Of Compost, Coffee Stirrers and Cash
Asit is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I'm contemplating an eleven thousand gallon rainwater cistern, glistening in the afternoon sun like a giant can of tomato soup which has been stripped of its label, when Big Al interrupts my reverie. Easy going and quick to smile, Al asks if he can take my tray, on which the remnants of my hot bar lunch are scattered. More than adept customer service, I know this to be a sign of a healthy obsession: Al will properly allocate each piece of silverware, food scrap and plastic to the proper bussing, composting or recycling bin stationed near the cafe entrance. My neighborhood Whole Foods Market (NASDAQ: WFM) store, the "North Raleigh" NC location, is the first Whole Foods ever to be recognized by the EPA as a zero waste facility. In the cafe area and inside the guts of this forty thousand square foot store, team members manically separate waste from what can be composted or recycled -- very little material under the employees' control ever hits a landfill.
Whole Food's management is similarly obsessed with their stores on a macro-level. In particular, they pay attention to Return On Invested Capital (ROIC), a metric that is consonant with the Whole Foods ethos of sustainability. It's also one of the single-best metrics to gauge the potential success of the Company's expansion strategy.
Tracking The Return On Stores
ROIC is a measure of the cash flows a company generates from its invested capital, expressed as the following ratio:
Net Operating Profit After Taxes / Invested Capital
"Net Operating Profit After Taxes" is simply net operating income after income taxes, with interest expense (net of taxes) added back in. "Invested Capital" is represented by total assets less excess cash and non-interest bearing current liabilities. The metric tracks the amount of cash generated by each dollar invested in the company, both internally and by long-term debt holders.
Whole Food's company-wide ROIC is nearly 13% (quite high for the industry) as of the last fiscal year. But for our purposes, we are going to examine the ROIC of individual stores, categorized by age. The following is a table provided by Whole Foods management in its latest earnings release:
|Whole Foods Comparable Stores ROIC||Comps||ROIC||# of Stores||Average Store Size (Sq. Ft.)||Total Sq. Ft.|
|Over 15 years old (19 years old, s.f. weighted)||6.40%||137.00%||72||27,400||1,971,400|
|Between 11 and 15 years old||8.20%||79.00%||73||32,000||2,337,500|
|Between eight and 11 years old||5.90%||85.00%||43||37,200||1,600,700|
|Between five and eight years old||8.00%||47.00%||53||50,700||2,687,300|
|Between two and five years old||11.40%||19.00%||51||49,700||2,533,500|
|Less than two years old (including three relocations)||15.90%||16.00%||19||38,700||734,900|
|All comparable stores (9.3 years old, s.f. weighted)||8.40%||52.00%||311||38,200||11,865,300|
|All stores (8.7 years old, s.f. weighted)||44.00%||335||38,000||12,735,100|
Fellow investing enthusiast, I can't say that my monocle popped out when I viewed this chart, simply because I don't wear a monocle. The contribution to total ROIC from older stores in Whole Food's mix is really impressive. Over 46% of Whole Food's total retail square footage exists in stores that are eight years or older, and fully a third of its total retail square footage is found in stores that are eleven years or older. The ROIC on these older store groups begins at 85% for stores between eight and eleven years old, and moves northward from there.
In some ways a higher return on invested capital is enabled by the passage of time: the older the store, the higher its accumulated (total) depreciation, and the less long-term debt outstanding is tied to that store. Both of these events decrease the denominator of the ratio, invested capital, and thus increase the ratio's result. But these advantages are often negated in the grocery industry by the declining revenue and net income of mature locations. The table numbers tell us that the grayest WFM stores hold and increase their local market share and profitability as well as the newest.
What's Whole Foods doing to achieve such impressive numbers on its oldest stores? Other grocery chains have traditionally opened new stores as an avenue to new revenues and higher margins. Aging stores are subject to changing customer demographics over the years. They also inevitably lose market share to competitor stores that set up shop nearby. Whole Foods counters these forces in two ways: 1) by continual investment, its stores rarely show their age and 2) their decentralized management model enables older stores the ability to improvise and innovate to keep market share, to an extent that competitor chains have difficulty matching. An example co-CEO John Mackey pointed out in the company's most recent earnings call illustrates this strategy: a longstanding San Jose location recently freshened its appeal by opening a nail salon within its Whole Body store.
I think of this model as evergreen capital allocation. A Whole Foods store in which ROIC is maximized appears to consist of the following profile: it's a zero-debt building, fully depreciated except for its additions and improvements, meticulously maintained, and run by a local team that has the authority to innovate as it sees fit to retain loyal customers and attract new ones.
Finally, location selection criteria is also geared towards supporting long-term ROIC. The company seeks to put stores in areas of 200,000 people or more within a twenty minute drive, as close to a college campus as possible. These two simple conditions position WFM stores for success in their niche, as the customer base is both robust and long-lived: academic types have long played an early adopter role in the natural and organic foods movement, and they tend to stick around as customers and advocates.
What About Valuation?
WFM's strong ROIC is perhaps the single best reason not to be overly concerned with the company's high PE ratio, which has been steep relative to peers for a long while, and currently stands at over 36.0. The efficiency of Whole Food's cash generation is improving with age, and the organization is now opening stores with its own cash. It has only $24 million of debt on its balance sheet as of 9/30/2012 (for some context, total assets at the same date equal $5.3 billion). When a company can consistently deliver rising earnings in the form of cash, some premium in the marketplace is warranted.
Smaller Details, Higher Returns
Whole Foods is roughly a third of the way through a multi-year mission to capture what it perceives to be its fair share of the natural and organic foods market in the United States. At three hundred and thirty-five locations, the company's sneakers are still clean on the marathon run to open one thousand stores. Management has structured the company's balance sheet to reach this goal on WFM's own dime, and this self-funding will return greater value to shareholders. The company's obsession with sustainability, down to the financial metrics it tracks, should help it weather the obstacles that will surely spring up as today's new stores eventually age into the fifteen year plus category.
You may have seen the tall compost bins placed beside coffee stations in some Whole Food stores that display only a circular, two inch diameter opening in the lid. This is to prevent customers like me from absentmindedly dropping anything inside except empty sugar packets and coffee stirrers. While this may be the epitome of composting earnestness, sustainable practices in the Whole Foods world have a way of eventually translating into cash.