I’ve written in the past about Walmart’s (WMT) crazy valuation around the turn of the century, and how it led to poor long term returns despite solid business performance. Today, I’d like to focus on another retailer: Whole Foods Market (WFM). If you pull up the company’s historic returns, you’ll notice something odd: the stock has gone nowhere over the past decade.
I say that’s odd because it doesn’t mesh with the business results.
Consider that statement in the context of some financial data: in 2004, Whole Foods reported $3.8 billion in sales; in 2014, the total was $14.2 billion – a 10-year CAGR of nearly 14%.
In 2004, Whole Foods reported $1.34 billion in gross profits; in 2014, the total was just north of $5 billion – a ten year CAGR of 14.2%. Again, a solid result for Whole Foods.
In 2004, Whole Foods reported $130 million in net income; in 2014, the total was $579 million – a 10-year CAGR of more than 16%. That’s good for a cumulative increase of nearly 350% over the past decade. On a per share basis, earnings increased at a 13% CAGR over the period, reflecting the impact of a rising share count due to preferred issuance during the financial crisis.
Not surprisingly, the difference between the business and the stock is driven by valuation.
Last year, the company earned $1.60 per share; with the stock trading in the low $30’s, the trailing P/E is roughly 20x. By comparison, the company earned ~$0.50 per share a decade ago – meaning the stock was trading at more than 60x earnings in 2005. As we often see, an absurd valuation has led to poor long-term stock performance despite solid underlying results.
With hindsight, I’m a bit puzzled: when a mid-teens CAGR for sales and EPS over a decade isn’t good enough, what could shareholders have possibly been hoping for? And for our consideration, is there any reason to believe these expectations had any basis in reality?
A quick look at the numbers raises some red flags. A decade ago, Whole Foods was consistently reporting comparable store sales growth of ~10% a year – a truly astounding number. In fact, the number is so astounding that the working assumption for anybody trying to look 5-10 years into the future should’ve been that this can’t go on for much longer.
For example, if the company had maintained ~10% annual comps, the average Whole Foods would currently be selling more per store than an average Walmart Supercenter – despite operating in a box that’s roughly one-fifth as large as the average Supercenter.
Considering that they’re selling food, as opposed to high-priced electronics, that sounds like a stretch to me (every day would be the equivalent of shopping on Black Friday). This is before considering the fact that new stores are likely to be less attractive opportunities long term than earlier additions to the company’s footprint (start with the low-hanging fruit).
Looking at margins (gross, EBIT and net) and new unit growth, it’s difficult to conclude from looking at the 2005 annual report – and the historic results up until that point – that investors should’ve expected much more than what has been actually delivered in the ensuing decade. In addition, nationwide competition should’ve been foreseeable as well; it may have taken longer than some expected, but it looks like selling organic / natural food is a lot like your everyday grocery store – a cutthroat business with few long term winners (look no further than the Fresh Market (TFM) for a company that’s finding trouble in an increasingly competitive environment).
A decade later
As I look at Whole Foods today, the picture looks a lot more interesting: at 20x earnings, you’re buying a business that can grow net units at a mid-single digit percentage (at least) and has grown comparable sales 6% a year (or so) over the past five years. Even with a decent haircut on both of those variables, I think this business can sustainably grow the top line ~8% a year for the next five-plus years. The returns on those new units are pretty attractive, and the balance sheet looks strong as well (current ratio of 1.5x, with ~$700 million in net cash). All in, there appears to be a decent argument for Whole Foods on back of the envelope math.
Taking this a step further, how bad would the next decade need to be to match the returns (roughly zero, not including dividends) of the prior decade? Let’s assume I’m too optimistic on comps and net unit growth: they’re actually +2% and +4% a year, respectively, in the coming decade (call it 5% sales growth to account for impact of new units relative to well performing legacy stores). Let’s also assume that net margins contract from the 4.1% reported in FY14 to the 3.7% trailing five-year average.
Under those assumptions, for WFM to go nowhere over the next decade, the stock would need to be trading at a P/E multiple of 10x – 12x in 2025 (that includes some benefit for uses for excess FCF for repurchases, as they’ve done in recent years). At that point, the company would have just under 600 stores, roughly half of what management believes is a reasonable long-term target for their footprint in the United States. That’s also well below what management has planned for the coming years (they plan to reach 575 units in 2018, well ahead of my estimate).
Conclusion
I always find it interesting to think about how Mr. Market falls in and out of love with certain companies, resulting in stock market returns over long periods of time that share no resemblance with the actual underlying returns of the business.
The real pain from investments like Whole Foods in 2005 (or Walmart in 2000) comes in the form of multiple contraction; if you pay a high price for a business that doesn’t perform even better than what Mr. Market has priced in (if that’s even possible), the result will be painful.
As I tried to show above, the valuation clearly doesn’t look as absurd as it did a decade ago; at the same time, it’s hard to find many people who are pounding the table on WFM as they’ve done consistently in the past. Those two things happening simultaneously is not a coincidence.
