Whole Foods in a Show-Me Situation

 | Jul 31, 2014 | 1:37 PM EDT
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How do you value stocks where the earnings are coming down? That's the question people are asking about Whole Foods (WFM). What's it worth? Where is it a bargain again? How do you determine if it's finally bottoming?

First, you have to ask yourself if it is worth the effort. Is there enough there to even justify doing the work and figuring it out?

In the case of Whole Foods, the answer is a definitive "yes." It's a terrific operator and has been an amazing performer over the long term.

Then you have to get clinical. What's gone wrong at Whole Foods? First, the competition has come on strong. We know that well-financed competitors like Trader Joe's, Fresh Market (TFM), Sprouts (SFM), Fairway (FWM), you name it, have come in with guns blazing. We also know that the traditional supermarkets like Kroger (KR) have gotten natural and organic religion and have decided they can't cede this field to anyone, it's growing too fast.

Finally, we have to respect that Whole Foods itself may be its biggest competitor as the company admits that when it opens new stores it can cannibalize its own operations.

What else could be going wrong? Pricing. Whole Foods, even after becoming much more competitive with pricing, is still not a low-cost operator. It prides itself on the best stores, the best help, and the highest-quality product and those don't come cheaply.

You add all of these up and you get the metric that governs retail sales: the comparable-store sales number. I always tell you that this is the number to focus on because it doesn't lie. Any chain can open new stores and put up bigger numbers. Companies can be profitable by firing a lot of people. But what matters to the future, the real future of the company and not just the stock, is how its individual stores are doing vs. themselves. Here, Whole Foods is putting up very good numbers for a retailer, plus 3.9% comps as we call them, they JUST AREN'T GOOD ENOUGH FOR WHOLE FOODS, which always used to be at the top in its same-store sales.

I remember when they downshifted from twice the comp stores that they are doing now down to 5% and I thought the stock had become dangerous because its price-to-earnings multiple was too high. Now, even as the stock has come down, its price-to-earnings multiple at 25x is still too high. But this time it's because earnings are coming down.

For example, Kroger sells at 15x earnings with same-store sales gunning at 4.6% and earnings-per-share guidance that is better, not worse, than expected. How can I pay 25x earnings for a company with lower same-store sales and numbers that are being cut?

The answer? You can do it if you think that the people who run Whole Foods are going to make changes that can accelerate those comparable-store numbers and I think they are. First, they are going to add an affinity program, something that's long been missing. Second they are going to do national advertising that emphasizes the culture of Whole Foods, which might resonate with Americans. Third, they are going to emphasize produce, which might give them an edge over the other guys who aren't known for their produce.

That's why, despite the disappointment on a really bad day, the stock's not being crushed. That in itself is saying something.

In the end, here is where I come out. After all of these misses, even the people running Whole Foods would say that this is a show-me situation. They need at least one quarter to show that they can make changes. Until then? We simply have to wait and see.

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