Friday, July 21, 2006

Whole Foods: A Little Too Rich?

News Analysis
July 21, 2006

Business Week Online

Whole Foods: A Little Too Rich?

The natural-foods retailer boasts strong sales and a solid brand in a fast-growing niche. Trouble is, the stock may be too high

Shoppers at Whole Foods Markets (WFMI ) are used to paying a little extra for the quality they want. The Austin (Tex.) natural-foods giant's shares, too, are trading at a premium, analysts say, even after a two-month decline. While green-focused gourmands will gladly splurge on organic cheese, investors may want to wait for a bigger markdown on the share price before putting Whole Foods in their carts.

Since its first store opened in 1980, Whole Foods has grown into a retail success story to rival coffee giant Starbucks (SBUX). Adjusting for dividends and splits, shares in the health-oriented supermarket chain swelled a staggering 855.8% in the 10 years through late trading July 20.

"We are a lifestyle brand and have created a unique shopping environment built around satisfying and delighting our customers," Whole Foods co-founder and CEO John Mackey said in a May 3 conference call. A Whole Foods spokeswoman declined to comment, citing a quiet period before the company's July 31 earnings announcement.

ON THE REBOUND.  As retail stocks have struggled in recent weeks, Whole Foods has not been immune (see, 7/18/06, "Target: The Canary in the Economy?"). On July 18, the grocer's shares touched a 52-week low of $54.66, down an adjusted 27% for the year. Shares have already rebounded somewhat, to $57.81 in late trading July 20.

Despite recent losses, the future looks relatively bright for the chain. Analysts laud Whole Foods' brand image, merchandising prowess, and store expansion plans. Meanwhile, 10 straight quarters of double-digit same-store sales growth can't hurt. Whole Foods has "revolutionized the way food retailing is being done in this country," says Citigroup analyst Gregory Badishkanian, who has a hold recommendation on the stock. "They do a phenomenal job in terms of their vision and their execution." (Citigroup owns 1% or more of a class of Whole Foods securities.)

Still, Whole Foods' sterling reputation may already be reflected in its share price. The stock trades at a roughly 40% price-to-earnings premium vs. other "best-in-class" food sellers like Starbucks, P.F. Chang's (PFCB ), and Cheesecake Factory (CAKE ), Badishkanian wrote in a May 3 report. Meanwhile, Whole Foods supply-chain partners United Natural Foods (UNFI ) and Hain Celestial Group (HAIN ) offer similar exposure at significantly lower valuations.

ORGANIC TREND.  Demand for natural and organic foods has sprouted rapidly in recent years. Organic-food sales jumped from $3.6 billion in 1997 to $13.8 billion in 2005, according to figures from the Organic Trade Assn. "There are some pretty deep commitments throughout our culture to organic food," observes Bill Wolf, president of New Castle (Va.) organics-market consultancy Wolf & Associates.

Whole Foods isn't the only grocer dedicated to this burgeoning market, but it is the biggest. The company operates 183 locations in the U.S. and Britain, compared with 113 in the U.S. and Canada for its closest rival, Colorado-based Wild Oats Markets (OATS ).

Traditional retailers, too, are catching the green bug. Supermarkets such as Kroger (KR ), Safeway (SWY ) and SuperValu (SVU ) have launched private-label organic lines. More recently, big-box behemoth Wal-Mart (WMT ) announced plans to double its organic offerings as it seeks to attract affluent customers (see, 3/29/06, "Wal-Mart's Organic Offensive"). In general, Whole Foods' wider selection and top-notch customer service give it a leg up on the competition, Badishkanian says.

SOCIAL-ISSUES EMPHASIS.  Moreover, consumers may go to Whole Foods expecting something beyond eggs from cage-free chicken. Like Starbucks or Apple (AAPL), Whole Foods is perceived to offer its customers not just products, but a lifestyle choice, in accordance with its company motto: "Whole Foods, Whole People, Whole Planet." In recent months, Whole Foods has further emphasized its environmentally and socially conscious image by pledging to increase its support for small farms. It has also banned the sale of live lobsters, citing concerns about inhumane treatment such as lobsters being held in storage facilities for several months. (The chain plans to offer frozen raw and cooked lobster products instead of the snapping crustaceans.)

Whole Foods appears better positioned than most retailers to weather a cooling economy (see, 7/5/2006, "Shedding Light on the Second Half"). History shows little to no relationship between the company's sales and data for economic growth, employment, or even consumer spending, according to Bank of America analyst Scott Mushkin, who rates the stock a buy. (Bank of America has an investment-banking relationship with Whole Foods and makes a market in the company's securities.)

Another encouraging sign is that rising oil prices don't appear to have dented margins. In the quarter ended Apr. 9, same-store gross profit rose four basis points as price increases absorbed higher energy costs.

GROWING PROGRESS OR PAINS?  While the company's expansion plans may curb profits in the near term, they should boost sales growth over the long run, analysts say. On May 3, Whole Foods management announced they expected square footage to rise 15% to 20% in stores in 2007, up from an expected 14% rise in 2006.

"We believe the rollout of additional large stores will ultimately prove to be transformative for Whole Foods," noted RBC Capital Markets analyst Edward Aaron in a May 4 report. Aaron has an outperform rating on the stock. (RBC Capital Markets expects to receive or intends to seek investment-banking compensation from Whole Foods and makes a market in the company's securities.)

At the same time, the new store launches could be risky should sales start to slow, others say. "Our major concern is the ability of Whole Foods to manage its expense levels to sustain its contribution margin should it experience a slowdown in its sales growth, which could result in more sudden margin pressure," wrote Bear Stearns analyst Robert Summers, who rates the stock underperform, in a May 3 report. (Bear Stearns make a market in Whole Foods securities.)

COMPARING THE P-E.  The bottom line, some analysts say, is Whole Foods' lofty valuation. Standard & Poor's recently pegged the stock's price-to-earnings multiple at 40.5 using estimated 2006 earnings, while Prudential has cited a forward p-e of 48. That compares to valuation in the teens for standard supermarkets. "We suspect that the name will trade sideways and 'grow' into its valuation," wrote Prudential Financial analyst Robert Campagnino in a May 4 report. Campagnino has a neutral-weight recommendation on the stock. (Prudential owns 1% or more of a class of Whole Foods securities.) Whole Foods has built a healthy business out of consumers' desire for cleaner, greener food offerings. Still, with the stock still trading at robust multiples, investors wishing to play the organic-food boom might want to consider its more attractively valued supply-chain partners until Whole Foods shares slim down a bit more.

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