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Why Whole Foods' Stock Price Is Still $10 Too High


The current long-term outlook from management does not make sense.

After many years of denying how important the fundamentals of retailing really are, the market finally woke up to the problems with Whole Foods (NASDAQ:WFM) this week. I'm not sure that this had anything to do with it, but 10 days ago, a Wegmans finally opened in Newton, Massachusetts. This location is easily accessible from the tonier sector of Brookline, as well as from Wellesley, an area with a disproportionate number of Boston analysts and portfolio managers living in it. Maybe some of them decided to wake up to the reality of the retail business more intensely than the last two quarters' results may have implied.

Whole Foods' present $39 valuation -- based on the newly lowered sell-side consensus of $1.54 and $1.75, respectively, for FYs 2014 and 2015 ending in September -- implies a 17% five-year EPS growth rate. (This is based on a 4.2% risk-free rate, derived by adding about 50 bps to the long Treasury to counter quantitative easing, a 6.0% risk-free rate for a strong retailer, and a 1.5% terminal growth rate.) This valuation is broadly in line with the newly revised 15% long-term outlook from WFM management.

Does this outlook make sense? No. 

Management sees square-footage growth of 10%-11%, 6% comps store sales growth, and a very slight decline in gross margin to 34.5% from last quarter's 35.9%, for 14%-15% EPS growth. According to National Business Journal, the natural and organic food category saw a growth rate of 9.6% (compound annual growth rate) from 2011 to 2020. But a recent CSFB report projects an 11.5% square-footage growth rate from just players in the organic food retailing segment. Add in Wal-Mart's (NYSE:WMT) recently announced big organic SKU growth in private-label organics at prices 25% below those of Whole Foods', as well as the regular supermarkets' increasing organic offerings at lower prices than Whole Foods', and you'll get tremendous pressure in either comparable store sales and/or gross margin.

Looking at store cannibalization and competition overlaps with direct organic competitors in store market areas, the 2005-2010 period was characterized mostly by increases from Trader Joe's and increased density from Whole Foods' own openings. The 2010-2013 period square-footage increase came mostly from more direct competitors who operate at lower prices, such as Sprouts (NASDAQ:SFM) and The Fresh Market (NASDAQ:TFM). These concept stores will represent the lion's share of US organic square-footage growth for the next three to five years.

Holding gross margin in the mid-30s is very unlikely. According to Nielsen, the average household income within 1 mile of Whole Foods stores -- as a median across the chain ​ -- is $66,000. The average household income in the US is $53,000. Whole Foods focuses on households earning $75K+, but the demographics in new store areas are getting pretty close to the US average, meaning the store's pricing will need to be fairly comfortable for consumers who also shop for organic offerings at mainline grocery stores or Wal-Mart.

Now Whole Foods management has said that it won't compete on price with the lower-priced sellers of organics because it's an upscale store and shopping experience. The implication is that the other high-end, nonorganically related products would still sell at a premium. Fine, understood, but while Wal-Mart won't hurt established stores, other sellers will.

Looking at some recent DC-area pricing studies, Whole Foods' pricing was 51% over Wegmans, and 31% over Safeway (NYSE:SWY) and Giant. Been in a Wegmans? It's my favorite food store and two years running has been Consumer Reports readers' favorite as well. Wegmans had a much higher satisfaction index than Whole Foods in the DC area, too. Obviously, Wegmans isn't taking over the world and can't be a major overall competitive factor to WFM now. But it does show that there's a pricing bubble for the entire SKU lineup at Whole Foods and that that bubble will be burst by the competition in three years (my estimate) without a strong economic recovery.

A best case for me is that square footage grows 10%, comp store sales grow more like 3% over the next five years (yes, I realize that the trend line is still closer to 6% right now), and gross margin drops to 33% -- still very high by supermarket standards. EPS then grows at around an 11% CAGR.

A more likely scenario might be 10% square-footage growth, a 4% comp, and a 30% gross margin. The five-year EPS compound annual growth rate would then be 10%. A worst case is certainly possible, too, but I haven't calculated what that would look like.

A 10.5% five-year growth rate with the valuation assumptions above implies a $29 stock, 28% below the current $39 -- not right away, but all of the fundamentals seem to be in place or coming soon.
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