There will come a time when this is no longer true, but it still seems to be the case that Whole Foods (NYSE:WFM) is a stock you want to buy when comps disappoint and sell-side analysts start collectively clutching their pearls and/or talking about slowing store expansion in favor of capital returns to shareholders. While consumer confidence is still pretty shaky, Whole Foods seems to be doing well with its value positioning and there's still ample store growth potential. Whole Foods isn't cheap today, but I'd be slow to part with these shares if I already owned them.
Back On Pace, In A Big Way
It looks like Whole Foods is back in its happy place with respect to growth and performance vis a vis Wall Street expectations. Revenue rose 13% this quarter, matching expectations even though comps came in just shy of estimates. Speaking of those comps, Whole Foods saw comps rise almost 7% on a fairly even split between traffic and ticket.
As The Fresh Market (Nasdaq:TFM) hasn't reported its April quarter yet, it's a little challenging to put those numbers into context. Still, The Fresh Market had just 2% comp growth in January (versus 7% for Whole Foods), while United Natural Foods (Nasdaq:UNFI) (a large distributor of natural and organic foods) saw 12% growth for its February quarter. Harris Teeter (NYSE:HTSI), a somewhat high-end supermarket chain, saw 3.7% comp growth for the April quarter.
Turning back to Whole Foods, it certainly looks as though the company's focus on traffic-stimulating pricing is not hurting bottom line profits. Gross margin actually improved a tick, while operating income increased more than 20% on a 40bp improvement in operating margin.
SEE: Zooming In On Net Operating Income
Doing More With Less (Pricing)
One of the known challenges facing Whole Foods is its pricing. Although the store's prices actually aren't as high as commonly believed, perception can be more important than reality when it comes to where shoppers show up. To that end, management has been “investing in prices” - looking for ways to offer more bargains and make the prices even more competitive.
Unlike stores that go with heavy couponing or promotional sales, Whole Foods seems to be taking a more sustainable approach. For starters, the company continues to invest in its 365 store brand line – a line that despite some controversy has proven popular with shoppers who want organic/natural products at more reasonable prices. Whole Foods is also working hard on “back office” functions to allow the company to offer lower prices without giving up gross margin – inventory turns increased notably from the year-ago quarter (16 v. 14.9), and the company has made a lot of progress with reducing shrinkage (not theft in this case, but mostly spoilage of produce and fresh proteins).
Of course, nothing comes without a cost, and I do think Whole Foods has to be careful. Controlling shrinkage can sometimes come at the cost of selection, and that can alienate shoppers. Likewise, if Whole Foods pushes back on suppliers too hard, they risk being seen as bullying small farmers and Whole Foods' customer base certainly includes those who love to share their social media outrage.
SEE: Behind The Big Brands
Still Dialing In The New Store Formula
Curiously, it sounds from management's commentary that they are considering moving back towards favoring more large new stores. As larger stores are more expensive to build and operate, I would think this would cause some concern among analysts and investors – or at least among those who really liked the move towards smaller, cheaper footprints.
Ultimately, I think the question comes down to whether you trust management. I'd never say that management has never made a mistake, but I think they've shown a pretty good understanding of their customers and markets, and if they think that larger stores are what's needed today, I'd give them the benefit of the doubt.
SEE: Evaluating A Company’s Management
The Bottom Line
If management is right that their distribution systems could support a store base of 1,000, there are likely still substantial operating leverage opportunities given the current store count of about 350. Moreover, if Whole Foods succeeds in recasting perceptions about its prices (and the value for money they offer), I think store growth and comp growth could continue to fuel significant financial growth for the decade to come.
Right now, I'm still looking for long-term free cash flow (FCF) growth in the very low teens, but wondering if I'm not giving enough credit for the margin and cash flow implications of better leverage and less incremental capex. As it is, though, I think Whole Foods is a little expensive today (as it usually has been). Just on principle I'd be careful about buying a richly-valued growth stock in a hot market, but operationally this is still a company that I'd like to own.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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