by John Jagerson and Wade Hansen | August 8, 2012 7:00 am
–Buy WFM shares on a breakout above $96 per share. Target $105- $107 to either take profits or increase risk control with a tighter stop or protective options.
–Alternatively, we recommend buying to open the $100 strike November calls on a break above $96 per share. We recommend selling or covering this trade before earnings in October.
Personally, I’ve always been a picky eater, and recently even more so as I try to improve the quality of my diet with “whole” foods. According to Michael Pollan in his popular book The Omnivore’s Dilemma, shopping for healthy food should be done around the edges of the supermarket where these whole foods, such as produce and fresh meat, are usually located. He suggests that his method of eating real food, not too much, and mostly plants is key to feeling better and avoiding weight gain.
It’s advice that I’ve taken to heart. Maybe it’s a fad, but so far I can report good results, and I’m glad to have made a change in my own diet.
Of course, I’m also a stock market nerd. And like any other stock market nerd out there, I can’t make a change in one aspect of my life without wondering if that represents a broader trend — and therefore a profit opportunity. Am I the only sucker willing to pay more for what I think is better quality food and selection? Or did the recession drive all shoppers back to the case-lot sales of the big chains?
Pollan’s premise may or may not work for everyone, but it’s clear that a growing segment of the population believe that it works for them. To find my whole foods, I shop at a local grocery store that has higher prices overall but a better selection and higher quality. I feel it’s worth spending an extra 10% to 20% to shop there rather than at the local Wal-Mart ) or Supervalu (NYSE:SVU).
It stands to reason that other consumers who are interested in the same diet changes are probably making a similar decision to pay more for better food. And it appears that a strong trend going in this direction could turn into a profit opportunity in the short term.
Whole Foods Market (NYSE:WFM) belongs to a market segment called “consumer defensive.” The name refers to investors’ assumption that, while a recession or downturn is likely to push spending lower for optional or “discretionary” goods (such as accessories and high-end clothing), everyone will still need food — and, therefore, grocery stores should continue to do well. A quick comparison of Wal-Mart versus Coach (NYSE:COH) during the 2008-2009 recessions highlights the difference between the two kinds of companies nicely.
However, defensive stocks are usually not as attractive during an economic expansion and/or a bullish stock market. At those times, traders are more interested in stocks likely to grow, with big “moats” and wide margins — and most defensive sectors fall short in those measures. But within each group, there are always exceptions to the rule: companies that have been gaining market share, expanding margins and disrupting the old business with something new.
WFM is one particular exception that we’re interested in as an investment. In the next chart, you can see how WFM compares to its major competitors since the bull market emerged in early 2009.
Now, relative strength compared to competitors is great — but expectations for the future are just as important. WFM has been performing very well over the last three years, but it’s actually a turnaround story following a disastrous series of mistakes from 2007 to 2008. The company has finally reached the point that shares are creeping just above their 2005 highs. And it has made amazing progress cleaning up its balance sheet while continuing to grow.
WFM has twice the operating margin of its competitors and has a moat in the form of a strong brand that provides some protection against erosion of its growing market share by larger national chains. Assuming that margins will remain at current levels but the trend of consumers willing to pay more for better food will continue to rise, we feel that the company is likely to be a winner through 2013.
We also believe that WFM has a smaller exposure to the rising prices of commodities like corn because of the nature of its customer demographic.
After reporting earnings on July 25, WFM erased the prior breakout to the bottom of an emerging channel. Sales were up 14%, and profits jumped 32% compared to the same period last year. Most important, same-store sales growth is running at nearly 10%, a figure that’s almost impossible to believe when compared to other stocks in the sector.
The stock has stopped at resistance on the top of the new channel, but we think it’s likely to break out in the short term and that buys above $96 per share are ideal. Based on the channel, our short-term target is $105 to $107, where we expect to see some profit-taking. You can see our projection and current resistance in the next chart.
Please note some risks are associated with WFM. Clearly, traders got nervous just prior to the last earnings report as they incorrectly projected smaller margins and lower growth. We should watch for similar resistance patterns before WFM reports earnings for its fourth quarter on Oct. 24. If the breakout we’re expecting occurs, we wouldn’t be surprised to see sellers take profits again just before that announcement. Covering with protective options, or even just selling before the report, would be a good idea.
Because price volatility is elevated, we think an outright long call position may be preferable to the stock itself. Time value will erode as we wait for the stock to meet our price objective above $105 per share. However, the trend isn’t likely to be smooth, so a call position will allow traders to be more generous with their stop-loss. We recommending buying to open the WFM 100 Nov calls on a break to the upside above $96 per share.
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