Could I Have Been Wholly Wrong?

By Chad Henage - August 22, 2012 | Tickers: COST, TFM, KR, WFM | 0 Comments

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I've made the comment in the past that I didn't believe Whole Foods Market (NASDAQ: WFM) deserved the premium that the stock was selling for at the time. However, after looking at the company's most recent earnings report, I may have to change my opinion.

Though many shoppers at Whole Foods Market have mentioned in comments to my prior articles that this is not just a grocery store but instead a “lifestyle choice,” the company does still represent a destination to buy food and beverages for consumption. This puts the company directly in competition with companies such as Costco (NASDAQ: COST), Kroger (NYSE: KR), and in the organic space The Fresh Market (NASDAQ: TFM). However, none of these companies has the reputation of Whole Foods or the cult-like following. The company is certainly keeping up its end of the bargain by delivering impressive quarters like the one that just ended.

Sales increased 14% driven by a strong increase of 8.2% in same-store sales. Even more impressive is EPS increased by 28%. The company says it wants to solidify, “our position as America's healthiest grocery store.” If the company continues this type of performance not only will it be America's healthiest, but it will also be America's most valuable as well. Beyond these headline earnings numbers, the company's financial statements showed impressive figures as well.

With the company producing 22.69% more operating cash flow, and generating $98.6 million in free cash flow, you can tell this is a growth story that appears self-sustaining. Speaking of free cash flow, this is one measure where investors can see the strength of the Whole Foods model. The company generated $0.037 in free cash flow per $1 of sales in the recent quarter. Of their previously mentioned competition, only The Fresh Market produced more per $1 of sales at $0.057. Costco and its near legendary status in the investment community was able to match Whole Foods at $0.037, but Kroger produced just $0.026 of free cash flow using the same measure. When a company with just 329 stores at the end of the period can match a competitor like Costco with nearly twice the store count is pretty impressive. Even more impressive is Whole Foods essentially doubled its cash and short-term investments year over year, and paid out just 25.96% of its free cash flow in dividends. This should give investors comfort in the current dividend, and hopes for dividend increases in the future.

When it comes to the company's future growth plans, this is really the most exciting part of the Whole Foods story. The company is ramping up its new store openings and did something rare by giving multiple year guidance in store growth. The company opened 8 new stores in the third quarter, and expects to open 7 new in the fourth quarter. With 329 stores at the end of the third quarter, and what should be 336 stores by the end of the fourth quarter it should be easy for investors to track the company's progress. If the company executes on this strategy they will have opened 25 new stores in 2012, representing 8.22% growth. For 2013, the company expects to open between 24 to 28 new locations, which represents about 8.33% growth. By 2014 Whole Foods expects to open 30 to 35 new locations, which would indicate 9.61% growth. Given that the company is speeding up its new store growth, it's not unreasonable for investors to expect faster revenue growth, and thus earnings growth. Since the company says it believes its total store count in the U.S. could rise to 1,000, this growth plan would put Whole Foods at about 400 stores by 2014. At just 40% of its expected market even looking several years out, the company should have many years of fast growth ahead of it. Of course the main issue is, how much should investors be willing to pay for this growth?

Whole Foods issued guidance of $2.51 to $2.52 for full year 2012. At current prices this puts the company at about 37 times earnings, with an expected growth rate of about 17%. That certainly doesn't sound like a great deal. However, when you look out to 2013, the company is expecting EPS to come in between $2.83 and $2.87 which would mean the stock sells for about 32 to 33 times 2013 full year earnings. Given the company expects to speed up new store openings, that starts to sound better. Looking at their competition, there are two different growth tracks depending on what type of company you look at: traditional grocer or organic grocer. Whole Foods and The Fresh Market have positioned themselves as organic grocers and both sell for higher multiples and have much higher expected growth rates. The Fresh Market actually sells for a slightly higher multiple, but also has a higher projected growth rate at 22% versus 17% at Whole Foods. Costco and Kroger operate in more the traditional grocery space. Though one is a warehouse club and the other is a traditional grocery store, they don't carry the amount of organic choices of the other two. Costco is expected to grow at about 13% and Kroger is expected to show growth of about 10%. The point is, there is a large difference in the expected growth rates of organic grocers and others. With more Americans realizing the health benefits of eating organics, Whole Foods is positioned well to capture a larger portion of this quickly expanding segment. With the company speeding up its new store growth rate over the next few years, this company might not be as overvalued as I once thought.

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