Whole Foods Market is a BMW. Stop Comparing it to a Kia.


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Jae Jun

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Whole Foods Market (WFM) is a “Buffett and Munger” cheap stock.

Put another way, it’s not really cheap.

It’s fairly priced but has the power to compound for years to come.

But if Whole Foods is so great, why is it selling near it’s 52 week low price?

Fear Mongering News

Newspapers use fear mongering methods and click bait headlines to get clicks and views.

Institutions are jittery and nervous folks and you can tell these big players don’t know what they hold.

Fingers are always hovering over the sell button in case any “bad” news breaks.

Doesn’t matter whether it’s right or wrong.

Buying and Selling Stocks...

Buying and Selling Stocks…

The fear surrounding Whole Foods all comes down to competition from Wal-Mart and copycats driving margins down.

Let me show you why that’s absurd and why the 52 week low price isn’t cheap, but still a handsome gift.

Competition from Wal-Mart is No Competition

Here’s a quote from Walter Robb, co-CEO of Whole Foods, and what he told CNBC.

“Their customer [Wal-Mart] overlaps least with us,” he said.

Robb also pointed out that despite his company’s reputation for high prices, the Wild Oats assortment is dry groceries and Whole Foods has its private-label 365 dry grocery line, which “is also very price competitive.” It’s a validation, he said, “the market is growing overall.”

Whole Foods and Wal-Mart Customer Overlap to Worry About??

Comparing and worrying about Wal-Mart is like BMW comparing itself to a Kia.

Just because both brands offer cup holders, it doesn’t mean they are the same car.

The customer demographic of Whole Foods and Wal-Mart is entirely different. Just because Kia wants to enter the luxury market, it doesn’t mean BMW has to jump out of his seat and alter his pricing strategy.

While 20 percent of Wal-Mart shoppers are on food stamps, that shouldn’t be an excuse for subpar sales performance. Why? It’s because 22.3 percent of its customers have an annual household income of $50,000-$74,999, and 11.1 percent of its shoppers have an annual household income of $75,000-$99,999. – source

A quarter of Wal-Mart customers reportedly do not use debit or credit cards or even have a bank account.

Whole Foods customers?

Whole Foods Customer Demographic

Whole Foods Customer Demographic

Whole Foods customers don’t focus on price. They like what Whole Foods stands for and the way they conduct business.

Wal-Mart has the buying power to strangle and bully suppliers into coughing up cheaper prices. They also squeeze wages as much as possible to bring prices down.

Whole Foods goes about it completely the opposite way.

Products are locally sourced, and every product must satisfy rigorous ingredient and quality inspections that is stricter than the FDA.

Whole Food buyers also control a much smaller region which makes stores feel very local and community supportive. Much different to the way big Wal-Mart buyers operate and source for products. They want mass producers.

Getting certified organic farmers capable of mass production and distribution will take years to cultivate.

Mass producing organic food, trying to drive down prices, pricing out the local family farmers and consumers not knowing where the ingredients are coming from go against the whole image of “organic”.

These are risks that Wal-Mart is bringing on themselves.

BMW Can Easily Go Down Market, but Kia Can’t Go Up Market

Whole Foods isn’t worried about Wal-Mart. But Wal-Mart should definitely be worried about their own plans and how it can backfire.

BMW easily sells it’s 7 series for $100k and they can take advantage of their brand and luxury image to sell $30k cars to the masses.

Kia may sell a lot of $30k cars but can’t sell any $100k cars.

If Wal-Mart trains its customers to seek higher quality food, guess where they will be going sooner or later?

Yup.

Whole Foods, Trader Joes or Sprouts.

If you’re used to getting food from Whole Foods? Wal-Mart is off limits.

Check out the products that Wal-Mart sells that would never make it to Whole Foods shelves and savvy consumers know this.

And that’s where the whole idea of Whole Foods reducing margins due to competitive pressure is wrong. Whole Foods will decrease margins, not because of competition, but to penetrate competitor territory by offering more value brands like their 365 value offerings.

Also, Whole Foods has demographic requirements that it must meet to open a new store.

But to achieve the growth of 1,200 stores in the US within the decade, they have to relax the criteria to enter more accessible markets.

By going smaller in markets such as Brooklyn and Boise, and bigger in previously unimaginable urban areas, such as Downtown Detroit and Englewood, a gritty Chicago neighborhood, Whole Foods is delivering on its bigger promise of becoming accessible to the masses – source

A Proper Comparison to Whole Foods Market

Costco and Starbucks are similar companies to Whole Foods.

What?

The culture, brand loyalty and following of these companies are very similar.

Costco members love the deals and the adventure of shopping there. There are other warehouse competitors, but Costco customers are extremely sticky.

Then there is Starbucks.

Coffee is a commodity but they’ve somehow made it into a status symbol. McDonald’s, Dunkin Donuts and Keurig machines were supposed to have damaged Starbucks’ business, but it’s thriving.

And the reason is that the brand goes beyond just coffee and doesn’t compete on price. They sell the experience, the status and the community.

Even with copycats like The Fresh Market (TFM) and Sprouts Famers Market (SFM), the industry is big enough to accommodate them all at the moment. In fact, the industry size should expand as people become more conscious about what they eat.

So What’s the Valuation?

Whole Foods is surprisingly easy to value because the company is very transparent with their plans and numbers.

With the info you are provided, you can calculate the growth and maintenance capex very easily. When necessary, I use Bruce Greenwald’s teaching to calculate maintenance capex. By splitting growth and maintenance capex, you can get a more accurate owner earnings number to use when valuing stocks with a Discounted Cash Flow.

Here are the important stats.

Calculating Growth and Maintenance Capex

  • Last year they opened 32 new stores
  • Total capex was $537m
  • $339m was growth capex used for new store openings

So the average cost to build each store is $10.5m. New store opening target for this year is between 33 to 38.

Multiply 10.5m by 33 to 38 and you get a growth capex range of $350m to $370m.

Now Whole Foods expects the total 2014 capex to be around $600m – $650m. To keep things conservative, I’ll use the $650m number.

So the maintenance capex is going to be around $280m to $300m.

But before I get into the analysis, just click on the image below to download my investment scorecard to help you pick stocks like a pro. You’ll also get exclusive content and resources we don’t publish anywhere else.

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Discounted Cash Flow Valuation

Putting it all together, my inputs to a DCF will be

  • 9% discount rate (how I choose discount rates)
  • using a growth range from 9% to 13% which includes a decay rate
  • starting FCF of $800m (8% growth in cash from operating activities minus $300m maintenance capex)

My intrinsic value range is between

Then using growth rates ranging from 9% to 13%, my DCF intrinsic value range is $38 to $48.

Whole Foods DCF Valuation

Whole Foods DCF Valuation

Whole Foods DCF Sensitivity Matrix

Whole Foods DCF Sensitivity Matrix | Click to Enlarge

At the moment, it’s fairly valued, but great companies rarely go on big sales.

EBIT Multiple Valuation

But if you don’t like DCF’s, here another angle to look at.

Let’s do an EBIT valuation to value the stock based on the income statement and balance sheet.

I’ve got an online EBIT calculator you can play with, but I’m using my OSV fundamental stock analyzer in this case to quickly do everything for me. Here’s a short tutorial video explaining how it’s done.

Whole Foods EBIT Multiple Valuation

Whole Foods EBIT Multiple Valuation | Click to Enlarge

The intrinsic value ranges from a conservative scenario of $34 all the way up to $60 with aggressive assumptions.

The base case valuation is $45. Very much in line with the DCF.

A Wonderful Company at a Fair Price

Like I said at the beginning, Whole Foods isn’t cheap, but it is Buffett and Munger cheap.

far better to buy a wonderful company at a fair price

Far better to buy a wonderful company at a fair price

I’m more than happy to hold Whole Foods at these prices and let compounding do its work.

Management have proven themselves to be great allocators of capital and there are intangible benefits within the community that will only strengthen their brand going forward.

Here are some extra valuation multiples to give you a clearer picture.

Whole Foods Valuation Multiples

Whole Foods Valuation Multiples | Click to Enlarge

 Summing Up

Don’t worry about Wal-Mart. A Kia can’t compete with a BMW.

Whole Foods is a company that I will comfortably hold for many years and watch it compound as the industry expands and management continues to meet goals.

Good References and Resources

Disclosure

Long WFM

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17 responses to “Whole Foods Market is a BMW. Stop Comparing it to a Kia.”

  1. lardassSEMIL says:

    This is fantastic. I get it. Kia (Walmart) can’t go upmarket.

    And analysts might be worried about a cascading effect.

    Maybe Target goes upmarket now. Then Trader Joe’s, Mother’s, etc.

    Maybe a new entrant – the Tesla of upscale supermarkets – will come in. Maybe Amazon Fresh. Or Instacart if they iterate or pivot.

    If Whole Foods has fat, juicy margins, competitors will try to come in.

    The key question is how durable is Whole Foods’ pricing power.

  2. Ivan C says:

    Jae, this is an excellent analysis. I had long scoffed at Whole Foods, even considering it as a short candidate at one point (it would have been a winning trade, if only because that was pre-2007). But when you put it in terms of the luxury lifestyle, it completely changes things. As I was reading your writeup, I thought of clothing lines. If Walmart started carrying some luxury line, I don’t think most shoppers of Nordstrom or Neiman Marcus would switch, nor do those stores have to worry about pricing.

    For the same reason why I could not understand this before (I could only stand to buy stocks with deep value numbers), I subscribed to another large newsletter (think two “jesters”) to help me look at growth stocks. One of the main guys has WFM has one of their top core holdings. I now feel comfortable writing some puts knowing I would be fine holding this fairly long-term if I end up with the shares.

  3. Hi Terrence,

    Good point.

    No new upscale competitors will come into the market. The main argument is that the industry is plenty big enough for new participants at the moment.
    The market has grown by leaps and bounds over the past 3 decades.

    WFM has some great things going for it though. They created the space, organic certified grocer, mega emotional ties with the majority of their customers.

    It’s a lot like the AAPL situation from last year. Fat margins, perceived competition, fear of margin erosion. None of which really happened to the extent that analysts feared.

    My bet is that their competitive advantage will hold and they will be able to continue growing.

  4. If it was below $35, I would but a lot more. But current prices are fair so difficult to go big.

    As I was doing some deep diving into the company, the intangible factors in their business is truly amazing.

    Found so many surprises that you would never see in any other company.

  5. Jonas says:

    Jae, Great article and Ive had Whole Foods on my radar for a while. Just a few points on why I dont exactly agree on the BMW KIA analogy.

    I personally live in Canada and we dont have Whole Foods in my city (hopefully we will soon). So I purchase my organic fruits and veggies from a combination of 3 places as it is not all available in one location. There is an organic store that carries everything but it is ridiculously expensive.

    I enjoy eating healthy because I feel its a subtle change in my lifestyle that will impact me positively while not compromising on taste or nutrition. I do not look at my consumption of organic foods as showing im somehow elitist living a status symbol but but rather eating a necessity and by eating organic something good for my health.

    If tomorrow walmart started carrying all the various fruits and veggies organically AND more affordable than the competition Id be silly not to shop there and buy it.

    The two flaws I find with your analogy are:

    1. A BMW is a status symbol. A BMW could very well be inferior but people want to SHOW everyone they drive a BMW. The buyer of a KIA looks at it as a necessity for transportation similarly to the people who will always buy non organic foods. Eating organic foods is something you do in the privacy of your own home aside from pretentious people that will constantly be ranting on this fact (doubt whole foods can support on this audience alone if organics come to Walmart in large order).

    2. An argument can be made that a BMW is better than a KIA due to features etc. If Whole Foods is selling Organic Pink Lady Apples for $3 per pound and Walmart is selling them for $1 per pound there is really no discernable difference like with the cars.

    Whole Foods is a great company but if Walmart and some of the other majors decide to carry all their produce as well as perishables it may be in serious trouble. For me it is irrelevant if 80% of their customers are on food stamps. If they carry the same products as whole foods does at cheaper prices I personally feel Id be foolish to shop there.

    Please let me know your thoughts.

  6. Hi Jonas,

    Thanks for your comments.
    Getting to your comments,
    1. many people shop at WFM as status. They want to be in the crowd, show who they are and what they stand for. People don’t just buy things to show off and for status. Lots of people tend to buy things as an expression of who they are. e.g. a large group of people only buy made in USA items despite the fact that the same quality item could be had cheaper at other places.

    The reason why WFM can charge so much is that they don’t compete on “food”. As mentioned in the article, they are like starbucks. Instead of just being another coffee company, they sell the experience, the trust and brand.

    You could get better and cheaper coffee at a small drive thru coffee hut, but people will go out of their way to find a starbucks.

    2. My wife likes to buy organic produce. I’m like you. I hate overpaying and do buy a very small select number of items from Wal-Mart. But mt wife hates getting groceries from there.
    She isn’t the target audience, Wal-Mart doesn’t come to mind when she thinks of groceries. Even I don’t think of Wal-Mart as a go to place for groceries.

    It’s really the same point as #1. If WFM starts to compete on price, that’s when I will sell, because it will be a death spiral. One of the major business lessons I have learnt and observed is to never compete on price, because there is always someone who is willing to lose money until you go out of business.

  7. Boris Marjanovic says:

    Great article!

  8. jim says:

    Hi Jae,
    Not sure why you’re giving them a growth rate for your valuation when you’re only using maintenance capex. If your 8-9% growth rate is predicated on growth investments then it would be inconsistent to only hit them for maintenance capex.
    best,

    -j

  9. Because maintenance capex is simply a number. It’s not a growth rate.

    You can do a DCF with a FCF value that includes maintenance + growth capex.

    You can also do a DCF with a FCF value that includes only growth capex.

    What I’m interested in is the growth based value of the business with the DCF.

    I may have confused you so think of it this way.

    Let’s say a multiple valuation is used. Peers are trading at 15x.
    Currently a stock is trading at 18x and looks overvalued. But you find hidden assets that are overlooked. When you factor that in, the multiple is now 10x.

    Same concept with DCF.

  10. james says:

    Sorry Jae, I don’t follow. This is one of my pet peeves when people do valuation work–they grow the business while using maintenance capex. You need growth capex to grow revenue (unless you have price increases or spare capacity)–you can’t give them growth (that is premised on store count increases) but use a capital figure that only supports the ongoing operations of the existing business. One can quibble as to what really is maintenance vs. growth capex, but it’s hard to get around the logical consistency of the underlying principle. Sure you can do a DCF with any number–that doesn’t make it right.

  11. Backtracking a little.

    I think there’s some confusion because I’m using growth FCF in my DCF.

    “starting FCF of $800m (8% growth in cash from operating activities minus $300m maintenance capex)”

    $800m is the growth FCF.

  12. seanickson says:

    Hi Jae, I’m a little confused about this also. Are you discounting the growth FCF or just whats left over after maintenance and growth expenditures?

  13. I’ll try to clarify.

    Simplifying a DCF, you need 3 inputs.

    Starting FCF.
    Discount rate.
    Growth rate.

    The confusion here is about the starting FCF.

    The discount rate and growth rate are fairly obvious. Growth rate is assuming the growth of the business, not the maintenance.

    The confusion here it seems is the misunderstanding of the starting FCF.

    You can do a DCF in two ways.

    1) Just a regular FCF which includes full capex (i.e. maintenance + growth).
    Growth rate is 10%.
    Discount rate is 10%.

    2) FCF without maintenance capex. I.e. just the FCF based on growth numbers.
    Growth rate is still 10%
    Discount rate is 10%.

    The growth rate should not be discounted is either scenario. It should be the same for both cases.

    The only difference is that the starting FCF for (1) is going to be higher than (2) because of the inclusion of maintenance capex.

  14. Er62341 says:

    As someone else at another venue remarked, Starbucks & Apple sell their own products, Whole Foods is a middleman, so no comparison. Never fall in love with a stock, for after all it’s the biz that you go for.

  15. Remember their 365 is also their brand.

    No love here. Just straight objectivity.

  16. Karlo says:

    Jae,

    I have been reading the 10Ks about the company also and I agree with you on a couple of fronts and want to get your opinion:

    1-Management: It seems clear to me that they understand their business, are great capital allocators, know how to select sites and recruit/motivate and retain in employees (in an industry with a lot of turnover). They seem to have an internal culture that is quite amazing (e.g. Southwest type with their employees).

    2-Pricing: I think WFM has great pricing power. They have 65%+ of their revenue coming from perishable foods, including ~20% of total revenues coming just from their “prepared food” area. To me, that is an amazing opportunity to increase prices year in and year out. In addition, if we could analyze the foot traffic of the store I have a sense that 30% or more of their customers go their to eat prepared foods (hot bar, pizza, coffee / juice bar, etc…) and end up buying other things. That is VERY VERY difficult to replicate, given the quality of the food (and its a good buy). This gives them the ability to have close to 35%-40% margins consistently.

    3-Balance Sheet: I love the balance sheet and the fact that they relly on cash flow from operations (mostly) and not debt to grow.

    What are your thoughts?

  17. Hey Karlo,

    1) I do like management. They took it from a single store concept to a huge and successful empire.

    The way they treat their employees and are not afraid to publicly talk about sensitive issues shows that they have guts and pride in what they do and say. They don’t say and do things to tickle the ears of the public.

    Management is very underrated at WFM. I don’t see too much praise of focus on management from things that I’ve read.

    Youtube does a better job of giving you insights into management than many articles online.

    2) This is something that I strongly believe is the key differentiator between WFM and the other cheaper alternatives. Other places can sell organic produce for a cheaper price, but they don’t offer the experience.
    One of the ways Costco immerses their customers with is the experience. Documentaries of Costco show how everything from the cheap hotdogs, gas, food samples, big TV’s are all part of the lure for shoppers to stay just a little bit longer.

    Works for Costco and it’s a strategy that has been working for WFM. They are more than just a grocery store.

    3) No debt, awesome balance sheet, plenty of protection.

    But these are positive points, do you have any negative questions that can break the thesis?

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