Whole Foods: Wait Until 2009

The food retailer's margins will be squeezed in the next year, but analysts are optimistic about earnings growth down the road

Just as shoppers at a favorite supermarket learn to excuse the temporary chaos in the aisles on delivery days, investors may want to cut Whole Foods Markets (WFMI) some slack and focus on its growth prospects over the longer term.

Lots of moving parts, including the $700 million acquisition of Wild Oats Markets in September, the shedding of Henry's and Sun Harvest stores and the construction of new stores in previously untapped territories, resulted in a confusing quarter from a financial perspective, analysts said. But once the business structure stabilizes, probably after 2008, the Austin, Tex., company is expected to increase its profits at an even faster pace.

"We weren't so concerned about this quarter or next year. The re-acceleration of same-store sales is real positive. That's the best thing we could have heard," said Mark Churchill, an equities analyst at Piper Jaffray & Co. in Minneapolis.

Given how messy the financial picture looks for the fourth quarter of fiscal 2007 and all of 2008, Churchill said he's trying to look beyond that toward what the outcome will be once it normalizes in 2009.

Sales in stores open at least one year rose 8.2% in the fourth quarter from a year ago, after a 7% growth rate in the first and third quarters and a dip to 6% in the second quarter.

On Nov. 21, Whole Foods reported a fourth-quarter profit of $33.9 million, or 24 cents a share, down from $39.8 million, or 28 cents a share a year ago, despite the 8.2% gain in same-store sales and a 35% increase in total sales to $1.74 billion. The results fell short of a 30-cent consensus estimate among analysts. For fiscal 2007, the company earned $182.7 million, or $1.29 a share, versus $203.8 million, or $1.46 a share, in fiscal 2006.

In the latest quarter, the store contribution was about $149 million, or 8.5% of sales, while general and administrative (G&A) costs were roughly $67 million, or 3.9% of sales, higher than average due to about $13 million, or six cents a share, in legal and integration costs, as well as the addition of Wild Oats' G&A expenses.

Sales at Wild Oats stores open at least one year were up 3.9% for the last five weeks of the quarter, and accelerated to a 6.6% growth rate in the first seven weeks of the new fiscal year.

For fiscal 2008, the company projects that sales will grow 25% to 30%, of which about 10% is expected to come from the Wild Oats stores. Comparable-store sales are estimated to grow at a rate of 7.5% to 9.5%.

But the company said it doesn't expect to produce operating leverage in fiscal 2008. That will be the result of a lower store contribution as a percentage of sales, driven by a higher percentage of sales coming from new and acquired stores, which contribute less than its existing stores, as well as by investments in labor and benefits at the Wild Oats stores and ongoing, but moderate, hikes in health care costs as a percentage of sales.

In a Nov. 21 research note, Standard & Poor's said it believes the integration of the Wild Oats stores, together with expansion into new geographic territories, will put significant pressure on the company's profit margins in the next year. The equity research outfit reaffirmed its hold rating on the stock but lowered its fiscal 2008 earnings estimate by 10 cents to $1.50 a share. S&P thinks the acquisition will ultimately enable Whole Foods to grow its earnings at a faster rate and kept its target price of $50.

Although the Wild Oats acquisition will eventually boost Whole Foods' profits, the company faces intensifying competition, especially in California, where conventional supermarkets are aggressively promoting to win back business and new rivals are entering the market, S&P said in a Nov. 17 note. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Cos.)

Churchill at Piper Jaffray said he's watching same-store sales to gauge how Whole Foods is faring against competitors. At this point, there's no evidence that increased competition is eating into the company's revenue or profits, he said. Whole Foods should be fairly successful in being able to pass high agricultural commodity costs through to it customers, he added.

Holding onto Whole Foods shares will be "a test of patience, but the 2009 earnings turn remains in our grasp," RBC Capital Markets analyst Edward Aaron said in a Nov. 21 research note.

Aaron reduced his earnings estimate for 2008 by 10 cents to $1.39 a share, due mostly to higher than expected G&A expenses. Rather than making quick and deep cuts in Wild Oats' G&A costs, which would have led to meaningful G&A leverage in 2008, the company plans to keep a significant portion of Wild Oats' corporate overhead through the initial integration period. Consequently, G&A costs are expected to be flat at 3.3% of sales in fiscal 2008, vs. Aaron's prior estimate of 2.9% of sales, he said in the research note. On its conference call to discuss the results, the company committed to substantial G&A leverage in fiscal 2009, he added.

Aaron said he expects margins to widen in fiscal 2009 as G&A expenses drop and Wild Oats' store-level metrics improve. (A member company of RBC Capital Markets or one of its affiliates does investment banking with Whole Foods and makes a market in its securities.)

With nearly half the sales and square footage productivity of the Whole Foods stores, the Wild Oats stores have potential to double their sales just by changing the merchandising assortment, which will occur throughout the coming year, UBS Investment Research analyst Neil Currie said in a Nov. 21 note. That, plus plans to drop more than one thousand higher-priced Wild Oats items to match Whole Foods' pricing should enable sales productivity to gain momentum in fiscal 2008 and improve significantly the following year, said Currie, who has a buy rating on the stock. (UBS does or seeks to do investment banking with the companies it covers, beneficially owned 1% or more of Whole Foods' common stock at the end of October and makes a market in the company's securities.)

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