Should You Buy Whole Foods Market, Inc. (WFM) Stock? 3 Pros, 3 Cons

Whole Foods Market, Inc. (NASDAQ:WFM) used to be the unparalleled natural foods leader. It used to be the only real option, in much of America anyway, to find natural, organic and healthier foods. The company rode its first-mover position to dominance and WFM stock soared.

Should You Buy Whole Foods Market, Inc. (WFM) Stock? 3 Pros, 3 Cons

But as so often happens in capitalist economies, the competition arrived soon after.

Earlier this decade, WFM stock seemed unstoppable. Now shares of the organic grocer have fallen by half from their prior peak, as investors fret over Whole Foods’ slowing growth rate and mounting competitive problems.

A downturn in food prices hasn’t helped either. Are the 365 stores and WFM stock’s dividend enough to support the share price here, or will it continue to fall?

WFM Stock Cons

Grocery Deflation Cycle: There has been a big problem for grocery stores as a sector: deflation in food prices. Many common staples have dropped and then dropped some more in price. Eggs, various meats, cereals and even produce have been under heavy pressure. In theory, you’d think this would cause higher margins for grocery stores. Generally cheaper input prices are good for business. However, it hasn’t worked that way for grocery stores.

This is because grocery stores are profoundly competitive. There’s very little moat around them — most stores compete tooth and nail against various other grocery stores, not to mention Wal-Mart Stores Inc (NYSE:WMT). Customers generally have limited loyalty to individual stores, and are intensely cost-sensitive. Think gas stations as a comparable business.

As such, when food prices decline, grocery stores pass this along to customers. Otherwise, the store across the street does, and you lose your shoppers. Thus, when grocery prices fall, stores are forced to push through virtually all the potential cost savings. However, stores are stuck with fixed overhead. Lease costs, wages and other costs don’t diminish when food prices fall. When total revenues fall then it ends up eating a fair chunk of the company’s overall profitability. Whole Foods finds protection, to some degree, in its stronger brand, but it is not immune.

Too Much Competition: There is a related issue; the sector now finds itself with too much competition. Grocery stores had a good period, particularly ones riding the organic trend. That caused management teams to expand heavily. Trader Joe’s, for example, had just 300 stores in 2013. It’s up to 460 now. And according to a recent Deutsche Bank comparison, a basket of 77 similar products was priced 21% cheaper at Trader Joe’s as compared with Whole Foods. Trader Joe’s is hardly the only threat. Sprouts Farmers Market Inc (NASDAQ:SFM) has grown revenues 22% a year compounded over the past five years, and notched a 20% increase over the past 12 months.

After this rapid expansion in the upscale grocery department, a period of store closings — or at minimum reduced growth — and retrenchment is needed to reduce the overall competition level and let profit margins tick up a few basis points.

Expensive WFM Stock: Yes, I know WFM stock has lost roughly half its value since its 2013 peak. But that doesn’t automatically make it cheap. In fact, WFM stock continues to trade at above a price-earnings ratio of 20. Sprouts, with its robust growth rate, trades at 20 times earnings as well. When given the option of a company growing at 20%/year such as Sprouts or Whole Foods with its shrinking earnings, you should generally pick the former.

Grocery stores, due to their low margins, tend to trade at modest P/E ratios. Walmart is far more than just a grocery store, but it is a similar low-margin business and sells plenty of food. WMT stock is at just 14 times earnings. Pureplay grocer competitor Kroger Co (NYSE:KR) trades at 16 times earnings. It’s hard to argue for paying a premium on WFM stock given its recent operational issues.

WFM Stock Pros

Food Prices to Rise: I suspect the deflationary food price trend will reverse soon. To start with, there’s an inflationary upturn in commodity prices generally. There’s not necessarily any direct correlation between grains or meats prices and the hard commodities, however given the importance of input costs and also general investor sentiment across the asset class, one should expect firmer agricultural prices if the commodity rally continues.

Trump is a plus for food prices if he generates more inflation generally. More specifically, cereals prices have been down for a long period of time. Corn prices, for example, have plunged since 2012. That benefits consumers directly. Americans eat tons of corn in various forms, and it also translates to lower feed prices, which has helped promote low meat and egg pricing. When corn goes up, it will boost food prices across the spectrum.

365 Stores: Whole Foods is rolling out a new smaller store format. Named 365, after its private label branded products, these space-conscious 28,000 square foot stores are up to 50% cheaper to open and operate than the mainline Whole Foods locations.

These smaller stores seem designed to compete more directly with Trader Joe’s. And so far, it is working, at least according to management. The company claims it has seen many Trader Joe’s bags turning up in the new 365 stores. In any case, Whole Foods plans to have several dozen of these stores up and running shortly.

Decent Dividend: WFM stock used to be a classic growth play. Up above $50/share, most people involved held with high hopes of grocery market domination. The collapse in the growth story sent investors heading for the exits. At today’s more conservative price, a lot less needs to go right to make WFM stock pay off.

That’s in part due to the increasingly attractive dividend. WFM stock yields 56 cents/share, amounting to a 1.9% yield. Not bad for a top brand, which, if things go right, may become a growth story again.

Verdict

If you’re looking for a trade in WFM stock, this is a decent place to consider. The margin pressures caused by falling food prices should begin to ease up soon.

WFM stock took a beating, and now looks oversold. As an investment, however, the valuation still looks iffy. And competition continues to mount an increasing threat to Whole Foods’ margins in the long term.

At the time of this writing, Ian Bezek owned WMT stock. He had no position in WFM stock. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2017/02/should-you-buy-wfm-stock-3-pros-3-cons/.

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