Shopping Whole Foods For A Double: Part II

Last month, Mike Koza made the case that Whole Foods Market (NASDAQ: WFM) can double its stock price in the next five years. Mike’s central thesis is that despite some struggles with the stock this year, the company continues to deliver superior margins. These margins, coupled with Whole Foods’ financially strong growth, will serve as a catalyst for the smart money to find an opportunity to yield better than market average profits.

You can view Mike’s top five holdings, learn more about his strategy, and track his progress with monthly Performance Insights emailed directly to you at the end of each month by visiting our website.

Like Mike, there are other investment-savvy members of our research community who are buying Whole Foods. A review of the data from our trading platform reveals that the better performing members hold larger proportions of the stock in their portfolios. There is a clear trend evident in the numbers; the more successful a group is, the more likely they are to have added Whole Foods to their portfolios. For example, our top quartile account for 43% of the “Buys” of WFM stock from our membership in the last 30 days.

Results matter, which is why we polled our investment research community about Whole Foods. For the m100 mutual fund managers who traded Whole Foods, their portfolios averaged 42.9% over the past year. They have acted on their stock insights, and their performance validates their decisions.

Of the comments I received from our members about Whole Foods, several particular opinions stand out to me as particularly compelling in the case for Whole Foods. These members have long-term records of accomplishment with Marketocracy and a history of making money on the stock to validate their opinions.

For my first question, I wanted perspectives on how Whole Foods will perform against competition from Sprouts Farmers Market (NASDAQ: SFM) and The Fresh Market (NASDAQ: TFM). How does the company maintain its competitive advantage?

We heard from Michael Roche, who has been an active member since 2008. He believes the leadership is key to the success of Whole Foods.

As long as the current management team stays in place, Whole Foods should compete well against all competitors. It enjoys a relatively insulated position right now based on customer loyalty and satisfaction with some customers perfectly willing to spend more than they would at Wal-Mart or other stores. As long as management stays intact, so should their advantage.

Michael seems to be on to something here. Whole Foods specifically targets Millennials, and their marketing efforts are geared to that end. This focus on this group of young adults has been noticed since at least 2012. Today, according to some marketing experts, the company dominates social media with their message, and are doing a better job at educating the public that the stores’ prices are actually better than those found at “cost-cutter” stores. Today, same as then, Whole Foods has the distinct advantage at competing for the health conscious consumer who is willing to spend more for higher quality food.

I also wanted to know from our members about the risks for Whole Foods. Michael believes Whole Foods would create their own risks by changing their strategy:

Risk would present itself if Whole Foods gave into competition by a sort of Wal-Martization process. The way they compete now is by providing a high-quality shopping experience. One might even call it a “Fun” experience. Going to Wal-Mart (NYSE: WMT) or to most grocery stores is not something that many people look forward to doing. Going to Whole Foods is an experience people enjoy.

Joshua Liebschutz added his opinion. He averaged 10.4% since July 2002, which is better than the market’s average of 9.8% over the same time period.

Whole Foods will perform well against all competitors because it has a proven track record of attracting customers. For a variety of reasons, more and more consumers are going to choose environmentally and ethically sound food items and many consumers are going to choose high quality food items; both of these groups are satisfied by Whole Foods. Because I believe that both these groups are going to increase in the long term, I see Whole Food's clientele expanding and the demand for it increasing.

So, does Joshua see a double in the near future for Whole Foods?

A double in 3-5 years? It would have to double its future profits. I don't see how they can do that in their current model without doubling the number of stores. I recommend they open small mini-Whole Foods that sell smaller sets of items. Whole Foods Fruit Cart, Café and Beignet Stands, Ice Cream Waffle Booths, and a multitude of other innovations could pepper the landscape at malls, boardwalks, arcades, etc. Put a mini-Whole Foods in the Grove Arcade in Asheville, put one in the Mall of the Americas, and put one in Times Square.

Joshua disagrees with Michael, and believes management is the problem.

The demand for what Whole Foods offers is growing. The only chink I see in Whole Foods' armor is their CEO (Walter Robb). Anyone can cross the street to go to another vendor, if it carried the same product. That is why people like me in Portland, Oregon prefer to shop at New Seasons. CEOs come and go, though, and maybe the corporate climate over there will get on track.

Thomas Bethke added his thoughts. With his average of 15.5% since 2006, compared to the market’s average return of 7.4%, his comments are not only appreciated but substantiated with real success in the market.

Whole Foods has great selections of locally sourced and unique in-season foods that other stores cannot match. It has well established supply chains that are not easy to replicate at this time, as well as higher quality food. It also has a good understanding of its customers.

I believe that the move towards healthier foods without pesticides, GMOs, etc. are strong trends that will continue as more people become more informed about health. Whole Foods is at the forefront of these trends and is a great brand. While it has had a rough year, over the long run it has good potential to outperform the market.

It needs to continue its push on the 365 value brands and convert more customers into "full-time" Whole Foods shoppers over from those that just go there for certain items, in order to grow organic revenues. A key item is to continue to add new stores in good locations.

What do you see as the potential risks?

If Amazon (NASDAQ: AMZN) can successfully launch Amazonfresh in more cities, it has the resources to establish a credible threat. Ideally, Whole Foods can establish its own online shopping/local delivery at some point in the next few years in order to compete better with new threats and help drive additional revenues, especially in markets where it doesn’t have large numbers of locations.

Thomas Pound, who has averaged almost 13% since early 2003, had this to say:

What impresses me about Whole Foods is the way they can generate as much profit as possible out of each sell. If one looks at their Income/Employee ratio, they generate bottom line numbers more efficiently than their competitors.

Thomas, who always says investing is, “Always about the numbers,” provided this chart for his analysis.

 Given the company’s historical growth, it would not surprise me to see at back at the $50 level, on a relative basis, in the next 12 months.

As the next commentary is suggesting, there is not a clear consensus among our investment research community.

Pej Hamidi, with a strong average of 20.3% since 2009 (vs. 19.6%), had this to say:

Although Whole Foods has a significant brand awareness edge over Sprouts, it has a severe price disadvantage against Sprouts Farmers Market. Sprouts is spending a great deal of advertising dollars and is closing this edge. Meanwhile, Whole Foods is relying on its sheer presence factor for advertising and word of mouth.

The problem with Whole Foods is that it has fairly saturated its markets, because of the limitations on areas where it can open stores. On the other hand, Sprouts is just entering a significant ramp-up phase in terms of growth. These are all competitive advantages in favor of Sprouts.

Why did Pej sell his stake in Whole Foods?

It was a stock experiencing significant earnings growth and hence stock price momentum. When earnings flattened out, so did the stock. When the market realized its growth appeared to be saturated, the stock took a massive haircut. Fortunately, we were out of the stock by then. 

I don’t believe Whole Foods can deliver a double in the next 3 to 5 years. It has reached a level of EPS that would require an enormous investment in infrastructure expansion just to double her EPS. At this time, there is very little positive earnings velocity, and infrastructure growth would create negative earnings velocity. It will take more than 3-5 years to double WFMI’s footprint. The wildcard is the Internet. If Whole Foods expands into online grocery delivery, which is a very rapidly growing sector, then all bets are off and it has the chance to put Sprouts out of business.

What do you see as the potential risks?

Whole Food sits on its position as the leading organic grocery store with over-inflated prices and pays little attention to the rear view mirror to notice competitors catching up fast. Moreover, with Amazon Fresh entering Grocery Delivery, including Organic Foods, at “Amazon Prices”, Whole Foods is in danger of delivering negative returns over the next 3-5 years. 

My take on Whole Foods is that they have shown themselves as the “Best in Class” in the grocer industry. Their gross margins (35.7%) are far better than the industry average of 22.5%. They maintain their dominance when it comes to the bottom line by posting net margins of 4.1%, which far exceeds the industry average of 2.4%. Mike makes mention of this when he talks about Whole Foods, and this adds to his belief that it is a company worthy of one’s investment.

Several of our members suggested that Whole Foods needs to expand for it to have a chance to double in the next five years. Whole Foods is doing just that with its goal of expanding to 1,200 units. During this expansion, the debt for the company is near zero.

I will also have to agree with Mike that Whole Foods has reasonable valuations (P/S = 1.02) for a company that is still growing revenues and earnings, while the rest of the industry is struggling to have any growth. While quarter vs. quarter sales growth is at 2.2%, this is still better than the industry average of -0.8%. Whole Foods is also able to maintain positive earnings with quarter vs. quarter growth of 7.1%. Even though this is lower than their five-year average of 36.9%, it is still far better than the industry average of -9.4%.

While the company’s stock price is struggling this year, Mike recognizes it presents a buying opportunity given the company’s performance relative to its competition. If one is able to buy quality at a discount price, then buy. For value investors, the risk has been discounted in the price, and presents itself with more upside potential

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 Disclosure: I am the portfolio manager for mutual and hedge funds advised by Marketocracy Capital Management, an SEC registered investment advisor. Before relying on the opinions expressed in this article, you should assume that Marketocracy, its affiliates, clients, and I have material financial interests in these stocks and may hold or trade them contrary to these opinions when, in our view, market conditions change.