August 21, 2015 (Investorideas.com stocks newswire) Whole Foods Market (NASDAQ: WFM) will benefit from the growth of natural and organic foods. Except the interest rate hike, all the macro points towards growth. Due to organic nature of the business, Whole Foods has a higher pricing power. Its goods are differentiated as evident from healthy sales in new stores. But, the stock is already trading at a premium; there is not much value in the stock as of now. Whole Foods looks like another case of a good company that investors have piled on without regard to fundamentals.
Whole Foods is a services company that belongs to the industry of grocery stores. The company is the largest retailer of natural and organic foods in the U.S. It is the seventh largest public food retailer in a broader food retailer category. Exclusive brands of Whole Foods include Everyday Value®, Allegro Coffee and Engine 2 Plant Strong. As of May 7, 2015, Whole Foods had 417 stores worldwide. The company operates though one segment, natural and organic foods supermarkets.
Net sales of Whole Foods totaled $14.19 billion during fiscal year ended 2014, an increase of 10% on a year-over-year basis. However, comparable sales increased 4.3% during the same period; rest of the sales came from store expansions. The company generates a major portion of its revenue from perishable goods; perishables were 66.8% of the total sales during 2014. Exclusive brands contributed 13% towards the total retail sales during the same period. Geographically, the company attracts most of the revenue from the U.S. followed by Canada and United Kingdom. Whole Foods is on its way for an annualized store growth of 10% during 2015. The company was founded in 1978 and is based in Austin, Texas.
Natural and organic food market is expected to grow in coming years.
Broader supermarket sales grew 3% during 2013 while natural foods increased 11% during the same period indicating adoption of organic foods. According to a market research, organic foods are projected to grow at CAGR of 18% during 2013-2018. The market's growth is supported by increasing awareness regarding health, environmental protection, food safety and animal welfare. Adverse affects of pesticide use and GMOs are accelerating growth of organic and natural consumption. Organic trade association notes that 51% American families are buying more organic food as compared to the last year. Whole Foods, being a large organic food retailer, will benefit from the trends of the industry.
Pricing power is relatively better for the organic industry and Whole Foods.
Among the reasons is the production shortage as compared to the demand. Organic utilizes only 1% of the U.S. cropland but sales make up 4% of the total food sales. This is a strong indication that the company will continue to enjoy superior margins going forward. Further, organic food is priced higher for its perceived quality. Case in point: Whole Foods enjoys a higher margin, 35%, as compared to Kroger's 22% margin. Net margin of the company is higher than every other large retailer including Costco and Wal-Mart.
Macro trends are positive and Whole Foods’ products are differentiated.
From a macro perspective, job gains, declining unemployment and higher consumer spending bodes well for retailers like Whole Foods. Federal Open Market Committee pointed towards the favorable economic activity recently. The company is also expanding its locations at a decent rate. 10% annualized growth is expected in store opening. The key thing to note here is that new store sales are witnessing strong growth despite rising competition, which point towards Whole Foods' differentiation over its counter parts. To add to the bullish thesis, it should be noted that the stock is trading at a low of $36, which was not seen since 2011.
There are also some bearish indications.
A rising interest rate environment is not good as far as retailers are concerned. High rates will impact the buying decision and customers might not be willing to pay higher premium for organic food. Competition is also heating up, which can lead to deteriorating margin going forward. Kroger's in-house organic sales surpassed $1 billion during 2014; Costco is the largest seller of organic food, says analysts; Wal-Mart has started selling Wild Oats at a lower price than the competition. All in all, higher competition can result in lower margins and lost market share. In the short-term, the stock is not likely to post decent gains amid negative publicity from an NY audit that found mislabeled packages.
Accounting For Value
The stock has a rich valuation, and a higher valuation can't be justified on such levels. Whole Foods trades at forward PE of 19 while the industry growth projections stand at 11%. It's also expensive on P/S basis.
Assuming 8% required rate of return, the current market price of $35.06 implies 4.65% long term residual earnings growth. This is a high residual growth number for a dividend paying grocer with 2%-3% same store sales growth, slowing top line prospects, and increasing competition from major players. Coming from a small base, Whole Foods can reasonably be expected to outpace competitor supermarkets, but implied residual earnings growth indicates substantial speculation.
Prudena's residual earnings model using consensus analyst estimates for the next two years and consensus five year EPS CAGR estimates value per share of $30.98, 11.6% below the current stock price. A Monte Carlo simulation building uncertainty into the model's inputs predicts a most likely value of $31.06, with the distribution of possible values ranging from $23.58 to $36.30. Note that these model inputs actually assume acceleration in earnings growth from the figures posted this year before slowly falling to 6.8% 10 years out.
The investor community reacted very negatively to Whole Foods' top line results in Q3 fiscal 2015, causing a sell-off. This negative interpretation is less indicative of genuine deterioration of fundamental and more likely due to an appropriate shift in narrative. Whole Foods should not be considered a high-flying stock set to displace traditional supermarkets, but rather an above average performer with room to continue outpacing peers. With superior performance comes increasing competition, harder comps, and less low-hanging fruit. The sky is not falling, but Prudena's models show that a reset of investor expectations was not only warranted, but incomplete. Even fairly optimistic analyst estimates (which assume no significant negative events in the next decade and growth roughly comparable to the current rate) are insufficient to justify the current price.
A different version of this article appeared on Prudena.
Ryan Downie, Director of Research, Prudena
Soid Ahmad, Contributing Analyst, Prudena
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