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.



More on Absolute Valuations

I felt pretty good after writing the post on Absolute Valuations a few days ago. It felt like a nugget of useful insight that had come out of forcing myself to write down my thoughts–exactly why I was hoping would come out of this exercise. It has been on my mind a lot since and while I still believe the idea has value, I am coming to think it may be overly biased by the current state of the market.

I am relatively young, and I did not experience what it was like to invest in the 70s and 80s, when long term rates were 10% or higher. The idea of getting a 10% risk-free return is completely foreign to me. Granted, inflation was a much more significant factor then, but event account for that, real rates were significantly higher than than anything I have seen in my investing career. Here is a helpful chart from a Paul Krugman post:

Real Rates since 1959

So when I say to myself that any investment must meet a basic level of absolute return for me to consider it interesting, I am inadvertently comparing it to what might be the “prevailing market rate of return”. The more interesting thing however–and what I think led me to write the original post–is that the prevailing market rate of return is so close to zero today. And zero is a special number because cash earns a return of zero. I may say I am unwilling to make an investment unless I am comfortable I will get a minimum return of 5%–that 5% is my absolute floor. But if I could get 5% risk free by buying government bonds, wouldn’t that be a silly floor to have?

There is merit in having an absolute floor, especially when valuations are high and prospective returns at historical lows. I admit, however, that as overall returns become more attractive, engaging in a more selective comparative process has a lot of merit.

Yandex: Emerging Markets Internet Search

“When there is blood on the streets, buy property”

                                                  — Baron Rothschild, 18th century British nobleman

Given the situation in Russia and the recent sanctions, I have been trying to look for undervalued opportunities there. I am looking at a relatively limited set of companies (only those with ADRs traded in the US), but I think that is a good way to limit risk. This give me some  comfort they are reasonably solid companies, something you cannot readily assume in general and specifically when it comes to investing in Russia.

I made a small investment in Gazprom (OGZPY) recently, primarily because the valuation is very very compelling (about 3x EBIT and 2.5x EBITDA), but I wanted to take a further look at Yandex (YNDX), which I see as a much more exciting company with very significant prospects.

Company: Yandex (YNDX)

Summary Investment Thesis: (1) Yandex is the leading search player in Russia with significant, stable market share and one of the few credible global alternatives to Google. (2) Continued internet penetration and online marketing spend in its core markets will provide the Company with tailwinds for several years and (3) the expansion beyond Russia has a lot of potential. (4) The company is generating significant cash flow and has been returning a meaningful portion to shareholders. (5) The valuation is high, but reasonable given the Company’s growth prospects and market.

(1) #1 Search Engine in Russia and Leading Global Search Player:  Yandex has over 60% market share (of visitors) of the Russian search market. Google’s (GOOG) push into the market back in 2006 and 2007 took dramatic share from leading portal Rambler (see Page 7 of this presentation), but Yandex share has remained incredibly steady. It is hard to compete with Google, but for the last several years, Yandex has been doing it successfully in its home market.

Market Share
Stable Market Share (Source: http://www.liveinternet.ru/)

There are basically three players of meaningful global scale in Internet Search: Google, Baidu and Yandex. Bing.com and Live.com from Microsoft (MSFT) get competitive global rankings on Alexa, but I find it hard to argue they will be a powerful force in the future.  I am purposely omitting the major portals (Yahoo, etc.), which of course play in search, because I do not think search is part of their USP and I do not think they are likely to be the ultimate winners. Mail.ru should be mentioned by exception since it could pose a threat to the Company. With under 10% of market share in search however, I do not think it will be a major issue and they seem more focused on going down the social media route than on leaning on search.

(2) Tailwinds in Core Russian Search Market: Internet penetration in Russia today is at about 60%, compared to over 80% for most developed markets. 60% penetration is equivalent to the internet penetration in the US back in 2001-2002. This alone would imply over 30% growth in the underlying market over the next 10 years, and as a larger proportion of the audience is reached, advertising spend should switch dramatically to online. Even in the US today where internet penetration from a user standpoint has largely ‘run its course’, online ad spend still continues to grow significantly taking share from print, radio and (surprisingly, only a very little bit from) television.

Internet Usage Per Capita (Source: Wolframalpha.com)
Internet Usage Per Capita (Source: Wolframalpha.com)

(3) Turkey and Other International Opportunities: The Russian business should be enough to sustain the valuation, but there is a significant amount of optionality in expanding the business outside of Russia. That would make the Company a truly global player and a real alternative to Google. Yandex is the #2 search engine in Turkey, a large and fast growing market which is also enjoying the tailwinds of increased internet penetration. They currently have only about 2% market share, but have a stated push to get to 20-30% market share in the next few years. Needless to say, achieving that goal would be great for the Company’s prospects.  I like is focused on actionable, achievable goals which would create lasting long term value, but it should be noted that increasing market share from 2% to 20% is a tall order and it remains to be seen if it can be achieved. The Company also has significant traffic in many of the former soviet republics, which are quite sizable economies and behind the curve on internet adoption. While somewhat speculative, I think their emerging market focus is key to what making this investment one with exciting prospects.

(4) Share Buybacks: Yandex’s operations are very cash generative. While there is a need for significant capital expenditures (and we should expect this to continue, certainly while the Company continues to grow), the Company has more recently demonstrated some commitment to shareholder value by spending significant amount of money buying back shares. The current level of buybacks may be above what is sustainable, but I like to see the Company taking advantage of a choppy market to buy back some shares.

Uses of Cash (Source: Company Filings and CapitalIQ)
Uses of Cash (Source: Company Filings and CapitalIQ)

(5) Valuation: I like to make investments which are attractive from an absolute value perspective. I prefer investing in a company where the earnings yield is material enough such that if there is no multiple expansion and earnings don’t grow materially, I still earn an acceptable return. This investment does not meet that criteria, but it does represent a case where I would expect the earnings to grow materially.  The valuation has decreased dramatically this year, despite the Company continuing to grow and deliver strong results, I suspect as a result of the current situation in Russia.

YNDX Valuation Multiples
Valuation Multiples (Source: CapitalIQ)

I usually think of an earnings yield of 5% (a PE of 20x) as a minimum requirement to consider an investment for the long term. Yandex trades at about 25x earnings, which is 25% too expensive given that threshold, but given the coming uplift in penetration in Russia should raise the Yandex audience by over 30%, I think this is justified. Furthermore, it is relatively early days for Yandex in terms of optimizing the firms revenues and profits, something which Google has demonstrated can have a lot of power.

Conclusion: From a value standpoint, it is always hard to quantify how much we should “pay for growth”. I think Yandex represents an opportunity to buy a leading search franchise while paying a much lower premium for the upcoming growth of the business.  It seems fairly likely that at the current valuation, the earnings will “grow into” a 2ox PE by 2015. Yandex is a good example of Growth At a Reasonable Price, if only because you have to take the risk of the political turmoil around it.


Portfolio Review: Xerox

Company: Xerox Corporation ($XRX)

Investment Thesis: (1) Xerox is increasingly a business services company. (2) The printer business (“Document Technology”) is an ex-growth cash cow and will continue to generate cash for a long time. (3) It is attractive priced in absolute terms and (4) has a shareholder-friendly strategy of returning capital through dividends and buybacks.

Investment Thesis Review:

(1) Services Business: The Services Segment grew revenues 3% in 2013 and now represents 55% of total revenues. Its contribution at the PBT level is even higher. Some of the increase in contribution is due to the fact that Document Technology shrank slightly, but so long as the overall profitability remains stable to slightly improving, the revenue quality of the overall business is improving, which is a positive.

Services Rev 2013
2009 – 2013 Services Segment Revenue

This segment is an attractive business composed of Business Process Outsourcing (59% of Services rev.), IT Outsourcing (13% of Services rev.) and Document Outsourcing (28% of Services rev.). These are long term contracts with high renewal rates (85-90%) and the Company has a strong pipeline of new opportunities. Document Outsourcing (managed printing services or “print as a service” if you want to be promotional) is probably a lower quality business, but the Company is incredibly well positioned here given its legacy. It is also worth noting that other outsourced printing companies such as VistaPrint trade at very rich multiples (11x LTM EBITDA and 30x LTM PE–although to be fair FY1 multiple look decent if they achieve the growth at 8.3x EBITDA and 14x PE)

(2) Document Technology: The Document Technology Segment shrank by 6% in 2013. and profitability fell to 966m (9% below 2012), almost as low as it was 2009. I am still of the view that the era of the “paperless office” is still a long way away, so I think this profit stream will continue to be sustainable for a long time. Certainly not a growing market, but it is a market that needs to be served and few serve it better than Xerox.

(3) Attractive Absolute Valuation:  Maybe the below will sound like a contradiction to what I previously wrote on the bias of the cost basis, but I think it is more about “knowing where you stand” than anything else. Here are some key valuation metrics for Xerox with the change in the metric since my last review of this position (11/4/13; which was when I bought the shares) in parenthesis.

EPS: $0.92 (+0.2%)

Price / LTM Earnings: 14.2x (+32%)

Price / FY1 Earnings: 12.0x (+27%)

EV / LTM EBITDA: 8.2x (+17%)

EV / FY1 EBITDA: 6.7x (+11%)

EV / Revenues: 1.1x (+20%)

EV / FY1 Revenues: 1.1x (+17%)

At first glance, it looks like the valuation part of the investment thesis is poorer across the board now–by about 20%. One the one hand this is a ‘nice problem to have’ and one that should hopefully be a recurring one for any value investor. On the other hand, it would be preferable for the near 30% price appreciation experienced to date to be a result of an improving business, rather than a richer valuation. In any event, the valuation remains attractive on an absolute basis. at A 12x forward PE, the implied earnings yield is over 8%. That is a very acceptable base case, and there is a lot of optionality here with valuation re-rating (there is a long way to go before getting to ‘market’ levels) and some growth in the long terms once the slow decline of the Document Technology business settles.

The dividend yield has now fallen below 2%, but I would not be surprised to see the Company raise its dividend at some point. The share repurchase has been aggressive, which is the right thing to do with a depressed valuation. It would be nice to see a shift in favor of more dividends and less repurchases if the valuation continues to increase at this rate.

(4) Shareholder-friendly Strategy: One of the first thing that attracted me to Xerox was that it had a decent dividend yield. I see that as a sign of sensible valuation (assuming its sustainable) and a shareholder-friendly management. Combined with the aggressive share repurchase program, it is very clear that the management has a strategy of returning capital to shareholders. The chart below compares cash flow from operations to the major uses of cash for the last 5 years.

Use of Cash
2009 – 2014 Cash from Operations and its Uses

With the exception of the large acquisition of Affiliated Computer Services (n.k.a. Xerox Business Services) the Company has had a moderate and disciplined M&A strategy. That acquisition bolstered the services business and seems to have been a good one.  They do enough M&A that I have not had the time to analyze each one specifically, but given the Company’s heritage, it seems like they are being appropriately opportunistic here. I like the optionality it creates

Other Considerations: The Company makes a lot out of their “Annuity-Based Business Model” (now 84% of revenues). I certainly like that about the business model in general–recurring revenues are a nice thing. It strikes me as a bit promotional, despite the fact that I think it is true. I wonder if it is a legacy of the printer business where selling the ink cartridges was always where all the money was made–one of the real classic “razor/razor blade” business models.

Conclusion: The original investment thesis still holds and this investment should stay in the portfolio (good! since it has only been 9 months). This is a nice business worth owning for the long term. Given current valuation and profitability I would expect it to generate an overall return of about 100% over the next 10 years (implied by 8% earnings yield, assuming a bit of degradation), which would be a good outcome.

In more general terms, I think this is a decent investment to hold in the event of a downturn. The printers business would surely suffer, but the services business should be resilient. Some concerns around the consumer financing (the Company lends people money to buy its products) to which most of the debt is related, but the balance sheet is strong and credits should be fairly safe.


Absolute Valuations

I have heard money managers I respect talk about investing as a ‘comparative process’, meaning that you should look at the whole universe of opportunities and select the most attractive ones. While there is obviously merit to this, it is ultimately not how I go about things. For one I like the time and resources of an industrial money management operation to ‘consider the whole universe’, but I also think there is a powerful aspect of risk management in limiting yourself to investments which you see as attractively priced on an absolute basis.

Portfolio Review

I think one’s “cost basis” is one of the biggest biases affecting most investors. The way professional investors are remunerated perpetuates this, but it affects personal investors just the same. With that in mind, I want to review the holdings in my portfolio and make an assessment about the initial investment thesis and whether it still holds. Hopefully this can be a periodic exercise, and hopefully it can be done independent of the entry price/cost basis of each holding.

Everything Boom

Reading this article the other day got me thinking: Welcome to the Everything Boom, or Maybe the Everything Bubble

What to do in an overall low return environment? We can just go to cash and earn basically zero returns. Buying short duration treasuries will get you to the same place. 10 yr. yields at 2.6%, near its lowest ever–so you can get some ‘safe’ yield of 2.6% but not without bearing big interest rate/duration risk as the central banks tighten and raise rates. It is worth noting that you could have said the same thing 10 years ago: in 2004 with 10 year yields at 4%–lowest since the 60s–rates have nowhere to go but up right? they have been in steady decline since. Who is to say that we can’t get another 10 years of currency debasement and nominal 10-yr rates dropping to 1.5%? where does that leave real rates? Either way, the last 10 years were a good time for fixed income.
Equities are about as expensive as they were in 2007, and we can’t even argue about ‘normalized profits’ with profit margins higher than ever. The Price/Sales multiple of the S&P 500 stands at 1.77x–at the peak of the market in 2007 it was 1.52x. You have to go back to the crazy days of the tech bubble in 1999/2000 to see levels like we see today.
Real Estate is also expensive and getting bid up based on cheap financing. Furthermore, Real Estate is not an asset class that has delivered long term return, with the exception of the latest bubble. It is a good inflation hedge, and ‘buying low’ following crises has been a good strategy, but hard to argue you would be doing that now. Commercial real estate is arguably ‘cheap’ today, but you have to wonder if the structural demand for retail (especially low-middle end retail, like malls) is ever going to come back given how much shopping is done at home/online. Blame the weather all you want, but last Christmas season may have well-marked a turning point. Teenagers don’t hang out in malls any more (See: all teenage specialty retailers which are really struggling: Abercrombie (ANF), American Apparel (APP), Aeropostale (AEO), etc.). High end / ‘experience’ retail may be here to stay, but I think that kind of ‘fifth ave.’ retail is not cheap (not really sure if there is a good vehicle to invest in that specifically).
I am sitting here with 30% of my assets in cash and maybe that is the right thing to do. I have 37% of my assets in passive index funds (pretty much the S&P 500), and I guess I have to be OK with the possibility of losing 50% of this value over a year (As happened in 2008). The remaining 32% is in actively managed , which could lose significant value as well. In the long term it should beat just holding cash and we will never do well timing the markets.
Howard Marks said it best: “You can’t predict. You can prepare” or more specifically: “We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.” So here I am trying to think of what is a sensible investment opportunity in this market, besides just buying defensive stocks (I am loaded up in consumer goods and dividend payers and also a little too much technology but mostly old names that look more like services/consumer companies like Xerox, IBM and–dare I say–Apple).