Buying Fresh Stock of Whole Foods

 | Jun 09, 2014 | 2:00 PM EDT
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For the past several weeks, maybe months, I've been talking about building stock watch lists, the importance of stock prices, being patient and waiting for Mr. Market to offer an opportunity. Today I'll demonstrate why all this matters and how the process can be substantiated. 

For a long time, I have been a big advocate of businesses such as Chipotle Mexican Grill (CMG), companies that provide quality, fresh products to a consumer base that is becoming more selective. For similar reasons, I've also been a big fan of Whole Foods Market  (WFM) for years. As a customer and close follower of the company, I find that Whole Foods falls right into the center of my circle of competence.

After reaching a high of $65 a share, Whole Foods' shares moved back to $37 in a manner of months as investors lost optimism in the company's growth rate. The pullback in the stock price significantly increased my own optimism, and as a result, I have begun to accumulate shares of Whole Foods.

At 27x trailing earnings and nearly 4x book value, Whole Foods won't show up on many "value" stock screens. Yet I view Whole Foods as an undervalued investment for the patient investor. The current stock price values the company at about $15 billion. That $15 billion gets you nearly 400 stores that average nearly $1,000 per square foot in sales, or $14 billion in annual revenue. In addition, Whole Foods generated nearly $500 million in free cash flow in fiscal 2013, ended Sept. 29, 2013.

Whole Foods operates about 400 stores and sees a potential for 1,200 locations in the U.S. The company adds 20 to 30 stores each year, and they average 35,000 to 45,000 square feet per store. So basically, Whole Foods is adding 700,000 to 900,000 square feet a year, or nearly $700 million or more a year in revenue, specifically profitable revenue. That revenue has a leveraged effect on profitability. In the past five years, revenue has increased from $9 billion to $13 billion. Over that same period, operating income has grown from nearly $300 million to nearly $900 million.

Free cash flow has grown from $273 million to $472 million. However, that cash flow includes increasing capital expenditures as the company continues to open new stores. If Whole Foods stopped adding new stores today, free cash flow would be nearly $800 million. But Whole Foods is not going to stop adding stores anytime soon. That is money well spent, given the track record of the return on capital that each new store produces. Consider the free cash flow in five years when the company has more than 500 stores.

Buying Whole Foods today is buying a compounding machine. The company has 10 to 20 years of additional store growth. Of course, I'd love to see the share price go lower so I can be more aggressive in my buying. But even at current prices, you are buying significant growth at a very fair price. Each year, growth will increase the intrinsic value of Whole Foods, and that means the company will become more undervalued with each year.

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