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.
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