Whole Foods Market: 2015 Update

It has now been about 18 months since I began accumulating shares of Whole Foods Market (WFM) in the high 30's. Since that time the stock briefly had a huge move back into the 50's before losing steam again. Same-store sales have decelerated but my investment thesis remains unchanged; just because competitors are copying WFM's model and seeing success does not mean that the company cannot continue to be the leader in the healthy food space. Investors were not pleased with WFM's quarterly earnings report last night, but the stock is finding some support around $30 and might be forming a bottom.

So how bad are things really? Well, if you only look at the stock you might conclude the company is all but dead. For instance, traditional supermarket chain Kroger (KR) now fetches a higher relative valuation (cash flow multiple) than WFM, despite the fact that they have more than 2,600 stores nationwide compared with 431 for Whole Foods. Yes, investors think Kroger will deliver better financial results going forward. I don't suggest taking that bet.

The financial media has concluded that WFM's troubles are due to people shunning their stores for the likes of Wal-Mart, Target, Costco, and smaller, regional WFM copycats since all of those places now sell organic food. While this may be true to some extent (especially with local WFM wannabe stores --- not many Whole Foods shoppers frequent their neighborhood Wal-Mart), there are other explanations that are ignored because they are not as obvious and do not make for interesting headlines.

A big one is the fact that Whole Foods is cannibalizing itself by continuing to open new stores at a rapid pace (32 in the just-completed fiscal year). In Seattle, where I live, there are now 7 Whole Foods stores, with several more in development. Over the last 6 years WFM has increased their store count by 50%. As soon as a new store opens that is 10 minutes away, people are going to stop traveling to the one that is 20 or 30 minutes away.

Interestingly, the company provides information about its store performance based on the age of the store. If the media was 100% right and people were simply switching from Whole Foods to Target or Kroger, sales at all WFM stores would suffer equally. But look at the data for fiscal year 2015:

Store Age       SSS

<5 years         +7.6%

5-11 years       +1.5%

>11 years        +1.1%

ALL                 +2.5%

The older the store, the worse the sales growth. This makes sense, right? If there has been a store in your neighborhood for a decade, chances are you will already be shopping there if you are at all interested in doing so. It's very hard to boost sales at older stores, especially considering that Whole Foods stores already sell far more food per square foot of space than any other grocer.

And when they open new stores those stores do well for many years, at the expense of the older stores. Existing WFM shoppers will migrate to the closer location (hurting older store sales) and shoppers that had no interest in driving longer distances just to shop there might check it out now that it is more convenient to do so.

Notice that none of this has anything to do with the fact that Safeway now sells Annie's fruit snacks.

Accordingly, the investment thesis for WFM must incorporate the fact that growing same store sales for the company's existing base of 431 stores is going to be very hard. In fact, I am assuming that they cannot post sales gains above inflation, which implies flat traffic growth for all stores after they have been open for a few years. So why invest?

First of all, the company has 431 stores vs over 2,600 for Kroger, so it is entirely plausible that Whole Foods ultimately reaches their 1,200 store goal in the U.S. And secondly, the company's stores are massively profitable even if sales do not grow. For all of the heat the company has gotten lately, fiscal 2015 same store sales actually grew 2.5% and operating cash flow totaled more than $1.1 billion. That's more than $2.6 million of cash flow per store. For comparison, Kroger does about $1.6 million per store, and their stores are bigger.

At $30 per share, Whole Foods stock trades at less than 8 times EBITDA and less than 14 times existing store free cash flow, both below their less impressive competitors. Such a price would only be justified if the company had minimal growth ahead of it.

Lastly, I cannot conclude without commenting on some of the odd analyst questions from last night's quarterly conference call. More specifically, the investment community is criticizing the company's decision to borrow money (they have never had any debt before) to buy back stock aggressively over the next few quarters.

Normally, companies are mocked for buying back stock as it hits all-time highs and then halting the purchases when things turn sour. Despite the fact that WFM did not start buying back any stock until last year (after it dropped dramatically) and now is accelerating those purchases (as it is hitting levels not seen since 2011), everyone just seems to want to pile on. Here is the first question from the conference call:

"Thanks for taking my question. So my one question has to do with share buybacks. I just wanted to understand the rationale for taking on debt and buying back shares right now maybe instead of waiting until maybe comp trends stabilized. So if you could maybe help us with your thought process."

I was shocked at this question. Whole Foods has no debt, more than a half a billion of cash in the bank and stores that generate over $1 billion of cash flow per year, so they are in pristine financial shape. The stock is hitting 4-year lows and trades at a discount to traditional supermarkets despite being far better in terms of sales and profits. And the analyst wants them to wait until business gets better before buying back stock?

It should be obvious why they are doing this. Because they know if they can improve the business at all going forward the stock is going to go up a lot. Buy low, sell high, right? In fact, if they took Oppenheimer's advice and waited until the stock was $50 before doing any repurchases, they would probably get mocked for doing so. This just tells me how negative the sentiment is for Whole Foods Market right now.

I may have been early last year with the stock in the $37 area, but since I invest with a five year horizon I am happy to average down and wait for the water to warm up. Right now the company is getting absolutely no credit for what they have built, how successful it continues to be even today, or any future growth opportunities that exist. It is the epitomy of a contrarian, long-term investment.

Full Disclosure: Long shares of WFM at the time of writing, but positions may change at any time.