What to Make of Whole Foods

 | Feb 13, 2014 | 8:25 AM EST  | Comments
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Few exercises in stock price analysis are as fraught as trying to figure out the price-to-earnings multiple for moderating or, worse, declining, growth. It's a struggle on so many levels. Is the growth pausing? Are there secular concerns? Is it just mature and the halcyon days are over? Are the expectations just too high and we must permanently lower them?

All of these principles come into play when trying to figure out what to pay for Whole Foods (WFM), which failed to deliver on expectations last night.

Here's a company that's classically valued like all retailers, by same-store sales. For years, Whole Foods spoiled us with same-store sales at 7% or even better. There have been hiccups, but it has been a pretty smooth run from $5 five years ago to $50 now.

But the stock had been as high as $65 last October when the company announced that because of competition and cannibalization and macro fears it was not going to hit its 7-7.5% target. Instead comp sales had decelerated to 5.9%, which, in the world of consistent high-growth stocks is a very big deal. Plus, revenue growth projections downshifted to 11-13% from 12-14%.

The stock got crushed immediately, falling to $57 from $64 and then, ultimately, $51 at the end of last month before rallying in the last few weeks because several analysts made worst-is-over calls ahead of the quarter.

Last night, we learned that the recent guide down from the previous quarter wasn't met, with the company first-quarter showing a 5.4% same-store sales growth and a 10% sales increase, producing 42 cents a share in earnings, a 2-cent shortfall. More importantly, the company shaded down fiscal 2014 (remember, it just finished its first quarter of the year) to $1.58-1.65 from $1.65-1.69. That implies a comp-store growth that will stay between 5.5-6.2%, depending on gross margins. It also means that the company's prospective growth rate goes from 12-15% year over year to 7-12%, a rather dramatic slowing.

At the same time, the company, intra-quarter, expanded its target of its total number of stores to 1,200 from 1,000 and it is leaving that target unchanged, implying that the category's still got tons of opportunity.

For that cut, the stock's taking a deserved hit, dropping almost 10%.

That's totally understandable, but is it buyable? We have to answer a host of questions before we do the multiple analysis. What we will pay for that $1.58-1.65 a share in future earnings and 5-6% same-store sales growth.

First, there's not a doubt that this company isn't the best of breed not just in the natural and organic space, but in the supermarket space entirely. But the whole industry is experiencing slowing sales after several years of acceleration.

I also don't think that you are getting a decline in the trend toward natural and organic. But you are getting a more crowded space with the addition of well-funded competitors like Sprouts (SFM), Fresh Market (TFM), Fairway (FWM) and Trader Joe's (the last being private so we have no numbers). Plus Kroger (KR), Safeway (SWY), Costco (COST) and Wal-Mart (WMT) recognize that they have to play in the space, with Costco CEO Craig Jelinek telling me that this space is not only NOT a fad, but THE place to be in the next few years.

I think the competition is behind some degree of the downshift -- remember it is a downshift and not an actual decline -- and that's going to be something this company will have to live with for ages, even as we saw both Fresh Market and Fairway recently disappoint, with the latter being a particularly horrendous number.

The competition is going to keep a lid on gross margins, which is going to maintain that gross margin pressure that needs to lift for the same stores to reaccelerate.

There's also the thought that Whole Foods is cannibalizing itself with all of its openings, which the company brought up in the previous quarter, but did not talk about much at all last night.

Finally, there's the real wild card: the weather. How much did it play havoc with sales? The company's a no-excuses, no-complaining company, so we can't really get a bead on that other than traffic did seem to decline by an unusual amount. I don't see Amazon (AMZN) being the fault for that decline either, unlike so many other brick-and-mortar retailers.

All that said, the company's being aggressive as ever, maybe even more aggressive in same-store sales openings, and it continually said in the call it sees the category and the opportunity expanding in tandem with the store-opening acceleration.

So what do we do? What do you pay for the best of breed in the category when the category is becoming more cut-throat and it is answering the challenge with lower prices?

I think you are bound by the price-to-earnings multiples of the other high-quality retailers. Starbucks (SBUX), for example, with 7% comp growth, trades at 28x earnings. Costco, with similar comp growth, trades at 23x earnings. No one else that I follow even comes near these guys except for Chipotle (CMG), which is growing at a same-store pace of 9%, so it can't even be factored into the equation.

If you think, like I do, that the weather played havoc and if it weren't so nasty out then Whole Foods could have hit 6%, then you are talking about a multiple somewhere between 28x and 23x next-year's earnings. With the new revisions, I am having trouble getting to $2.00 for next year. Let's say it can do $1.90. That puts it right around $50.

In other words, the darned thing is pretty perfectly priced unless we see some sort of acceleration.

The good news?

I think that if we got better weather that number's attainable and we could see a re-acceleration. The bad news is the competition is not diminishing.

Ultimately, had the analysts not raised expectations with their recent pushes, this stock would barely be hit. But they did raise those expectations and now we have the damage that simply must occur.

So, I think the stock marks time here until we know more. It remains a terrific growth company, just not as terrific as it was. So, shareholders have to pay the price, the reduced price, for the reduced earnings where it's neither here nor there short term, but deserves a better price long term simply because I believe that the quarter represents a trough decline and there won't be another cut expected.

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