Whole Foods: Undervalued Retailer

Retail is a tough sector and it is getting tougher. More of the market will move online over time. Food may just be the one place where a retailer with a good USP has a chance at continuing to be a good business for a long time.

Whole Foods Market (WFM) is probably the strongest premium food retailer in the world. As such it has often commanded a valuation that is too rich to consider investing. The recent poor news have sent the shares tumbling on concerns that same-store-sales are not growing fast enough and that gross margins are eroding. This may present an opportunity.

In late March 2012, I bought some shares in the company for $42.33 (split adjusted) with the intention of holding them for a long time (10+ years horizon). About 18 months later, in October 2013 I sold them at a 40% profit–it was trading at a 40x LTM PE and I thought that was unsustainable. The shares have since come down to about $38.50, so I think it is time to reconsider investing. The long term thesis has not changed, but the valuation is once again somewhat attractive.

Company: Whole Foods Market (WFM)

Investment Thesis: Whole Foods is (1) a leading premium food retailer, (2) with significant additional global rollout potential. (3) It is trading at an attractive valuation considering its long term potential.

(1) Leading Premium Food Retailer: Without dwelling on this point for too long, there are only a few global companies in this space and Whole Foods is certainly among the top names. Perhaps the only comparable company of real scale is Sprouts Farmers Market (SFM), which is in fact considerably smaller today. Traditional retailers like Wal-Mart (WMT) might present a bigger threat in the long term, but I believe being focused and “niche” will prevail in retail.

(2) Global Rollout: This is really where the crux of the thesis is. At some point Whole Foods will run out of room to roll out additional stores, and we should not expect it to trade much higher than 15x PE then. So how many stores do we need to believe they can open to feel good about this investment? Doing some very rough math, you would feel pretty good if they can get to 800 – 850 stores in 10 years. That is about 2.2x the current store count which would be no small accomplishment. It also means opening about 45 stores per year, which is a much faster pace than their current c. 27 new stores per year. My ‘back of the envelope’ math is below:

'Back of the Envelope' Calculations
‘Back of the Envelope’ Calculations

If we assume the shares will trade at 20x in 10 years (still within the bands of ‘typical’ trading multiples, an 18% discount to today’s multiple, and a 50% discount to some of the lofty multiples at which the shares were recently trading), then we would only need about 25 new store per year to reach similar return goals. But what if 25 stores per year for 10 years is all we get before we are out of room and the shares trade at 15x? That is an interesting base case to consider, and the returns would actually be acceptable:

'Back of the Envelope' Calculations - Base Case
‘Back of the Envelope’ Calculations – Base Case

A 7% – 10% total return over 10 years certainly sounds acceptable to me, but all of this assumes the Company can open 250 – 500 stores over this period, while maintaining or slightly improving margins.  Regarding the–more interesting–topic of whether or not this is commercially achievable, I thought it would be helpful to look into more detail at the Company’s current stock and other comparable retailers to get a sense of what the rollout potential might be here.

International Opportunity: Perhaps the most interesting fact about this Company is that almost 97% of revenues are in the United States (source: WFM annual report). In other words, it is very early days in terms of the Company’s international expansion. The Company has 7 stores in the United Kingdom and 8 in Canada, with the remaining 359 being in the United States. If we can believe the overall concept will work well in a few other geographies, believing in the store count doubling does not seem very hard. It should be noted however that Canada and the UK combined represent roughly 100bn people, or about 1/3 the population of the US.

Comparable Retailers: Whole Foods stores are big, so only a few global retailers represent meaningful comparables. Wal-Mart has 4,779 stores (70% of revenue in the US), which may not be relevant, other than to set an absolute aspirational maximum. I thought the following retailers were interesting to get some perspective:

Company 2013 Retail Sales (000) Worldwide Retail Sales (000) USA % of Worldwide Sales 2013 Stores Growth
(’13 v ’12)
Sales per Store
Kroger $93,598,000 $93,598,000 100.00% 3,519 -1.80% $26,598
Safeway $37,534,000 $42,982,000 87.30% 1,335 -5.30% $32,196
Aldi $10,898,000 $50,081,000 21.80% 1,328 5.40% $37,712
Publix $28,917,000 $28,917,000 100.00% 1,273 2.80% $22,716
PetSmart $5,298,000 $6,117,000 96.90% 1,247 4.10% $4,905
Michaels Stores $4,132,000 $4,570,000 90.40% 1,147 2.00% $3,984
Trader Joe’s $8,350,000 $35,214,000 23.70% 410 3.80% $85,888
Whole Foods Market $12,491,000 $12,917,000 96.70% 347 7.80% $37,225
Apple Stores / iTunes $26,648,000 $30,736,000 86.70% 254 1.60% $121,008
Harris Teeter Supermkts. $4,710,000 $4,710,000 100.00% 216 3.80% $21,806
Roundy’s Supermarkets $3,946,000 $3,946,000 100.00% 163 1.20% $24,209
Price Chopper $3,784,000 $3,784,000 100.00% 132 1.50% $28,667
IKEA North America $4,370,000 $37,877,000 11.50% 38 0.00% $996,763

(Source: https://nrf.com)

I find the table above relatively encouraging in terms of  how much additional potential there may be in the US. It is interesting to note that only a few retailers have actually had the ability to go cross-border.

(3) Valuation: One of the main reasons I am looking at this Company again is that it’s valuation has come down significantly in the last few months. The shares have not traded at this kind of level since 2010, when the market overall was trading at a much lower valuation than today. The chart below shows EV as a multiple of LTM Revenue and LTM EBITDA (PE tells a similar story but is ultimately less representative of underlying trends):

WFM Valuation over the last 10 years (Source: CapitalIQ)
WFM Valuation over the last 10 years (Source: CapitalIQ)

Valuation has varied dramatically over the last 10 years, influenced heavily by the market conditions as well as by the Company’s same store sales growth (SSS) for the last quarter. The historical SSS track record of the Company is spectacular, but I find the valuation swings based on short term changes to SSS to be unwarranted. This is the trouble with a stock that becomes a Wall Street darling. My assumptions above assume 2% SSS going forward (in line with inflation). Needless to say, if the Company can continue to deliver anything like the what it did over the last 5 years, the picture could look dramatically different.

Whole Foods Quarterly SSS (Source: Company Filings)
Whole Foods Quarterly SSS (Source: Company Filings)

Conclusion: At current valuation levels and with reasonable growth assumptions, Whole Foods represents an attractive investment opportunity. It is still trading at a premium multiple, so the Company needs to continue to grow at a decent rate for a few years to justify its current valuation. The growth prospects are strong and at the current depressed valuation should be sufficient to deliver a good return over the long term, even assuming that the multiple will come down to a market average over time.



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