Tough Times for Value Hunters, Part 2

 | Jun 17, 2014 | 1:00 PM EDT  | Comments
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Monday's column discussed the shrinking pool of attractive value investments in the market today. When I say "value," I don't use it as a rigid term defined by single-digit valuation ratios, even as such opportunities are clearly desirable. To me, value is simple: buying something at a meaningful discount to its future intrinsic value.

The words "meaningful" and "future" are the key elements of that definition. Future intrinsic value is increased by higher future cash flows -- hence the need for growth to create value. The higher the likely future growth rate, the narrower today's discount needs to be in order to meet the test of value. The lower the future growth rate, the bigger the discount must be.

Consider grocery giant Kroger (KR), which is currently trading at $47 a share, or 17x earnings. The company has market capitalization of $24 billion and an enterprise value of $35 billion. Over the past three years, free cash flow has increased from approximately $800 million to $1 billion. Capital expenditures have grown from $1.8 billion to $2.3 billion as a result of maintenance capex for store remodels.

Compare Kroger with Whole Foods Market (WFM), which is currently trading at $42, or 28x earnings. Whole Foods has a market cap of $15.4 billion and an enterprise value of $14.4 billion. Whole Foods also has around 365 stores, as compared with more than 2,600 Kroger owned locations. So Kroger has nearly 7x more stores than Whole Foods, yet its market cap is 1.7x that of Whole Foods. Kroger looks cheaper, right?

Well, first consider that, from those 365 stores, Whole Foods is generating $14 billion in annual revenue vs. $98 billion from Kroger's 2,600-plus stores. So, yes, a Whole Foods store pulls in sales of nearly $30 million a year, as compared with about $37 million per Kroger store. But this is an apples-to-oranges comparison. Whole Foods stores are less than half the size of Kroger locations. So sales per square foot -- the most accurate comparison -- is nearly $800 at Whole Foods vs. just over $517 for Kroger.

Free cash flow at Whole Foods has grown from $600 million to more than $800 million in three years, or by more than 30%. At Kroger, this metric is up just 22% for that period. Furthermore, with less than 400 stores, Whole Foods foresees a tripling of its store count over the next decade or more. For Kroger, that sort of growth rate would be unlikely.

The potential growth factor of Whole Foods, in my view, supports the argument that this stock is perhaps a significantly better value at 27x trailing earnings than Kroger is at 17x. Whole Foods may not trade at a 50% margin of safety today, but its margin is likely to expand over the years as the additional cash flow keeps coming in. As a result, in several years today's price could look like a real bargain. That said, Whole Foods shares have gained more than 10% since I mentioned the stock in June -- so any pullback from today's prices would be very intriguing.

Whether it's Whole Foods or any other company, the key to value is truly understanding what drives the levers for future cash flow growth, and then comparing those metrics with the current stock price.

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