My colleague Jeff Reeves delivered a bearish take on Whole Foods Market (WFM) following its most recent earnings. Jeff’s take has been that the company may be in big trouble, following lower earnings guidance as far back as November, and then lowering guidance again in February and May.
Jeff argues the competition is heating up in the space from privately-held Trader Joe’s, Sprouts Farmer’s Market (SFM), The Fresh Market (TFM), and Wal-Mart (WMT), and that a forward P/E of 21 is too pricey. He suggests selling.
I disagree, and here’s why.
Let’s start with competition. WFM stock has more than twice the footprint of Sprout’s or The Fresh Market, and it has the capacity to grow more than both combined. It has $800 million in cash, only $60 million in debt, and generated $530 million in free cash flow in the first three quarters of this fiscal year.
Cash, cash, cash.
Sprouts has $150 million in cash and $423 million in debt, and generated $73 million of FCF last year. Fresh Market has only $19 million in cash and $34 million in debt and only generated $18 million in FCF last year.
Clearly, WFM stock is far better positioned. It has 388 stores but sees potential for 1,200 stores. If TFM and SFM are stealing market share, WFM stock has way more price leverage because of its cash position to undercut on prices.
Don’t even talk to me about margins. Whole Foods is a far more efficient operation, with SFM and TFM yielding a mere 12% and 8% of WFM’s net income, despite having 50% of its store base.
Why is Whole Foods struggling, anyway? Well, when you look at the details, WFM is struggling only in regards to past performance. Its earnings shows a 10% revenue increase, a 3.9% comps increase. Things are not bad at WFM … they just aren’t gangbusters.
There are a few factors at play. I think upscale consumers are shopping around — the economy isn’t great, and people are looking and trying out alternatives. I think there has been some competition from the other grocers. And I think the joke of “Whole Paycheck” is starting to harm the company’s PR a bit.
However, if you noticed, Whole Foods has made it this far doing virtually no marketing. Its brand has been built on word of mouth. It will be starting its first branding and marketing campaign this fall, and I’m interested to see the results. I think that once consumers experiment a bit, many are gong to return to the brand they know best.
As for WFM stock, the company has $2 per share in cash, giving it an effective price of about $36 per share. Despite the earnings results, the stock did not fall much below its previous low, so investors seem content to hold.
WFM stock trades at 21x next year’s estimates, yet Safeway (SWY) trades at 30x estimates — despite SWY having more debt than cash, and declining FCF. Kroger (KR) is loaded with $9.6 billion in debt, $265 million in cash, and while it generates a billion in FCF, it trades at 14x next year’s estimates. No thanks.
WFM stock, on the other hand, is the best positioned grocer out there, with a brand name, smack in the middle of a long-term trend in healthy eating. I opened a small position when the stock fell below $40 and am holding it. I will keep adding to it below $35. I think WFM is in the transitional phase we saw with Starbucks (SBUX) many years ago, right before Starbucks took off.
As of this writing, Lawrence Meyers was long WFM and SBUX. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets at @ichabodscranium.