Teddy FreedmanJuly 26, 2014

Whole Foods (WFM - $36.88) Analysis

Equity Value - $13.522 BEnterprise Value - $12.522 BEPS 2013 - $1.47EPS 2014 - $1.52, +3%EPS 2015 - $1.66, +10%EPS 2016 - $1.89, +14%

Conclusion:

Based on my analysis, I believe WFM is a buy for an investor with a long-term time frame. I think the stock could trade at $55 in two years, 48% higher than its current price.

I suspect that Whole Foods’ stock will be volatile over the next two years, but the current price is attractive for a long term investment approach. I believe that WFM will continue to be the leader in the attractive natural and organics food market. They have overcome previous competitive threats and weak economic conditions and I expect their first mover advantage, superior store-level execution, and unmatched brand equity to prevail. Short-term results will likely be unpredictable as the company fends off numerous new entrants into the natural and organics space and makes tactical price adjustments. The stock’s weakness over the past 12 months, down roughly 33%, and below-historic average valuation adequately reflect the near-term uncertainties and make the stock attractive at its current price.

Upsides to my longer-term investment thesis include: 1) An attractive end market, the on-trend and rapidly growing natural and organics foods market, 2) WFM’s first-mover and leadership position in the market, with an estimated 20%+ market share, 3) a long runway for future growth (357 stores currently, with a potential for 1,200 in the U.S. alone), 4) an experienced management team who have survived previous competitive threats, and 5) below-historic average valuation.

Downsides include: 1) both existing supermarkets and new chains are targeting the natural and organics space, 2) increased cannibalization from WFM’s aggressive new store opening program, 3) the popular perception that Whole Foods’ prices are too high, and 4) the risk that WFM will derail its strong U.S. business with an expensive entrance into international markets. In addition, my earnings estimates for the next three years are modestly below consensus expectations.

Two tables, one from a General Mills presentation and the other from a recent Credit Suisse report lay out the industry growth opportunity and WFM risks nicely. The first highlights the relatively rapid growth of the natural/organics market. The second shows the number of new entrants and accelerated store expansion targeting the market.

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Whole Foods Overview:

Whole Foods Market is the leading retailer of natural and organic foods and America’s first national “Certified Organic” grocer. The company opened the first store in 1980, and is based in Austin, Texas. Whole food's IPO was in January 1992, is traded on the NASDAQ under the symbol WFM.

The natural and organic food industry has moved from an offbeat or fad segment in food retailing to more of a mainstream, on-trend positioning with consumers. Whole Foods has been largely responsible for popularizing the segment and dominated the marketplace through 2010.

Whole Foods has one business, natural and organic foods supermarkets. They are the largest retailer of natural and organic foods in the U.S. and the 12th largest food retailer overall based on 2012 sales rankings from Progressive Grocer. As of May, 2014, the Company had 379 stores which average 38,000 square feet and are adding around 20-30 stores a year.  It is estimated that at full saturation Whole Foods could be operating around 1,100 stores nationwide, which provides ample runway for potential long-term growth.  Whole Foods has an estimated 23-25% market share of the natural/organic industry and is forecasted to continue to increase share in unison with the growth of the natural food industry as a whole.

In addition to the U.S. segment, Whole Foods currently operates 7 stores in the United Kingdom and 8 stores in Canada and are looking to open more units internationally.  Stores are supported by the headquarters in Austin, Texas as well as the regional offices, distribution centers,  bake-house facilities, commissary kitchens, seafood-processing facilities, meat and produce procurement centers, and a specialty coffee and tea procurement / roasting operation.

In each store, Whole Food's offers a mix between prepared foods and baked goods, perishable goods, and non perishable goods. As of 2013, the breakdown of store sales is:

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19%: prepared foods and bakery47%: other perishables (produce, floral, meat, seafood, coffee/tea, alcohol, cheese), and34%: non-perishables (nutritional supplements, vitamins, body care, books, pet supplies, household goods)  

 Therefore, roughly two-thirds of Whole Foods total sales come from perishables. This compares to 45% to 50% for a traditional supermarket.

Whole Foods’ also boasts a wide selection of exclusive brands which helps further differentiate the company from their peers.  In FY13 exclusive brands represented 12% of the company's total retail sales, and 16% of non-perishable sales. Store, or exclusive, brands typically carry above-average gross margins. Kroger is best-in-class with 25% of its sales made up of store brands.

Whole Foods Competitors:

The success of natural and organic foods has not been lost on the rest of the food industry. Accordingly, Whole Foods faces growing competition from both new specialty store entrants as well as existing retailers making a more concerted effort to capture some of the sector’s above-average growth. Importantly, the typical “natural/organics” customer is attractive – in general, better educated with relatively high disposable incomes.

Wal-Mart and Kroger have begun expanding their organic offerings recently further showing the success and potential for the organic/ natural foods industry. Wal-Mart attempted an organic initiative once before in 2006 but was very unsuccessful and harshly criticized due to their organic offerings being extremely different from what consumers expected. They essentially had big food companies make organic version of processed foods already found on Wal-Mart shelves. Wal-Mart’s own organic milk brand was also criticized for their poor treatment of cows not in accordance with organic standards. Wal-Mart was even charged with selling nonorganic food marked as organic.

Kroger has begun to create a new store concept, Fresh Fare Markets, which is designed to look more like a Whole Foods, with food cooked in the store and more organic offerings. Also, they have made it a strategy for their company to improve natural food offerings across the country. All new stores and remodels will take a more aggressive positioning on the amount of natural food products they carry. Whether these new initiatives can take market share away from the loyal and growing customer base of Whole Foods is another question and hopefully will be addressed in the third quarter earnings report coming out July 30th. Kroger has also stated in their first quarter 2014 conference call that they are aggressively pursuing a stronger position with natural foods among the products they carry in their new stores and remodels due to the fact “natural foods are really connecting with customers right now.” They also reported double digit growth in their natural foods department clearly showing the strength of the organic food industry as a whole.

There are also many new chains that are targeting the attractive natural and organics space, such as Fresh Thyme, The Fresh Market, Spouts, and Mariano’s.

We outline the many options that consumers have to purchase groceries today. Accordingly, Whole Foods competes with traditional grocery, other organic/specialty stores, and non tradition stores as well.  Competitors can be broken down into four general categories: 1) Traditional supermarkets: Kroger (KR), Safeway (SWY). 2) Dollar stores: Family Dollar (FDO), Dollar Tree (DLTR), and Dollar General (DG). 3) Mass merchants: Target (TGT), Wal-Mart (WMT).

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4) Other supermarkets: Sprouts Farmers Market (SFM), The Fresh Market (TFM), Fairway Group Holdings (FWM), Roundy's (RNDY), and 5) Club Stores: Costco (COST)

Customers:  

Whole Food's target customers are upper to middle class consumers looking for a healthy place to shop.  As the natural/organic fad increases in popularity more and more customers are demanding the natural and healthy foods that Whole Foods provides.  In this upper to middle class bracket, Whole Foods biggest competition would be Fresh Market, Roundy's, Fairway, Kroger, and possibly Safeway. Research, from a recent Wolfe research report, shows Whole Foods is the most trusted retailer among the educated (upper to middle class bracket) for purchasing food.

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Other consumers who are also looking for some natural/organic foods but are not capable of, or not willing to pay the premium that is currently associated with Whole Foods products (even though price investments are underway to squash this notion), these consumers are more likely to shop at Wal-Mart, Target, Dollar General, Dollar Tree, Family Dollar and Costco.

Whole Foods Strategy and Competitive Advantage:

Whole Foods first-mover status in the natural/organic foods industry is a key competitive advantage as they already have developed the distribution networks and regional supplier relationships to provide the freshest foods around the country. Along with this comes the strong brand recognition that Whole Foods benefits from as customers are generally comfortable in knowing that at Whole Foods you can find premium quality organics.

Whole Foods' main growth strategy is rapid expansion, in existing markets as well as new markets. In 2009 Whole Foods only opened 15 stores in contrast to the 32 store openings in 2013 and the 80+ store openings planned for the 2014-2015 timeframe. Whole Foods targets real estate locations based on area demographics and where the Whole Food’s brand image can best suit a given market.

Another important strategy Whole Foods is pursuing is acceleration of comparable sales. New stores have been by far posting the highest comps throughout the company (shown in the table, from a Morgan Stanley research report) and with the large increase in new store openings the overall comp sale number should see a positive boost.

Prepared foods growth is another key focus for Whole Foods. In combination with bakery goods, prepared foods accounted for 19% of revenues in 2013. Prepared foods are an important differentiator for Whole Foods. Many of their top competitors (Wal-Mart, Fresh Market, Target…) do not offer this unique segment in their stores. Drawing people into Whole Foods for the prepared foods can be a massive boost to overall sales as customers will also be inclined to look around and become grocery shoppers as well.

The one constant knock on Whole Foods is the perception that they have high prices. While management refutes this claim, saying that they have a range (good, better, best) of product offerings in many categories and that their prices are reflective of the quality of the offerings. The fact that the company’s gross margins are higher than traditional food or club store margins is consistent with this perception. To see for myself, I did a small survey of a basket of natural food items at several retailers in my area (see below). It does appear that WFM’s prices are high

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relative to traditional grocery, but consistent with other specialty stores focused on the natural/organics space.

Whole Foods has been recently stepping up its investment in price cuts due to high competitive pressures, which are finally leading to the much-anticipated decline in gross margin that investors have been expecting for the last couple years. Gross margins have risen, despite previous price investments due to reductions in shrinkage and inventory management, which offset the increase in cost of goods sold

Whole Foods is also unveiling new technology initiatives that promises “to keep Whole Foods relevant in the social media space, expand into the e-commerce segment of food retail, as well as help them keep better track of inventory on a national scale.” They have been very tight lipped about the details of the initiative so far other than saying they have invested money in doing so.

Whole Foods’ long-term growth potential relies heavily on continued growth in demand for healthy/organic products and their ability to maintain their top market share/differentiate themselves from the growing competition. Ultimately, successful new store openings (in the U.S. and abroad) and their ability to increase same store sales are the keys. Expansion into new markets is an important measure but if the existing store base cannot improve year over year in sales the growth will be modest at best.

Whole Foods and Competitor Economics:

Due to Whole Foods being one of the first movers in the natural / organic food industry they already have an established customer base, strong brand recognition, and in turn the largest market share of the industry. They are therefore able to charge a premium price for their product and through their continued growth they have been able to leverage cost of goods sold to help raise their gross margin. Their gross margin as of 2013 is the highest for the industry at 35.8%. Due to the influx of new competition from new specialty organic retailers as well as the club stores, supercenters, and traditional supermarkets expanded organic selection, Whole Foods is undergoing price investments which will put pressure on their gross margin. Their gross margin will still remain among the top of the industry but will see some decline over the next few years. For comparative purposes I have created a table comparing Whole Foods and their main competitors’ gross margins, ROI, and cost to build a new store among other figures.

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The ROI calculations do not appear to be directly comparable, and I do not place much emphasis on them. It is interesting to note that WFM’s gross margins (36%) are high relative to traditional grocery (25%), but consistent with dollar stores and other specialty food stores. Their operating margins are high (7%) relative to grocery (3%), but low relative to dollar stores (10%). I suspect ROI’s are somewhat more comparable at a direct store investment level, but I have been unable to get adequate information to prove this.

In a recent Roundy’s company presentation they compare store ROI’s for the specialty sector, which are reasonably similar.

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Whole Foods Model and Forecast:

I valued Whole Foods using three different approaches. Each involves forecasting WFM’s financials. Based on historic financial statements and my analysis of key trends affecting WFM, I have forecasted income statements (EPS), cash flows, and key balance sheet items.

Over the next three years, I estimate revenues to grow on average roughly 12% based on square footage growth of 9.5%, same store sales of 5%, and new store productivity of 68%. WFM’s management has announced its intention to make “price investments” which I believe will lower store level profitability over the next few years. I forecast both gross margins and store level margins to decline roughly 100 basis points to 35% and 9% respectively.

Operating income and EPS should both average 8-9% growth, with fiscal year 2014 being up modestly and a return to double-digit growth in 2015 and 2016. My 2015 and 2016 EPS estimates are $1.66 and $1.89 respectively, slightly below Wall Street consensus estimates of $1.73 and $1.95.

Free cash flow should be $1.2 billion for fiscal years 2014-2016. We estimate the company will use its cash flow to pay dividends of roughly $666 million over the next three years, and repurchase roughly $600 million worth of stock (all in fiscal 2014). By year end 2016 Whole Foods should have $1.05 billion of cash, and no debt, on their balance sheet.

Additionally, I attempted to analyze WFM’s historic return on investment trends. In the table below, I show that WFM’s EBIT/Store/PPE declined modestly as they ramped up store growth in the early 2000’s. They then purchased Wild Oats (their main competitor) in late 2007, which caused this metric to be reduced. Since then, along with the recovery from the deep recession WFM’s profitability has been increasing nicely.

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The methodology for forecasting key variables is outlined below:

Revenues – Whole Foods grows its revenues in two ways. First, they sell more product from stores already open – this is called same store sales (for stores open more than 12 months). Second, WFM opens new stores. To forecast revenue, I estimated going forward same store sales (taking into account historic trends, the increase in competition, and WFM’s stated strategy to be more price competitive) and multiplied this by the year-ago sales. For sales from new stores I measured historic and recent “new square foot productivity” (new stores open at a lower sales per square foot than existing/older stores) and estimated both new store square feet and the new store productivity. Productivity for WFM’s new stores has been declining recently due to increased competition and slightly more cannibalization than in the past. This was done on a quarterly basis to forecast revenues for the next three years.

Gross Profit Margins – Based on reading WFM’s recent earnings transcript and the management meeting that I attended, the company stated that they intended to lower prices (“undertake price investment”) and reduce gross margin over the next few years. Their targeted gross margin level is 34-35%, versus recent levels of 36%.

Direct Store Expense – To forecast direct store expense I calculated the store expense per square foot, looked at its historic growth rate, and estimated it would grow 2.5% going forward.

S,G & A Expenses – In light of the difficult operating environment, I expect the company to control non-essential costs relatively well and estimate S,G &A to grow at a rate slower than sales, roughly 6% per year.

D&A – In order to estimate depreciation and amortization, I calculated that an eight year useful life with straight-line depreciation fit the historical numbers reasonably well. I utilized my estimate of future capital spending to forecast depreciation and amortization.

Capital Spending – In order to calculate capital sending there are two variables that go into it; the value of new location development expense as well as the capital expenditures to maintain existing stores. New location development is calculated by multiplying forecasted new store openings (reported in 10-Q) by estimated capital expenditures per new store (based on historic figure). Capital expenditures for existing stores is calculated by multiplying the store count from 2 years ago (existing stores) by estimated capital expenditures per existing store (historic figure). Summing these two figures together gets you forecasted capital spending.

Working Capital – I measured Whole Foods’ working capital two ways. First, current assets less current liabilities (adjusted for cash and debt) and second, calculating inventories + accounts receivable less accounts payable. In both cases, Whole Foods’ net working capital was small as a percentage of revenues.

Valuation:

I examined the value of Whole Foods’ stock using three different valuations methods, P/E ratios, Enterprise Value / EBITDA multiples, and discounted cash flow analysis.

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P/E ratio: A P/E ratio compares the current price of a share of stock to earnings for that same share of stock. The average P/E multiple is 16-17x, which represents the shareholder’s entitlement to future earnings, (which are capable of growing). All else equal, faster growth translates to a higher P/E ratio. Whole Foods stock is currently trading at a 24.1x 2014 earnings. This compares to a historic four year average P/E ratio of 38.5x. I believe the lower P/E ratio is a result of WFM’s recent disappointing earnings and reduced growth expectations due to increased competition. When compared to P/E ratios of other major competitors, WFM sells at a higher multiple than all but Costco. But the relative multiple is lower than it has been at any point over the last four years. It therefore appears that Whole Foods is priced to grow as fast as Costco but faster than Wal-Mart, Kroger, and Dollar General. I think this is fair and consistent with my belief that the stock is cheap at its current valuation. If WFM is able to recover 50% of its lost historic average P/E ratio, it could sell at 30x its 2016 earnings of $1.89, or $57 a share. To see if my 30x multiple was reasonable I screened companies in the S&P 500 with similar low double digit earnings growth expectations and found them to be selling at an average P/E ratio of 26x.

Enterprise Value/EBITDA: An EV/EBITDA multiple compares the value of the entire company to its pretax cash flow. Whole Foods currently has an enterprise value that is 9.6x its pretax cash flow. This compares to a historic four year average EV/EBITDA ratio of 14.6x, where as their competitors sell for 6-10x. If WFM is able to recapture 40% of the lost EV/EBITDA multiple over the next three years (to 12.0x), the enterprise value for the company would be $18.6 B and its stock price would be roughly $53.

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Discounted cash flow analysis (DCF): The value of a company is based on its future cash generation. DCF methods are potentially useful in that they allow me to estimate the impact on value (stock price) of potential growth, the value of using more or less capital, and understand the value of higher/lower earnings. I started with WFM’s free cash flow in 2016 and grew it at different rates to get an estimate of how many years into the future that the stock price was discounting. Using a 10% discount rate, it took more years of future cash flow to equal the current price than I expected (more than 20). Interestingly, only 17% of WFM’s value is captured in the first 5 years of a DCF model. Using the market-based DCF model from Crystal Rock Capital, it looks like WFM’s current stock price captures roughly 11% longer-term growth. The company uses a lot of capital since much of their growth is coming from opening new stores. If the company executes well over the next two years (and their price investment generates the impact that management expects) and investors believe that WFM can sustain 13% long-term growth the DCF model estimates a 2-year price target of $57.

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Reflection:

This internship has been an incredible opportunity for me and has been very educational and complimentary to my business studies. I have been exposed to countless resources, techniques, reports, and data I would have not had the chance to study for years to come. Among these I was exposed to sell-side research reports where I was able to read and learn about Whole Foods and all of their competitors. I was able utilize Bloomberg terminals for data crunching and learned about how powerful of a tool it can be. Also, I was given special access to new data analysis software called Alpha-Sense and was also able to take advantage of its incredible data mining tools to easily extract the information I needed from the endless information on the companies I was researching. I read and familiarized myself with SEC filings, company presentations, and conference call transcripts. I was even able to attend an investor meeting hosted at William Blair with the Co-CEO of Whole Foods, Walter Robb. To conclude, this internship has been an outstanding educational experience and I look forward to applying all of the techniques, research strategies, and frequently used resources to my future business education.

Whole Foods Historic and Forecasted Income Statement

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Whole Foods Historic and Forecasted Cash Flow Statement

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Whole Foods Forecasted Working Capital and Key Balance Sheet Items Analysis

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Whole Foods Quarterly Historic Revenue Analysis and Forecast

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