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Small-Cap Recap: Shopping For Groceries

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...virtually all the moving averages are trending in the wrong direction...

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For the better part of the last 6 years the Whole Foods (WFMI) story has been about growth, growth and more growth. That's why this grocery store has consistently been able to command multiples two to four times those of its peers. As one would expect from hyper-growth companies that stumble, WFMI's stock has occasionally been punished for the occasional miss, but none ever proved to be more than temporary. Even when WFMI's performance decelerated in 2003, WFMI was able to mount a comeback.

But playing the "comeback kid" while your stock P/E hangs in the 50's and 60's is a dangerous and finite game. With growth and time, the law of large numbers becomes an unavoidable headwind. Currently, the trailing four quarter average of several growth measures has been slumping again, and this spell is creating yet another lower low for most of those metrics. In my humble opinion the odds are stacked against WFMI's growth reaccelerating, and sooner than later investors will begin to question why this $10b market-cap grocer growing at 20% deserves a forward multiple higher than 30% grower Google (GOOG).

Of the basic statistics I looked at, none specifically raise a red flag, which is good because I don't have to put everyone to sleep with a bunch of numbers. But virtually all the moving averages are trending in the wrong direction. Here are the charts for sales growth, income growth, and EPS growth.

So what makes me think that WFMI can't regain its past glorious growth? For one thing, despite very impressive sales growth, neither its gross nor operating margins have budged over the last five years. If WFMI can't increase margins with sales growth in the 20% range, it's tough to see how that's going to happen. To boot, even the models of some of the most bullish sell-side analysts (take Morgan Stanley for example) assume annual sequential declines in sales growth.

Second, this is hardly an undiscovered business. Safeway (SWY) is aggressively rolling out its own "O" organic brand line (very competitively priced I might add) and even Walmart (WMT) is getting into the action. I agree with the view of most analysts that WMT is playing to totally different demographics, and the locations of their respective stores do not have much overlap (only about 20% of WFMI's stores are within 15-20 miles of a Wal-Mart superstore). But bear in mind that these companies operate off of 2-5% operating margins: maybe WMT might not gain much by jumping into the fray, but it wouldn't take much to hurt WFMI.

Third, on its conference calls, WFMI has regularly answered with disdain (hubris?) the question of how inflation impacts its sales. The answer is always that they pass it through to the customers. Forgive my skepticism, but with food inflation running 4-8% per year (depending which index you look at) at some point those third-growth basil leaves for true Genovese pesto sauce might start leaving me a stinky taste in my mouth.

Lastly, but perhaps most important, more than 50% of WFMI's future sales growth is estimated to come from new stores. In absolute, the annual number of new stores is projected to increase out as far as the projections can see. This inevitably puts pressure on WFMI's free cash flow. In fact, estimates show that, after its regular dividend, WFMI will not have any free cash flow for the three year period 2007-2009. As a point of reference, compare WFMI and Starbux (SBUX) (a similar company in many respects) four-quarter moving average of their Sustainable Growth Rates. See the chart here. This is not to say that WFMI can't finance its growth, but there's a big difference between a company that can generate growth internally and one that has to leverage its balance sheet to do that. And yet, today both companies trade roughly at the same multiples.

So what do I think WFMI is worth (as if that mattered)? A straight Dividend Discount Model with a long term growth rate of 19.5% gives a present value of $50; jack up the bond rate in the model to 5.5% from 5.0% and the PV falls to $44; use this year's expected 39% EPS growth rate on $1.38 of EPS and you get $53; blend the '06 and '07 growth rates on '07 EPS of 1.67 and you get $50; and if you are into pretty pictures, the dandruff projects to $45. Whichever way you slice it, I'll take that 2lbs. cordon-bleu before the stock.
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Position in WFMI, GOOG
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