A Whole Foods Story

Now the stock advocate on the show kept saying, “buy a stock on sale”. Sound familiar? I actually agree with him. But how do you know when stock is on sale? Surprise, surprise, they never explained that.

In this case, we’re going to have to resort to some numbers and some math (I know, ugh!). Once you spend a little time on the math though, you’ll find it quite simple the next time around, and quite useful as well.

The Price to Earnings Ratio (aka PE)

There are lots of ways to value a company, but for the moment, we’ll use the most basic and mostly commonly cited, the PE ratio. Mathematically, it’s quite simple – “ stock price per share divided by earnings per share:

Stock Price Per Share/Earnings per Share

So think about this a bit. If a company earns more, then you pay more for that company.

If you look up Whole Foods PE, you’ll see that it’s about 33x ($45.88 share price = 33.25 x $1.38 earnings per share in 2006). By itself, the ratio of 33x doesn’t tell you anything. Now if I tell you the average PE of the S&P 500 is 17x, now we have a whole new interpretation of the number. Whole Foods trades at almost twice the PE of the average stock.

Why would it trade at such a premium? Because investors expect it to grow faster than the average stock.

The PEG Ratio

And that brings us to the next metric, the Price-to-Growth Ratio. The PEG ratio is often used to assess growth companies such as Whole Foods. Again, the PEG ratio is mathematically very simple:

PE Ratio/Growth Rate

Most websites will give you the PEG ratio and the growth rate. On Yahoo, the finance section says the estimated growth is 17.4%. Companies also provide category_idance, so if you go to a company’s website and look at their quarterly earnings announcement, they’ll usually give you an estimate of next year’s sales that you can compare to the last year’s sales.

Let’s interpret this number for Whole Foods. With a PE of 33x, divided by an expected growth rate of 17%, our PEG ratio is about 2.

Again, that doesn’t mean much by itself. But let me give you some fairly standard investment category_idelines. As the theory goes, if the PEG ratio is less than 1, then the stock could be undervalued. For the average stock, if the PEG ratio exceeds 1, then it’s overvalued. For growth stocks, the standard shifts because investors are willing to pay more for higher growth. Growth stocks often have PEG ratios of around 1.5, and 2 is considered the high end of the range. Cramer, of Mad Money fame, has a rule of thumb that says a PEG ratio of 2 is the maximum you want to pay for a stock.

Adds a lot to the picture, doesn’t it? Basically, Whole Foods’ PE ratio is much higher than the average, and it’s PEG ratio is at the limit of what most investors will accept. In investor parlance, Whole Foods is fully priced. Meaning that at the current price of $45, it has to have excellent performance just to keep the stock from going down.

The Role of Expectations. As you can see, expectations play a major role in determining stock price. When a stock’s actual results exceed expectations, investors get excited and the stock price goes up. When the company’s results fall below expectations, investors head for the exits. If the stock just meets expectations, it can go either way, depending on the situation.

This helps explain why Whole Foods stock took a dive in November, 2006. For retail stocks such as Whole Foods, investors like to look at the change in same store sales open more than a year. For the three previous quarters prior to November 2006, Whole Foods had double digit same store sales growth. In November, Whole Foods announced that same store sales growth would fall to 6-8%. The stock fell 23% in a day:

Was there something fundamentally wrong with the business? Not really. “After producing such strong growth over the last three years, we believe fiscal 2007 will be a transition year for us,” CEO John Mackey explained. “As we revert back to our historical comparable store sales growth range, without yet producing a fully offsetting increase in sales from new stores, we believe our total sales growth will be impacted.”

In other words, growth, and Whole Foods’ strong numbers, is being driven by new stores. As we wait through 2007 for sales in the new stores to ramp up, the overall growth for the company will reflect the slower growth rate of established stores. For a growing entity, this is normal; companies don’t grow predictably at a quarterly rate.

So it’s clear, at least in my mind, that consistent, strong growth had created a high stock price through the first three quarters of 2006. Investors expected that to continue, and had valued the stock based on a high double-digit growth rate. But in reality, even the best companies have periods of high growth, followed by periods of moderate or slower growth. So the real growth rate is lower than what investors expected. In this sense, Whole Foods was overvalued, and its lofty valuation simply came back to earth.

Is Whole Foods a Bargain?

Why go through all this? Remember our discussion of value investors – “ they look for stocks that should be trading at a higher level, but are currently out of favor. If you accept the previous argument that investors had overly high expectations of the stock, then Whole Foods is an overvalued stock whose valuation fell to more realistic levels, not a stock on sale. There’s a big difference between the two.

I don’t own any shares of Whole Foods, and I don’t expect to buy any in the near future. Here’s why: first, I think that last year, it was an overvalued stock trading at unrealistically high levels; second, today’s levels are more realistic, but even at these levels, the stock is fully priced; and third, because the stock is fully priced, there is very little cushion, or margin for error.

The Cushion

We all like big cushions, which are nothing more than deep discounts. Face it, we’ve all done it. We’ve all walked into a store, or a stall, and said, “that’s so cheap, I’ll buy two.” Value investors like to buy with a deep, deep discount. As much as 50% is ideal. Boeing, which I talked about in my last article (and a reminder, I own Boeing stock), was such a stock a few years ago.

For a truly disciplined value player, a small discount is enough of a reason not to buy a stock. That’s because you might be wrong about whether a stock will or up, or about how fast it’ll go up. But if you buy it at a low enough price, you probably won’t lose any money and you might still make money if you’re wrong about the stocks fundamentals.

Remember that earlier, I said that stock investing isn’t always about “good” or “bad” stocks, or about hitting a certain “target price”. It’s sometimes just about increasing the probability that a stock will go up, and eliminating the risk that it’ll go down. So the simple thing is, with enough of a discount, you’ve achieved both goals.

But Won’t Whole Foods Still Grow?

Even though I’m not buying, I have not doubt that Whole Foods will grow. I think management is great at execution, and they will find a way.

So why not buy?

Let me give you a few facts first.

Whole Foods’ goal is to hit $12 billion in sales by 2010. 2006 sales were $5.6 billion. That’s more than double, and if they achieve this goal, then that means the annual growth rate would have to be 21%.

According to their press releases and annual reports, Whole Foods has already signed leases for 88 stores, and if you do the math (average square footage of the new stores x sales per square foot of stores in 2006 x 88), then you could reach $9.9 billion in total sales.

Last year, Whole Foods agreed to acquire Wild Oats, who has another $1.2 billion in sales. That means combined, Whole Foods would have $11.1 billion in sales. In fact, the actual number is probably higher, because the average sales per square foot at Wild Oats is lower than for Whole Foods, so Whole Foods could probably get much more out of each Wild Oats store. In other words, management could very well hit $12 billion in sales.

Sounds great, right?

Two issues remain. The first is timing. Over the next few years, Whole Foods has to ramp up 88 stores and integrate Wild Oats. With Wild Oats, they will have to assess each store, close some, and redevelop others. That’s a lot of stores, and that will slow down growth. At some point, synergies will kick in, but I think that’s not around the corner.

The second issue is competition, which is actually hard to assess. No question all the other supermarkets, including Wal-mart, will be selling healthy, organic foods. How much of a dent that will put into Whole Foods is unclear because we haven’t really seen what the established grocers can offer that will knock down Whole Food’s sales. For the moment (emphasis on moment), I don’t think it’s a big issue, but look at it this way – “ if you think competition is really a big issue, definitely do not buy the stock.

If we accept that competition isn’t a big deal (yet), then we’re left with the price and timing issues. This is sometimes the hardest kind of valuation, because it’s not that Whole Foods’ is a bad company, or whether Whole Foods’ has bad management. It’s about whether Whole Foods’ can execute fast enough to exceed already high expectations.

In other words, there’s not much margin of error. And I like big margins of error. I also think timing is important to the market. Value investors are patient, but growth investors and traders are not. If it takes a while for sales to ramp up, growth investors and traders will get out of the stock. That means there’s a fair possibility that the stock (given that it’s fully priced), will disappoint and go down before it goes up. So without a good cushion, and with questionable prospects of exceeding expectations in the short term, I’m not buying. But I am keeping Whole Foods on my radar.

Update, May 16, 2007

This article was originally written on May 1, 2007. After close of trading on May 9, 2007, Whole Foods announced that sales had risen almost 12 percent, but that net income had fallen 11 percent, to 32 cents per share. The analyst consensus estimate was 36 cents per share, a miss of 4 cents a share. The company said that accelerated store openings – “ six new stores in the last quarter, 15 in the last year – “ caused the dip in earnings.

At the same time, the Federal Trade Commission (FTC) expressed concerns about Whole Foods’ acquisition of Wild Oats. On Thursday, May 10, Whole Foods stock dropped 10.7%, or $4.92, to a new 52-week low of $40.88. Today, the stock’s price is $39.82, and it has a PE of 28.83x. Take a look at the latest 1-year chart:

Given that, the slew of negative press that followed won’t surprise you. Mad Money’s Jim Cramer featured Whole Foods in his article, “Two Toxic High-Multiple Stocks” (guess what, the stock was Starbucks). “Growth Pains for Whole Foods” declared Businessweek Online, while Forbes lamented “Bitter News for Whole Foods Shareholders”.

Observations

If you’re into the market, there’s a lot to be learned here. I’ve often heard people say, “I’m afraid that the pros might know something I don’t.” The first thing this experience should tell you is the pros don’t necessarily know anything you don’t. They might be better at running numbers and estimates, but they don’t know anything more about the outcome. And if you understood the basic concepts in this article, it wasn’t hard to figure out that expectations were high. After that, common sense should tell you that there’s downside risk and low margin for error.

Warren Buffet, the “Oracle of Omaha”, often says, invest in what you know. I’ve heard that stock advice transformed into “buy a stock you love”. I would say that this is often misinterpreted by individual investors. My version of it is this: “buy a stock where you understand the business”. Whole Foods is my case and point: just because you love the product, doesn’t mean that you understand the stock or the business. I think a lot of people bought Whole Foods simply because they love shopping there (heck, I salivate when I walk into that place). While a good indicator, it doesn’t tell you what to pay for that stock. I’m throwing this into one of the top ten mistakes that investors make.

I’ve also mentioned that investing, at least for someone that looks at the fundamentals (like me), is often more about probabilities and risk than anything else. Specifically, what’s the probability, at a given price, that a stock will go up or down? As a statement, that might seem obvious, but a lot of us get caught up in the “target price” for a stock. I’ve heard a lot of people say, “stock’s at $45, I’ll buy if it falls to $44.” Target prices change, and often. But the fundamental value of a stock changes at a much slower pace. What’s more, when you look at fundamentals, there’s a price range at which the stock is a good buy. So if a stock is cheap, then the difference between $45 and $44 might be irrelevant.

And Prognostications

So should we be thinking about buying Whole Foods now? I still think it’s rich. Let me explain why.

First, we have new information. It’s now clear that accelerated store openings will crimp earnings. And without new store openings, sales won’t hit double digits (same store sales growth is usually in the 6-8% range, a fact which is readily available in Whole Food’s earnings reports).

It takes several months (at least) to open new stores. It also takes several months for those new stores to generate sales. Given that Whole Foods is trying to open stores at an accelerated pace, that means earnings will be low and costs will be high for much of the next 6-9 months. Sometime after, you can expect earnings to increase and the sales for the new stores start to hit the registers.

But wait, let’s not forget about Wild Oats. I actually think the Federal Trade Commission concerns are unlikely to be an issue. Why? Because Whole Foods will argue that there’s lots of competition coming from Trader Joe’s, Kroger, Safeway and Wal-mart (By the way, many have argued that Whole Foods purchase of Wild Oats is defensive. Meaning, Whole Foods had no choice but to buy Wild Oats, because if they didn’t, someone else, like Kroger or Safeway, would have, and Whole Foods would have another competitor on their hands.).

Now if the FTC concerns fade, Whole Foods stock will jump, but only momentarily. Because afterwards, Whole Foods will have to digest the acquisition. That means evaluating each store, re-modeling, re-stocking and so forth. That will require cash and time, and will actually slow down Whole Foods even more. As they complete the conversion, sales will increase, but that will take time as well.

So we have new store openings, and if the Wild Oats acquisition goes through, the company will need time to absorb the Wild Oats stores. There will be some upticks in the stock, but it could be sometime before the stock really takes off.

In the meantime, the stock still trades at a 28x PE. If we follow our rule of thumb that a PE of 2x the growth rate is the high end, that means the current price reflects an expected 14% growth. Given that this year’s growth rate is likely to be in the single digits, a 28x PE is high. I think momentum players will pull out their cash, put it somewhere else where there’s a better return, and then come back in at a later date when they think the stock is ready to take off again. In other words, there’s still fair downside risk at this price level.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.