  Still, though, they could expand significantly from here as the stores mature and Wild Oats integrates better.  Even without significant expansion, valuations could certainly improve.  I believe that the recent print near 20 will prove to be the bottom and that the stock has a decent chance of retracing a large portion of its decline in the coming months (call it 28-30).  I intend to watch the stock closely between now and their next report, perhaps going long before the numbers are released.  I have always loved the company, and I am now warming up to the stock.

Download wfmi_072708_daily.jpg

Short-interest is massive:  25mm shares, up 50% from when I last wrote in November.  In Q1, the investor base shifted dramatically, with value-oriented Davis Selected Advisors adding 5mm shares and several other large buys and sells.  I anxiously await the Q2 data - it would be nice to learn that some capitulation was behind some of the massive selloff during the quarter. Insiders haven't been selling and appear to have been exercising expiring options.  I like these dynamics.  From a trading perspective, 28-30 seems rather realistic.  From a longer-term investment perspective, though, the rewards could be much greater.  For FY2010, if I assume that the analysts 2009 estimate is correct and that sales can grow 10%, the company should see sales of about $8.5 billion.  The current EPS consensus for FY2010 is $1.92.  A year from now, that number will represent the one-year out estimate.  Is it reasonable?  If we assume a 4.5% pre-tax margin, that generates about $1.64 per share in earnings, so that seems a bit aggressive to me.  I believe that the PE ratio, though, could rise to 20X as growth begins to pick up again over the next year, yielding a 33 target.  Maybe sales grow faster, maybe margins do a little better than I expect.  Still, 33 represents a 50% return over the next year, making this one worth some extra due dilligence.

Disclosure:  No position in WFMI