The Next Growth Stock To Fall?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The trick with any growth company according to Peter Lynch is deciding how much you are willing to pay for that growth and figuring out when the company's growth will slow down. There is one company that is telling the market to expect slower growth next year, and the market is refusing to listen. Whole Foods Market (NASDAQ: WFM) could be the next growth stock to take a tumble unless investors adjust their expectations.

If you look at the industry that Whole Foods operates in, there are multiple major competitors. In the organic segment of the market you have companies like The Fresh Market (NASDAQ: TFM), which runs a business similar to Whole Foods, yet is a smaller competitor. You have traditional grocers like Kroger (NYSE: KR), that offer a mainstream grocery experience, yet are not focused on organics. Then you have both Target (NYSE: TGT) and Walmart (NYSE: WMT), which are positioning themselves to take grocery sales because of their co-dominance of traditional retail. The argument for Whole Foods is the company's focus on organic sales is a lifestyle choice, and this won't be disrupted easily. However, I would counter that as organic sales continue to show impressive growth, each of these competitors will step up their efforts to appeal to the organic marketplace. Granted, Whole Foods is growing much faster than most of the above competitors, but the question is for how long? 

There is no question that Whole Foods' last quarter showed impressive growth. The company reported sales growth of 24%, diluted EPS increased 44%, and comps jumped an impressive 8.5%. For nearly any retailer, these would be fantastic results. In fact, over the last five consecutive quarters, the company's overall sales growth has increased sequentially from 12.2%, to over 14% in the last three months. Whole Foods has consistently been able to turn out 8% to 9% comparable store sales growth as well. Unfortunately, I believe investors have been lulled into a false sense of security that the stock and earnings will increase at an impressive rate forever. However, management's targets for 2013 paint a picture that the market seems to be blissfully unaware of.

One number that I think investors need to pay closer attention to is analysts and management's expectations for sales growth for 2013. As many people know, both Whole Foods and The Fresh Market operate in a different league when it comes to revenue growth relative to their competition. Analysts are calling for 14.5% revenue growth from Whole Foods, and over 18% revenue growth at The Fresh Market for 2013. By comparison, Kroger is expected to see revenue increase by 3.4%, and Target and Walmart are expected to post around 5% revenue growth. On the surface, this would seem to argue for buying Whole Foods or The Fresh Market and calling it a day.

However, there is one big problem. According to Whole Foods' management, they are targeting between 10% and 12% sales growth in 2013. Considering that sales growth for 2012 was 15.7%, this is a drop that some investors might not see coming. What is interesting is the company is planning on opening more stores in 2013 than in 2012. In fact, Whole Foods is targeting 6% - 7% new store growth versus 5.4% new store growth last year. In any case, the company's targeted revenue growth is significantly lower than investors have been use to, and this could be a big negative surprise. In addition, management is suggesting this lower sales growth will lead to significantly slower EPS growth.

How many investors in Whole Foods are ready for a potential 50% drop in the company's EPS growth rate? I would suggest not many at all, yet that is exactly what management suggested with their guidance for 2013. The company targeted 31% EPS growth for 2012, but suggested diluted EPS growth of 14% - 16% for 2013. This is a massive difference, and if this materializes, investors are likely to sell first and ask questions later. Given the stock's current valuation, I would suggest slower EPS growth is probably the number one risk to the stock in the near term.

I hate to make this comparison, but it seems appropriate. How many people remember what happened to Chipotle when they reported same-store sales growth of 8%? For most companies this would have been enough to cause the stock to jump, but Chipotle at the time had a history of even higher comparable store sales, so an increase of 8% was seen as a disappointment. The earnings report came out, the stock fell off a cliff, and still sells for a roughly 30% discount to its 52 week high. Is Whole Foods likely to suffer the same fate?

Whole Foods is valued at over 30 times 2013 projected earnings, but analysts are calling for EPS growth in the next five years of about 16.7%. This gives the company a PEG ratio of 1.84. Looking at The Fresh Market, this competitor seems like a better value. The company is expected to grow revenue by over 18% in 2013 versus 14.5% at Whole Foods. The Fresh Market is expected to see 23% EPS growth versus 16.7% at Whole Foods. Last but not least, The Fresh Market sells for about 28 times projected earnings versus over 30 at Whole Foods. With a PEG of 1.23 compared to 1.84 at Whole Foods, The Fresh Market has better numbers than Whole Foods in every category. While it's true that Whole Foods pays a dividend, I don't believe this less than 1% yield is enough to warrant such a big difference in valuation.

Though the more traditional retailers like Kroger, Target, and Walmart, can't hope to match Whole Foods or The Fresh Market when it comes to growth, they each offer better relative values. All three companies pay a yield of at least 2.3%, which is more than double what Whole Foods offers. These three companies are expected to grow earnings by 9.2% at Walmart, 9.8% at Kroger, and 11.7% at Target respectively. These might not sound like great growth rates, but none of these stocks sells for more than 12.6 times projected earnings. In plain english, all three are growing slower, but they sell for a relative 58% or greater discount to Whole Foods' P/E ratio.

When you add it all up, investors might be about to take a hit they don't seem ready for. Just like Chipotle said for months in their earnings reports to expect slower growth and investors weren't ready, Whole Foods is doing the same thing. It's one thing to think that management is sandbagging results, but if management is being honest, then Whole Foods stock is in trouble.


MHenage has no position in any stocks mentioned. 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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