Whole Foods Market: WFM Stock Is Too Pricey

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Shares of high-end grocery store chain Whole Foods Market, Inc. (NASDAQ:WFM) had a rollercoaster ride in 2014 after the company recorded a worrying decline in both its top and bottom line growth during the first half of the year.

whole foods stock earnings wfm stockInvestors feared that intense competition from newer and trendy upstarts such as Sprout Farmers Market Inc (NASDAQ:SFM) and The Fresh Market Inc (NASDAQ:TFM) was responsible for the company’s anemic growth and fled in droves, leading to WFM stock tanking by as much as 40%.

Whole Foods, however, managed to post more encouraging results in the second half of the year, which helped to restore investor confidence in the company — leading to a 35% rally that almost fully recovered its earlier losses.

The question now: Is this newfound optimism about WFM stock misplaced, and are investors expecting too much from this organic foods giant?

Unrealistic Expectations?

Investors were spooked when Whole Foods first showed serious signs of slowing growth during 2014’s second quarter. Earnings of 38 cents per share on revenues of $3.32 billion missed expectations of 41 cents on $3.34 billion, respectively.

But what really rang the tocsin was same-store growth of 4.5%, well below the year-ago period’s reading of 71%, as well as gross margins that fell 51 basis points to 39.5% thanks to an increase in the cost of produce. The September quarter was worse for comps growth, which hit just 3.1% — Whole Foods’ lowest in years — and it suffered another 31-basis-point contraction in gross margin. However, overall revenues of $3.3 billion were the company’s best in history, easily beating expectations, and sent WFM stock popping after its November 2014 report.

The market was further relieved when the company posted same-store growth of 4.5% for the December quarter, which fueled a massive rally in the shares.

During the February earnings call, WFM laid out the company’s growth plans, chief among them adding more private labels and boosting total store count to 1,200 from 410 currently. This strategy is primarily aimed at boosting Whole Foods’ top-line growth, though it could significantly hinder the bottom line. Investors can’t overlook this — WFM stock trades at a considerable premium to its peers because of its history of better sales comps and higher margins.

Apparel sellers frequently tout their private labels’ ability to provide nice boost to margins. Private labels by companies such as J C Penney Company Inc (NYSE:JCP) sport better gross margins than national brands by as much as 500 basis points. But private labels for organic food vendors such as Whole Foods are a different story.

Whole Foods’ private labels are in fact cheaper than comparable products at traditional supermarkets, which suggests they carry far lower margins. However, WFM has been introducing more of these private-label products because its shoppers are becoming increasingly price-conscious. The tradeoff? Whole Foods will sell more, but at lower margins. Goldman Sachs has projected that WFM’s EBITDA margins will progressively fall from 9.6% in 2013 to 8.9% in 2017.

Regarding WFM’s new store openings, it’s important to note that the company did not offer concrete timelines of when it expects to achieve the 1,200-store count. Whole Foods did say, however, that it expects store count to reach 500 by 2017, which works out to roughly 50 new stores each year, or 16 years to hit the 1,200 mark. With the company facing plenty of competitive pressure from new organic food companies, it’s rather doubtful whether WFM can continue expanding at this fast clip over the next decade.

During its last earnings call, Whole Foods management said its new stores have a 40-basis-point spread in growth compared to existing stores, meaning they are not growing significantly faster than older stores. This is somewhat anomalous considering that, across several industries, new stores tend to record much better growth than existing stores.

Valuation out of Touch With Reality

WFM stock trades at 33 times trailing earnings and 27 times fiscal 2016 earnings. Compare that to, say, Kroger Co’s (NYSE:KR) trailing P/E of 22 and forward P/E of 18, and consider that Kroger has consistently recorded comps of more than 6%. WFM guided for same-store sales growth in the low to mid-single digits for the rest of the year.

Whole Foods can achieve 9%-10% sales growth over the next two years, while same-store growth is unlikely to exceed 5%; however, current valuations suggest WFM can maintain comps growth of 8%, which clearly is untenable.

Long-term investors should be wary of investing in companies whose shares appear too pricey. As Goldman Sachs warned, historical trends indicate that shares of such companies tend to lag their peers in both the short and long term — not grow into their steep valuations.

As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/03/whole-foods-market-wfm-stock-still-looks-too-pricey/.

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