Business Overview & Industry Analysis
Whole Foods is a leading natural and organic foods supermarket which operates primarily in the United States. Whole Foods operates stores in Canada and England which accounted for only three percent of Whole Foods’ total sales this past fiscal year.
Whole Foods differentiates its products by demanding stringent quality standards from suppliers with sustainably sourced products and bans on over a hundred ingredients commonly found at other stores such as hydrogenated fats.
Management concedes that a significant risk to the company’s profitability is the increasing competition in the natural and organic foods space, which may cause decreasing profit margins if the company fails to differentiate itself and foster customer loyalty. Historically, Whole Foods has been able to keep 2%-4% profit margins above the the industry’s 2% profit margins. Whole Foods is moving some of its product lines to more competitive pricing which is an added risk to profitability.
The American Retail and Wholesale Food Industry has under performed the market over the past year. The operating environment is favorable to the industry due to stronger economic conditions (such as rising personal incomes) and a strong dollar all while avoiding struggling economies in Europe and Asia (Value Line). Whole Foods in particular benefits from the strong dollar because of low oversees exposure and low oil cost.
Whole Foods Financial Position
Whole Foods is primarily equity financed and holds far less debt than its competitors. Kroger, one of the leading grocers in the United States, is 60% debt finance compared to Whole Foods’ 17% as shown by the long term debt ratio.
Whole Foods’ internal Weighted Average Cost of Capital (WACC) is 8%. Even though Whole Foods has a strong financial position with conservative leverage ratios, the company is not aggressively rolling out 365 stores, with goals of . Whole Foods’ investment decisions are affected more by individual store performance and its 8% WACC; And not by a significant debt burden. If Whole Foods wanted to roll out more 365 stores rapidly in the future, it could do so easily by taking on debt and benefiting through its after tax cost of debt interest since Whole Foods effective tax rate was 39% this past fiscal year.
Between 2000 and 2013, Whole Foods has increased shares outstanding by approximately 161 million shares, but the company has since bought back 15 million shares. Since Whole Foods’ number of shares fluctuate, the P/E ratio is less of an apple to apples comparison from year to year. Similar to the P/E ratio I compared market cap to earnings which has decreased has been slashed in half from 39 to 20 since year’s end in 2013.
Capital expenditures in 2015 totaled $851 million of which $516 million was for the development of new locations and $335 million is attributed to remodels, as well as property and equipment expenditures
Profitability Driver: Price
Whole Foods remains a distinguished market leader in the natural and organic foods niche and charges higher prices than the competition. As the industry shifts towards organic foods, Whole Foods profitability driver may change as it needs to adapt to a more competitive market.
Growth Potential & Pitfalls
According to management, Whole Foods’ commitment to quality will remain being an important driver of sales growth over the long run. Another primary source of growth will be new emphasis on its value programs with its 365 Everyday Value high quality products; but as mentioned above, competitive pricing on its value product line pose risk on profitability. Whole Foods 365 stores have long term growth potential in targeting younger generations with a lower foot print and costs with smaller stores and higher sales per square foot.
Comparable store sales increase (growth) has declined from 8% in 2012 to under 3% in the most recent year. The drastic changes in comparable store growth result from increasing competition in the organic foods niche from stores like sprouts and existing grocers like Kroger who offer more organic products into their stores.
Whole Foods is at a pivotal point in a growing and changing industry. The company is ready to adapt to changes in the industry while remaining a market leader in its organic niche, even though decreasing margins and the shift to everyday value remains a significant risk for the company.
Based off of market cap to earnings ratio, potential growth in every day value, management’s conservative investment decision making, and strong economic conditions in the United States, I recommend Whole Foods as a buy and hold.
The following is spreadsheet contains financial ratios for fiscal years 2015 and 2014. All inputs are in millions.
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