Whole Foods Q3: More of the Same
Board: Value Hounds
Good but not Whole Foods Great
The third quarter was good but not great. Whole Foods revenue increased 10% to a record $3.4 billion for the quarter. Other news wasn’t as cheery especially same store sales coming in at 3.9%. That’s the lowest number since 2008-2009. There is an uneasy feeling across the market that Whole Foods best growth is behind it and competition is going to keep Whole Foods down forever.
WFM is a long way from its best growth 6-10 years ago when revenue growth was in the high teens and low 20’s. Comps were mid-to-low teens. Since the recession lows WFM appeared to stabilize with respectable growth with 2012 revenue growth at 16% and 9% comps. These results were good enough to keep WFM at the top of their price range through the end of 2013.
Since the end of 2013, the company has delivered a string of disappointing comps and growth with lower guidance and corporate worry over pricing, volume and defection of customers to competition. That bleeds through and investors and the market see the frustration and search for direction and they sell into the uncertainty.[See Post for Tables]
The above same store sales show how Whole Foods went from fabulous 2004-2007 to acceptable stabilization 2010-2012 in the high single digits. What the market won’t tolerate is low growth, low comps and downward guidance—call it the perfect retail storm. And that’s just where WFM sits now.
While the Q2 10% growth in revenue isn't bad, it is two things:
First the 10% is disappointing when compared to the growth investors have come to consider “normal” pre-2008 and in 2012 when it looked like the company was rebounding resoundingly. The 10% growth won't support premium valuations.
Second the comps that contributed to low growth are also falling and seem to drift lower every quarter. The slower traffic numbers and the price increasing as a percentage of comps are signs of retail weakness. Price has increased as a percentage from 40% in June 2013 to 49% in 2014 while traffic has decreased from 53% down to 51%. Because future growth is predicated on lower prices driving higher traffic/transactions, this year-long trend isn’t in line with Mackey’s vision for the future of Whole Foods. The growth and comp numbers are going to have to climb and traffic/transactions are going to need to reverse the current trend to lure the love of the market.
Slowing growth and slowing comps that fail to produce the same high growth Whole Foods has predictably turned in over the decades starts the market believing these are harbingers of the death of WFM. Add to that the threat of margin compression forced on them by competition and it’s not hard to see why they are in free-fall since late 2013 when the numbers began to erode. For investors the fall seems like forever.
Gross margins declined and rather than thinking of this as a negative, investors should consider it as a move towards offering more value priced products to consumers. Going forward we need to see that the lower margins are creating higher traffic, otherwise this strategy won’t work well.Sales per square foot continue to climb even as margins contract and average weekly sales increased.The Whole Foods Plan
Growth through new stores and remodels
Remodels do improve comps. Mickey D saw some excellent returns when they updated restaurants. It’s worth the investment. Stores less than 2 years old have high teens comps and are worth building. New stores average weekly sales are $503,000 with sales/SF of $727. WFM is on track for 38 new stores in 2014 and the new and relocated stores are estimated to add $1 billion in 2015 revenue. In short, building new stores isn’t a bad idea.
From the CC regarding the remodeling:
I was just talking to Omar, our Regional President in the South region, he is at our new Hilton Head store which just opened today, and he was talking about a couple of stores that they had refreshed in North Carolina that have gone from a negative 4 to a positive 4 (comps), so that’s just one example, but we see - we’re really encouraged by that, and we actively are looking to do these refreshes in the first half of this new fiscal year.
Competitive pricing is key to spurring sales growth, but that requires traffic. Bottom line is the declining percentage of comps in traffic need to be watched for reversal.
For the first time in WFM history they will try national marketing to promote brand awareness. The spend will be small at less than 1% of sales but it may further compress margins if it fails to stimulate sales.
Finally, they will go online and offer home delivery, an affinity program that was extremely vague and a mobile app.
Some of these may be less successful—marketing, mobile apps and affinity (customer loyalty?) seem destined to have little impact. Remodeling and getting high comping new stores in the base looks like a good strategy. The value “menu” may help if WFM can get the pricing right and inform potential customers they can now afford to shop at WFM.
Competition and locations
I think we did say last time it was 164 competitive openings last year, so about one every other day, it’s that or little bit more now. So it’s not any one competitor per se, it’s just the - it’s the changing landscape which we’ve all talked about is and there really is silver lining in all that is that you look at a market opportunity that continues to grow and grow and grow, and so if people use a number sort of $50 billion for natural and organic sales right now, people are saying by 2018 it’s sort of $225 billion an opportunity and that’s why we are continuing our growth prospects and even though there maybe some short-term surfeit of these different openings, I think we’re going to find a way through this and out the other side and continue to lead the market.
WFM stores are concentrated on the coasts especially in the east and there is room for expansion without cannibalization.
I think part of the other rest of the story too is remember that we’re still expanding into new markets, so in Q4, for example, more of our stores will be in new markets than existing markets, so that number moves around depending on that. We intend to - we have a lot of frontier space out there to continue to expand Whole Foods Market into it that doesn’t have any cannibalization.
Sprouts will create competition in the southwest and California and WFM will need to move carefully watching where they put stores on a neighborhood level. Sprouts has a heavy presence around Phoenix and Los Angeles and is no doubt draining off customers from WFM. Natural Grocers tends to overlap less with heavy store presence in Colorado, the Midwest and the northwest.
Sprouts had a respectable quarter
• Net sales were $743.8 million; a 20% increase from the same period in 2013
• Comparable store sales growth of 9.5% and two-year combined pro forma comparable store sales growth of 20.3%
• Net income increased to $30.2 million with diluted earnings per share of $0.20
• Gross profit for the quarter increased 20% to $224.0 million with a gross profit margin of 30.1%, consistent with the same period in 2013.
• Leverage in occupancy, utilities and buying costs were offset by lower merchandise margins from increased promotional activities and higher inflation in certain categories
• During the second quarter of 2014, they opened six new stores -- two in Nevada, and one each in Arizona, California, Colorado and Georgia. Five additional stores, including a second store in Atlanta, have been opened in the third quarter to date, bringing 2014 new store openings to 15 for a total of 182 stores in ten states. They plan to open a total of 24 stores during 2014.
Margins are lower and Sprouts is considered to be a better ”value” than WFM for consumers. Lower prices don’t always translate into better value but Sprouts growth would suggest they are an attractive competitor to WFM and the more they invade WFM territory, the bigger that impact may be. So far, Atlanta is about as far east as they have gone.
Sprouts guidance is comps at 8.5%-9.5% and revenue growth of 19%-20% making WFM 3% comps and 10% revenue growth look even more disappointing. They may be real competition.
Natural Grocers is struggling. Most of the revenue increase was new store openings and comps were only 2%. Gross margins were 28.8% and flat. NGVC is near it’s 52-weel low at $20 after seeing $45 earlier this year. Sprouts is also seeing a steep decline in share price at $32 down from $50. The publicly traded organic sector overall hasn’t performed well and Whole Foods is not alone (scant comfort). The market doesn’t have much love for organic grocers.
Whole Foods guidance
They reaffirmed guidance but really there was no guidance from Q2 to reaffirm—just a mission statement and vision of the company years in the future. The 31¢-33¢ EPS in Q4 is 13% to 18% lower than Q4 2013 and comps at 2.5% to 3.5% are pretty awful. The market reaction was entirely understandable. As investors we are left to decide whether we believe John Mackey can adapt to the new organic market place. Is declining traffic a symptom of customer defection to Sprouts, NGVC, Walmart, Kroger’s and the local stores we never hear about? Is it price? Selection? Karmic vibes? I don’t think we can know and it’s clear WFM is looking for the answer too. They have formulated a plan and we have to wait to see what shakes out. An investment in Whole Foods is a bet on John Mackey and his ability to take the company forward. He’s done OK for three decades.
One last note—
While it may seem like we are obsessed with comps and traffic, its importance is key to measuring progress and this is from the CC:
In terms of our near year, our top and bottom line results depend largely - the New Year, excuse me the next year, our top and bottom line results depend largely on comps, and those are hard to forecast so far out right now