Under-Selling and Over-Delivering at Whole Foods

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When Whole Foods Market (NASDAQ: WFM) reported its fourth quarter earnings in February, the stock quickly fell to the bottom of its 52-week trading range. On Wednesday, after releasing stellar results for the fiscal second quarter of 2013, the company’s stock zoomed to a new all-time high.

Whole Foods was able to quell investors’ fears that price cuts and promotions would cut deep into the company’s sales and margins, resulting in lackluster earnings growth. Not only did the company prove the market wrong earlier this week, it expects to keep it up. That’s why, even at an all-time high, Whole Foods remains a great investment.

Margin notes

A big contributor to Wall Street’s reaction last quarter was management’s focus on price and value. This quarter was loaded with both everyday price cuts and more sales promotions.

One benefit of sales promotions at a grocery, like a one-day mango blowout, is a reduction in spoilage. As co-CEO John Mackey pointed out on the conference call, “If you sell what you have, you don’t have to throw away.”

A reduction in spoilage helped contribute to lower shrink levels. In addition, leverage in occupancy costs in the quarter helped boost gross margin to 36.4%. That’s a slight improvement from the same period a year ago, and better than the 35% margin the company posted the previous quarter. As a result, operating margin came in at 7.5%, better than analysts’ expectations of 7.3%.

These margins are some of the best in the industry. Whole Foods’ closest competitor, The Fresh Market (NASDAQ: TFM), consistently posts gross margin between 33% and 34%. Its operating margin was 7.6% in 2012, boosted by fantastic first and fourth quarters where the company earned a 9.6% and 8.3% operating margin, respectively.

Compared to non-specialty grocers, like Kroger (NYSE: KR) and Safeway (NYSE: SWY), there’s no competition. Kroger reported a gross margin of 20.5% last year. That number has shrunk over the years as food prices climb. As a result, operating margin was a miniscule 2.9%. Safeway has fared even worse, as operating margin shrunk from 2.8% in 2010 to 2.5% last year.

As margins at traditional grocers shrink, Whole Foods, even with price cuts and promotions, is expanding its margins. The timing of the company’s price investments couldn’t have been better, as food inflation seems to have peaked.

Even so, in the cutthroat grocery industry it’s hard to say whether margins will improve for traditional grocers as they fight for customers. All Whole Foods needs to do is maintain.

Same-store sales

Comparable store sales grew 6.9%, slightly better than expected. One would expect higher traffic to drive that growth as lower prices cut into the average basket size. Yet, the company showed a near 50-50 split between traffic and basket size as the cause of growth.

Perhaps this is a testament to the company’s focus on price. Customers are buying more goods at Whole Foods because its prices are more competitive than ever before. Over the quarter, Mackey said surveys showed Whole Foods’ prices improved compared to other food retailers and supermarket chains.

As word continues to spread about Whole Foods more competitive pricing, it ought to drive more traffic. As co-CEO Walter Robb explained in last quarter’s conference call, Whole Foods is now “going for the big prize, which is those folks that are not eating as healthy.” After all, the biggest complaint I hear about Whole Foods is that its prices are too high, not that its food is too healthy.

I believe price cuts and promotions will continue driving same store sales growth through both bigger baskets and higher traffic.

Expanding store count

Whole Foods currently operates 349 stores, four more than when it last reported. Its pipeline for new stores has also expanded from 85 last quarter to 89 today. In the last year, the company opened 32 new stores – more than any previous one-year period.

The company has fueled its growth with very little debt. It has just $25 million of debt on its balance sheet and $1.3 billion in cash and investments. It generated $178 million in free cash flow last quarter, and invested $109 million in its stores.

Healthy free cash flows will allow the company to continue expanding at an even faster rate going forward. There is currently a wealth of real estate opportunities for Whole Foods, and the company plans to take full advantage of them. With a larger footprint, it ought to be able to continue gaining market share from traditional grocers like Safeway and Kroger, while fending off smaller competitors like The Fresh Market and Natural Grocers.

What’s not to like?

Whole Foods proved this week that it’s not just your average grocery chain. It’s always provided a unique shopping experience, but now its prices are more competitive with those at traditional supermarkets. So far, the price investments have paid off, and I expect them to continue doing so.

If you’re looking for a new investment, Whole Foods can still provide some healthy returns.

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Adam Levy owns shares of Whole Foods Market. The Motley Fool recommends The Fresh Market and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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