Whole Foods stock on the rise
Investors are betting on an economic recovery, but are they counting their free-range chickens before they hatch?
NEW YORK (Fortune) -- Whole Foods shares have more than doubled this year as investors bet that recovering consumers will return to the high-end grocery chain.
But signs of economic weakness still abound, raising questions about shoppers' willingness to spring for organic arugula and grass-fed beef.
"We upgraded Whole Foods to a buy in June because its business model is working after three tough years. This was a cult retail stock earlier this decade. Then it started opening stores that were too big for some markets. Shares fell 80% from 2005 through 2008.
"But since last summer, Whole Foods has been slowing store growth, downsizing corporate-level functions, and introducing cost discipline at stores. It planned to open 25 or 30 new stores in 2009 -- now it's more like 15.
"Now that its growth has slowed, the Whole Foods store base will start aging again. That is fundamentally good for margins -- as stores mature capital expenditures costs are recovered -- and will offset some of the pressure from weakened consumers.
"And part of what's happening at Whole Foods is that the company is becoming more disciplined in how it manages costs, especially at the store level, in terms of the number of workers on the floor and reducing spoilage.
"At the same time, it's slowly chipping away at the "Whole Paycheck" stigma by sending better value messages to its customers while at the same time maintaining service levels.
"With better expense control and its improving image, Whole Foods can beat estimates in the next couple quarters without a quick recovery in consumer spending.
"Earlier this year, it gave an earnings framework that was based on the assumption of flat comparison sales. At the time we were very skeptical of this company's ability to actually have flat comps, and so we thought there was risk to numbers.
"But lo and behold, with all of the expense control that it has done, halfway through the fiscal year its comps are tracking down 4.4%, and the company is on a pace to exceed targets it put out there.
"This sets Whole Foods apart from other retailers.
"This is an early-cycle stock that we think will trade around $25 in the next year."
"Whole Foods is a great company. But the unemployment rate is still rising -- it just hit 9.4% -- and the Whole Foods customer is buying cheaper goods within Whole Foods' stores or switching to lower-priced retailers. Same-store sales reflect that: In the last quarter they fell 4.8%.
"As long as the economy remains weak, there is tough competition from traditional food retailers like Safeway (SWY, Fortune 500) and Kroger (KR, Fortune 500), which have increased their natural and organic products.
"And even as Whole Foods has pulled back on expansion, it is still committed to a lot of leases for very large stores. The average size of Whole Foods' newer stores is 56,000 square feet. The average for all its stores is 36,000 square feet.
"A larger store needs bigger volumes. But Whole Foods is not seeing the traffic increase now that it expected years ago when it committed to this type of expansion.
"We don't see traffic increasing -- or Whole Foods shoppers trading up to premium goods -- over the next 12 months. Job losses need to end before that happens.
"And with the increased competition from traditional grocery retailers it's going to be much more difficult for Whole Foods to build its customer base and increase traffic trends.
"In addition, the stock is trading at a valuation that is more a reflection of the strong growth it has had historically. For valuation, I use my own price-to-earnings model, where I compare it to the consumer staples group, the S&P 500, and company's own historic levels.
"On a price-to-earning growth basis, it's trading at about 2.05 times growth. Staples are at 1.4 times growth. It's a significant premium to the staples group.