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May 2014



Sometimes You Get What You Pay For

May 31, 2014 – Comments (1) | RELATED TICKERS: WMT

This is a fantastic article which explores the traits that made Wal-Mart such a great business and investment over the past several decades. I think it is helpful for investors to look back on annual reports, 10Ks, and other past documents of great businesses -- whether it be Amazon's 1998 10K or Wal-Mart's 1974 annual report. I ask myself, "Would I really have invested in this business?" On the flip side, we can also learn from the many duds in the business world. 

This article reiterates the important lesson that great long-term investments will not necessarily look like a bargain in the present day. The key is to find those businesses who have the innovation, staying power, and competitive edge to continue growing over the long haul (such as Wal-Mart in the 1970s and '80s). 

Every business is, of course, very unique, but there are lessons from the successes and failures in the business world that can help us improve as investors. I find it enjoyable and valuable to learn more about the early histories and overall evolution of truly great businesses. 

With that in mind, here is a snippet from a terrific article which I recommend reading in its entirety: 

The reason that Wal-Mart produced a fantastic return from 1974 to now is not that it was cheap relative to its present or near-term future earnings. By the standards of 1974, it was actually a growth stock–priced at almost twice the market multiple. In the current market, an equivalent valuation would be something like 30 or 40 times earnings–for a business with uncomplicated earnings that had already been in operation in Arkansas for three decades. It produced a fantastic return because it was a fantastic business, with miles and miles of growth still in front of it....

Now, what is the maximum price that you should be willing to pay for $WMT, knowing what it’s going to become? And what sort of valuation would this price imply? One way to answer the question would be to discount $WMT’s total return from 1974 to today at the rate of return of the overall market. $WMT at $12 produced a 40 year annual total return of 23%. It turns out that the price that would bring this return down to the market rate, 12%, is roughly $600.

In 1974, $600 for a $WMT share would have represented a PE ratio of more than 600. In the current market, which is much richer, this would be the equivalent of something like 1500 times trailing earnings–again for a company with undistorted earnings that has been in operation for decades.

To account for risk and uncertainty, which doesn’t exist for you, but does exist for anyone that’s not traveling through time, suppose that we cut our $600 maximum fair price for $WMT by 90%. Then we cut it in half. Then we cut it in half again. Normalized to the 2014 market, the multiple would still be roughly 40 times earnings. Many people would balk at such a “rich” price–but for $WMT, it arguably would have been, and arguably actually was, the single greatest buying opportunity of that generation.

The next time we see an excellent business trading at 40 times earnings, or 75 times earnings, or 100 times earnings, or wherever, and we shy away, it might help to remember the example of Wal-Mart. High multiples can be entirely justified, provided that the growth potential is real. We definitely should remember the example if we ever come under the temptation to short individual names based on valuation concerns. Nothing is riskier or more imprudent than to short a high-quality business with an uptrending stock price, simply because we think the price is too high. It can always go higher–often, it will go higher, for fundamentally valid reasons that we’ve failed to appreciate.

Ultimately, the market has to do what we just tried to do above–figure out how to price the obvious superstars of the future, not for next year, but for the next forty years. And so we should give it some slack when we see it catapult the $TSLA’s, $AMZN’s, and $FB’s of the world to valuations that make us uncomfortable. Depending on how things turn out, those valuations may prove to have been cheap.

As investors, we intuitively conceptualize the P/E ratio as a measure of how much “upside” a stock has, how much juice is left in the can. This is pure anchoring bias–we envision the expansion of the multiple as the ultimate source of our return. If we’re long-term investors, the ultimate source of our return will be the growth that the company generates in its business–not in one year, but over it’s entire lifetime. And so a stock priced at a high multiple can be overflowing with juice left in the can, if the potential to grow is there. It can be a screaming bargain, just as $WMT was.

I also encourage folks to check out Wal-Mart's 1974 annual report: http://c46b2bcc0db5865f5a76-91c2ff8eba65983a1c33d367b8503d02...

Which businesses will we look back on in 10, 20, 30+ years as the businesses that successfully grew for many decades, adding tremendous value to the world and rewarding long-term investors with market-crushing returns? This is probably the question that most intrigues and motivates me as an investor. 

David K  [more]



Comparing Whole Foods to Smaller Competitors

May 29, 2014 – Comments (3) | RELATED TICKERS: WFM , SFM , TFM.DL

I recently delved into a comparison of Whole Foods Market (WFM), Kroger (KR), and Safeway (SWY) (see post here: Kroger and Safeway are the largest conventional grocers in the U.S., both of which have steadily been increasing their organic and natural food offerings over the past decade. As competition heats up for Whole Foods, we also need to pay attention to the smaller up-and-coming competitors. 

Whole Foods has been joined by Natural Grocers by Vitamin Cottage (NGVC), The Fresh Market (TFM), and Sprouts Farmers Market (SFM) in recent years on the public stage. These businesses are considerably smaller than Whole Foods (Sprouts is the largest of the three with a market cap of $4.12 billion), but are nonetheless competing for consumer dollars with Whole Foods.

A background of the competitors 

Natural Grocers by Vitamin Cottage was founded in 1955 by Margaret and Philip Isely and remains under the control of the Isely family today. Until the second generation of Isely’s took over in the late 1990s the company did not focus on expanding outside of Colorado, but has since opened a total of 72 stores in 13 states. Each Natural Grocers store is only 12,300 square feet in size on average, less than a third the size of a typical Whole Foods store and the smallest of the grocers evaluated here. 

The Fresh Market was founded in 1982 in North Carolina and today operates 151 stores in 26 states. The company’s largest market is Florida, where it had 33 stores at the close of the 2013 fiscal year. The average size of a Fresh Market store is roughly 21,000 square feet.

Sprouts Farmers Market opened its first store in 2002 and has since opened 170 stores in 9 states (most of which are concentrated in the Southwest U.S.). This makes Sprouts both the youngest and the largest of these three competitors. Each Sprouts location averages 27,500 square feet in size.

As a recap, Whole Foods Market was founded in Austin, Texas, in 1980. At the close of fiscal 2013 Whole Foods operated 362 stores in 40 U.S. states, the District of Columbia, Canada, and the United Kingdom. Only 15 of those stores are outside of the U.S., and each store averages approximately 38,000 square feet in size. 

Whole Foods: the cash flow behemoth

We know that competition is only going to increase for Whole Foods as organic and natural foods become increasingly cost effective for grocers to carry. With that in mind, let’s explore just how successful (or not) these smaller competitors have been compared to Whole Foods when it comes to generating cash flow. 

Let’s start with Natural Grocers, which produced $25.72 million in cash flow in fiscal 2013. This equals $357K of operating cash flow produced by each store. 

The Fresh Market produced $140.37 million in operating cash flow in fiscal 2013, equating to $930K of cash flow produced by each store.

Sprouts Farmers Market produced $160.59 million in cash flow in 2013; each store produced approximately $945K in cash flow. 

Whole Foods produced $1.01 billion in cash flow or $2.79 million in cash flow per store, more on a per-store basis than these three competitors combined.

Leading where it counts: free cash flow

Of course, what really matters is free cash flow -- operating cash flow less capital expenditures -- because it measures the cash retained by a business after making capital investments to maintain current stores and open new locations. 

Over the course of fiscal 2013 Whole Foods produced a total of $472 million in free cash flow or $1.3 million per store. Sprouts Farmers Market produced $73.13 million in free cash flow or $430K per store. Fresh Market produced $18 million in free cash flow or $119K per store. 

Natural Grocers was free cash flow negative for the year, posting free cash flow of -$13.99 million or -$194K per store. This means that the Natural Grocers business is not producing enough cash flow itself to finance expansion. Natural Grocers’ Chairman and co-president Kember Isely says that the company will be free cash flow neutral in fiscal 2014. So far the company is still free cash flow negative, but there are two quarters remaining this fiscal year. 

Once again, on a per-store basis Whole Foods generates and retains more cash than these three smaller competitors combined. This gives you an idea of just how powerful of a cash generator we have in Whole Foods. 

Let’s take it a step further

We can take this analysis a step further and evaluate the cash flow and free cash flow generated on a square foot basis. This is a helpful metric because, as noted above, these businesses have different store sizes in terms of average square feet per store. Looking at per-store numbers only gives us a piece of the picture. We can really see how efficient (or not) each business is when we compare the cash flow generated per square foot.

The space of every Whole Foods store equaled 13.76 million square feet at the close of fiscal year 2013. Natural Grocers had 886K square feet, Fresh Market had 3.17 million square feet, and Sprouts Farmers Market had 4.68 million square feet.

First, let’s look at operating cash flow per square foot. Since I didn’t include this particular figure in my previous post comparing Kroger and Safeway, let’s start with those two. Kroger produced $24.09 in cash flow per square foot, while Safeway produced $19.56 per square foot. Natural Grocers produced $29.04 in cash flow per square foot of store space. Fresh Market produced $44.26 per square foot. Sprouts Farmers Market produced $34.35 per square foot. Whole Foods produced $73.42 in cash flow per square foot, making it a decisive leader in cash flow production once again. 

But free cash flow is really where our attention should be focused. Because of its negative free cash flow, Natural Grocers produced -$15.78 in free cash flow per square foot. Fresh Market produced $5.68 in free cash flow per square foot. Sprouts Farmers Market produced a respectable $15.68 in free cash flow per square foot, but it is still less than half of the $34.31 in free cash flow per square foot produced by Whole Foods. 

In this instance, Whole Foods produces more free cash flow on a square foot basis than these three smaller competitors combined. In fact, Whole Foods produces just under the amount of free cash flow per square foot produced by Kroger, Safeway, Fresh Market, and Sprouts Farmers market combined (which is $35.36). If you include the negative numbers from Natural Grocers, of course, Whole Foods produced more free cash flow per square foot than these five competitors combined. You can see these numbers in table form here:  [more]



Whole Foods Market is a Cash King

May 28, 2014 – Comments (2) | RELATED TICKERS: WFM , SWY.DL , KR

Whole Foods Market (WFM) has been lambasted over the past month -- the stock has fallen more than 23% in the past 30 days -- after reporting quarterly results that didn’t mesh with shorter-term market expectations of the company’s performance. In the most recent conference call, co-founder and CEO John Mackey reiterated his confidence that Whole Foods “will continue gaining share as the demand for fresh, healthy foods outpaces rising competition, creating millions and millions of new customers for us.”

While the optimism from Whole Foods’ experienced and innovative leadership team is somewhat reassuring for investors, it is worth exploring the competitive landscape to see how Whole Foods stacks up against larger and more mainstream conventional grocers such as Kroger (KR) and Safeway (SWY).

A background on the competition

For the purposes of this analysis, I will focus on comparing Whole Foods, Kroger, and Safeway. Walmart (WFM) is another notable participant retailing natural and organic foods, and we can’t forget smaller up-and-comers such as The Fresh Market (TFM), Sprouts Farmers Market (SFM), and Natural Grocers by Vitamin Cottage (NGVC). I will explore these competitors more in a future post. 

Kroger was founded in 1883 and operated 2,640 supermarkets in the U.S. at the close of the 2013 fiscal year. Each Kroger store averages 61,000 square feet in size and the company is the largest conventional grocer in the country. In 2002 Kroger launched its “Naturally Preferred” line of organic and natural foods -- one of the largest brand launches in the company’s history -- and further expanded its organic food offerings in 2007. 

Safeway was founded in 1926 and operated 1,335 stores at the end of fiscal year 2013. Each Safeway store averages roughly 47,500 square feet in size. Safeway is behind Kroger as the second largest conventional grocer in the U.S. The company launched its organic food product line in 2006, and joined other grocers (including Kroger) earlier this year in resisting the sale of genetically engineered salmon in its stores.

Whole Foods Market was founded in 1980 and had 362 stores at the end of fiscal 2013. Each Whole Foods store averages approximately 38,000 square feet in size. Interestingly enough, while Whole Foods has a reputation for having gigantic stores, the average Whole Foods tends to be 20%-40% smaller than the typical respective Safeway or Kroger store. As many here already know, Whole Foods has long been the leader when it comes to retailing organic and and natural foods under one roof. In addition to this leadership position in the organic/natural foods retail market, Whole Foods has taken on related initiatives with animal welfare and genetically modified organisms (GMOs) transparency. 

Here is where Whole Foods is king

A recent article from Fortune speculates that "what we might be seeing now is a realization that Whole Foods' best days are behind it." Competition is nothing new to Whole Foods. As noted above, the two largest conventional grocers in the U.S. both launched their own lines of organic and natural products last decade. Competition is bound to increase as organic foods become more mainstream and increasingly cost effective for grocers to carry. 

While increased competition for Whole Foods should be (and is) acknowledged by many, including Whole Foods’ leadership, I have noticed a curious amount of silence from financial analysts and writers when it comes to a certain metric that demonstrates the financial dominance of Whole Foods. It is fairly obvious that Whole Foods reigns supreme when it comes to more qualitative measures such as employee happiness, social engagement and responsibility, and company purpose. With that said, I am amazed how little attention Whole Foods’ cash flow production receives and I think you’ll agree with me once you see the numbers below. 

In fiscal 2013 Kroger produced a total of $3.38 billion in operating cash flow. This equates to $1.28 million in cash flow produced by each of its stores over the course of the 2013 fiscal year. 

Safeway produced a total of $1.24 billion in operating cash flow in fiscal 2013 or an average of $928K of cash flow produced per store. 

Whole Foods produced $1.01 billion in total of operating cash flow in fiscal 2013. This means that each Whole Foods store produced an average of $2.79 million in cash flow, more than twice as much produced by a typical Kroger store and three times that produced by each Safeway store. 

These numbers get even juicier when we look at free cash flow (operating cash flow less capital expenditures), which measures the cash retained by these grocers after they have made the necessary capital investments to maintain and expand their respective bases of stores. In fiscal 2013, Kroger produced $1.05 billion in free cash flow (or $398K per store). Safeway produced $477 million or $357K per store in free cash flow. Whole Foods produced $472 million in free cash flow, which equates to $1.3 million in free cash flow produced per store. 

We can take this a step further and look at the free cash flow generated by each square foot of store space. At the close of fiscal year 2013 Kroger had 161 million square feet of store space, Safeway had 63.41 million square feet, and Whole Foods had 13.76 million square feet. 

This means that Kroger produces an average of $6.52 in free cash flow per square foot of store space. Safeway produces $7.52 in free cash flow per square foot. Whole Foods produces $34.31 in free cash flow per square foot, more than twice the free cash flow per square foot produced by Kroger and Safeway combined. This represents an astonishing ability to generate and retain cash that is unmatched in the world of grocers. This just goes to show that Whole Foods is more than a qualitative investment seeped in the mushy-gushy awesomeness of conscious capitalism. Whole Foods is a cash king with unparalleled efficiency when it comes to utilizing store space to generate free cash flow which can be plowed into expansion in the years ahead. 

This should remove any shadow of a doubt as to why more competitors are trying to grab a piece of what Whole Foods has masterfully created. So far I haven’t seen any competitors that come close to matching Whole Foods’ ability to generate cash, and it shows on their balance sheets. Kroger has over $9 billion in debt and Safeway has more than $4 billion in debt. Whole Foods only has $60 million in long-term debt and more than $1 billion in cash.   [more]



Pencils IRA Purchase: Whole Foods Market (WFM)

May 18, 2014 – Comments (2) | RELATED TICKERS: WFM , SFM , TFM.DL

Through my Pencils IRA Project, each month I invest in a business that meets the five pillars of a “megagrower” -- purpose-driven business, innovative products, visionary leadership, increasing cash flow production, and strong company culture -- with significant potential to create stakeholder value and substantially beat the market over the long haul. (Please note that I am not a TMF analyst, but I am a proud member of the Fool community.) 

Whole Foods Market (WFM) has had a rough go of it lately. Whole Foods shares tumbled nearly 20% earlier this month after the company reported mediocre quarterly results. While the market has lost interest in Whole Foods in the short-term, I believe this presents an opportunity for patient investors to take advantage of a shortsighted market. For the five reasons explored below, I am adding Whole Foods to my Pencils IRA Project with the expectation of market-beating returns over the long haul.

1. Purpose-driven business 

Founded in Austin, Texas, in 1980, Whole Foods has long strived to exemplify its motto: Whole Foods, Whole People, Whole Planet. Whole Foods' co-founder and co-CEO John Mackey literally wrote the book on conscious capitalism, serving as a key proponent of the notion that a business should include the well-being of all stakeholders -- customers, employees, shareholders, community, environment, suppliers, and so forth -- in its definition of success. Says Mackey:

"We want to improve the health and well-being of everyone on the planet through higher-quality foods and better nutrition, and we can't fulfill this mission unless we are highly profitable. Just as people cannot live without eating, so a business cannot live without profits. But most people don't live to eat, and neither must businesses live just to make profits."

2. Innovative products and services 

Today, Whole Foods is the premier national brand when it comes to the offering and selection of high quality natural and organic foods. With 379 grocery stores in the U.S., Canada, and U.K. -- each averaging 38,000 square feet in size -- Whole Foods has an expanding base of locations which serve an ever-growing demographic of health conscious consumers.

The USDA estimates that organic food accounted for 4% of total at-home food sales in 2012, and a recent report from TechSci Research projects that the organic foods market will grow at an average annual rate of 14% through 2018.

With its growing national and global presence, Whole Foods has helped bring organic and natural foods to the mainstream market. The company's decentralized business model encourages innovation and an entrepreneurial spirit, leading to some wild (but oftentimes successful) ideas such as adding bars to some stores. This innovative culture has played a major part in Whole Foods' success and now nearly $13 billion in annual sales.

3. Visionary, experienced, involved leadership 

Much of Whole Foods' innovative environment is thanks to the leadership of co-founder and co-CEO John Mackey, who operates with the understanding that purpose inspires people. Fellow co-CEO Walter Robb joined Whole Foods in 1991 and, along with Mackey, is among the top five insider owners. In 2003, Mackey was recognized as the "Entrepreneur of the Year" by Ernst & Young, and in 2011 Businessweek named both Mackey and Robb "Businessperson of the Year."

With a record 114 stores in the company's development pipeline, Mackey and Robb maintain a long-term outlook with Whole Foods. The company now expects a total of 500 stores to be opened by 2017, representing just under 10% annual store growth over the next three years. Management believes the company can open and support 1,200 stores in the U.S. alone. In addition, Mackey and Robb have set the goal for Whole Foods to bring in $25 billion in revenue by 2019.

Experienced and innovative management with a proven record of delivering results is exactly what I like to see. We get all of this with Mackey, Robb, and the leadership team they have assembled at Whole Foods.

4. Consistently increasing cash-flow production 

Whole Foods has increased operating cash flow at an average annual rate of 14.59% between fiscal 2010 and fiscal 2013, producing $472 million in free cash flow in fiscal 2013. Over the past four fiscal years, Whole Foods has managed to increase free cash flow production at an average pace of 9.49% annually. This consistent free cash flow growth has helped Whole Foods build up $1.08 billion in cash with only $60 million in debt.

There is certainly room for more than one competitor in this field. Whole Foods has the leader's edge in terms of store count, revenue, and cash flow production. I am confident that the company's healthy balance sheet, along with the ongoing innovation of the business, will help Whole Foods command the leadership position in the organic and natural food retail market for years to come.

5. Strong company culture

Whole Foods enjoys a 3.6/5 employee rating based on employee reviews on Glassdoor, while Mackey and Robb have a solid 83% employee approval rating. Compare this to Whole Foods' smaller competitors:

Sprouts Farmers Market has an employee rating of 2.7/5 on Glassdoor, and CEO Doug Sanders has an employee approval rating of 52%.

The Fresh Market has an employee rating of 2.5/5, while CEO Craig Carlock has an employee approval rating of 31%.

Natural Grocers by Vitamin Cottage has an employee rating of 2.8/5, and CEO Kemper Isely has a dismal 22% employee approval rating.

Trader Joe's does have a 3.6/5 employee rating, but CEO Dan Bane currently has a 65% employee approval rating. 

The same can be said for Whole Foods’ larger and more mainstream competitors: 

Kroger has an employee rating of 3/5, and CEO Rodney McMullen presently has a 50% employee approval rating. 

Walmart has an employee rating of 2.9/5, with CEO Doug McMillon sporting an employee approval rating of 49%. 

These numbers speak for themselves. Considering the importance of happiness and engagement when it comes to employee retention and productivity, these numbers bode well for Whole Foods going forward (especially compared to the mediocre ratings of both its smaller and mainstream competitors).

Whole Foods -- which has been ranked for 17 consecutive years as one of Fortune's 100 best companies to work for -- has several attributes that set the company's culture apart from both its peers and many other businesses across all industries. Whole Foods employees enjoy numerous benefits such as store discounts, dental and health care plans, paid time off, as well as the opportunity to vote on new hires and view the salaries of all employees (including executives). Whole Foods cultivates an innovative, transparent, and engaged company culture, and has significantly higher employee ratings to show for it. 

Foolish bottom line 

"I'd say competition is more intense right now than possibly we've ever experienced before," explained Walter Robb in the company's most recent conference call. These competitive challenges may cause short-term bumps in the road for Whole Foods, but the company is a market leader in a growing field. Not only that, but Whole Foods has an innovative leadership team, top-notch company culture, and unparalleled cash flow production in its field. 

With Whole Foods' focus on long-term results, and an arsenal of cash to support continued innovation, I am happy to take advantage of the recent sell-off to add the company to the Pencils IRA Project.

Foolish best,

David K

For more on the Pencils IRA Project:  [more]



My first visit to a Chuy's

May 07, 2014 – Comments (1) | RELATED TICKERS: CHUY

Today I made my first visit to a Chuy's location; this one in Lexington, KY. Chuy's (CHUY) is a promising up-and-coming Tex-Mex restaurant -- initially founded in Austin, now with approximately 50 locations throughout the Southeast region -- which specializes in preparing fresh Tex-Mex food from scratch. 

My mom and I arrived at the Lexington, KY, location, at 6:30PM tonight (Tuesday). The parking lot was packed; I only counted three open parking spaces surrounding the restaurant. I believe this location opened in August 2011. 

There were people inside and outside waiting for a table. We put our names down and were told the wait time was probably 20-25 minutes. Not to worry: Chuy's has a free "nacho bar" where you can load up on freshly made chips and tasty salsas and sauces. We had a table after roughly 15 minutes of waiting. 

Our waitress was very helpful and friendly. Being vegetarian and gluten free, we are not exactly the easiest customers for a restaurant (let's just say we keep things interesting wherever we go). The waitress was honest with us and let us know which items were "created" in an area where gluten products are also put together.

My mom loved the restaurant's decor, calling it "original but tasteful." She also noted that Chuy's is a sort of cross between a Mexican restaurant and a classic 1950's diner. (As they say, "When you've seen one Chuy's... you've seen one Chuy's.") In other words, Chuy's is not your stereotypical Mexican restaurant. The originality of each location brings its own charm. 

Our food arrived within 15 minutes, and the food tasted great. I went with the nachos, and must say they are some of the best nachos I have eaten at a restaurant. The nachos were $7.99 -- a great price compared to other restaurants, especially when considering the superior quality. My mom, in all seriousness, says they are the best nachos she has seen in her entire life. 

All in all, Chuy's was a great experience at a very reasonable price. The place was bustling with activity, although it started to clear out as time moved closer to 7:30PM. I think there is a lot of potential for this brand, particularly if the business can begin to produce positive free cash flow on a consistent basis. 

Today Chuy's reported 1Q 2014 results, with revenue increasing 19.8% YOY and comps increasing 4.2%. Once it is available I'll be curious to explore the 10Q to see how Chuy's fared with its cash flow production. 

1Q 2014 earnings report:

Conference call transcript:

Chuy's continues to sit toward the top of my watchlist. If the stock gets knocked to a P/E closer to 40 (currently it sits around 53) I will be tempted to open a small position. My new investing capital is limited, so I am carefully exploring numerous possibilities to open/add positions in my portfolio. 

I hope this "Chuy's channel check" was helpful. For others who have visited Chuy's, how does this compare to your experience? 

David K  [more]

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