Whole Foods (NYSE:WFM) is still most commonly identified as the supermarket for organic, natural, and healthier foods. While plenty of shoppers know about chains like Sprout's (NYSE:SFM), Natural Grocers (Nasdaq:NGVC), and The Fresh Market (NYSE:TFM), just about everybody has been to a Whole Foods once. With more organic/healthy food options in the stock market, not to mention a significant expansion at conventional retailers like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), just how special is Whole Foods anymore? While the numbers continue to support the notion that Whole Foods is an uncommonly well-run retailer with considerable growth potential, it's increasingly challenging to justify the price on the shares.
 
The Third Quarter Was Fine, But Not Thesis-Changing
Operationally, it doesn't look like Whole Foods is running dramatically ahead of expectations. Revenue rose 12% this quarter, actually coming in below the 13.4% average growth estimate. Same-store sales were good, though, as comparable store sales grew 7.5% (ahead of the 7% estimate) and identical store sales rose 7.2%. Within that number, transaction count increased about 4%, with 3% coming from price.
 
Whole Foods did beat on margins, and that might be more of a mixed blessing than you would think. Gross margin improved 60bp and came in ahead of estimates by the same amount, as the company didn't reinvest as much margin back into pricing as expected. Operating income was slightly (2%) ahead of plan, growing 21% as operating margin came in at 7.5% (up 60bp). Inventory turns continue to improve noticeably – rising from 15.3x last year and 16.0x in the prior quarter to 17.3x this quarter.
 
Margins Still Need Some Work
The reason I say better margins could be a mixed blessing is that Whole Foods management has made no secret of its intention to sacrifice some gross margin to lower prices (or raise them at a slower rate) and become more price competitive. I think management desperately wants to lose the “Whole Paycheck” nickname, and though Whole Foods isn't as pricey as commonly thought, the growth of organic and healthy food selections at mass-market retailers like Wal-Mart and Target is forcing them to get more aggressive.

SEE: A Look At Corporate Profit Margins
 
With this outperformance, I think two factors are at work. One, management still hasn't quite figured out just how much leverage they can get from logistics, back-of-house efficiency, and so on (including those inventory turns). Second, I think margins and same-store sales are probably going to show more quarter-to-quarter volatility in the coming periods as management tries to dial this in better.
 
Succeeding In New Markets, But Facing More Rivals
On the post-earnings call, management highlighted that the company continues to see better than expected results in markets that are smaller and less affluent than their traditional target markets. That's encouraging as it pertains to the company's sales and margin expectations along the long road from from 355 stores to 1,000. It also suggests that companies like Natural Grocers may not have as much leverage in secondary markets as previously believed, nor that supermarket chains can box out Whole Foods by simply adding to their organic/natural assortment in these secondary markets.
 
On the other hand, I still do wonder if Whole Foods owes some of its multiple to its legacy scarcity value. For quite a long time, Whole Foods was really the only investable play on organics, and though the company still has excellent prospects as a well-run supermarket operator, investors are increasingly spoiled for choice in the organic/natural space. From Annie's (Nasdaq:BNNY) and White Wave (Nasdaq:WWAV) in food to the aforementioned Natural Grocers, Sprout's, and Fresh Market in retailing, there are quite a bit more viable investment options today.
 
The Bottom Line
The problem with Whole Foods today is that whether it's scarcity value, appreciation of excellence, or just the underlying bull market, the shares don't look cheap even with some aggressive assumptions. If I project a decade of compound revenue growth of over 10% and free cash flow growth of 13% (which includes the assumption of a 7.5% free cash flow margin down the line – unheard of in food retailing) that still just gets me to today's price. Stripping down the discount rate to parity with long-established companies like Coca-Cola (NYSE:KO) or Wal-Mart adds another $9 or so to the target ($63.50), but that's a pretty aggressive set of assumptions.
 
With that, I don't see myself adding Whole Foods today. There's nothing wrong with paying a fair price for an excellent business, but I think even Whole Foods will find it challenging to live up to these expectations.
 

Disclosure: At the time of writing, the author did not own shares of any company mentioned in this article.
Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  6. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  7. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  8. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  9. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  10. Investing News

    Alphabet Earnings Beat Expectations (GOOGL, AAPL)

    Alphabet's earnings crush analysts' expectations; now bigger than Apple?
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center