Questioning Management at Whole Foods Stock

It wasn’t that long ago that Whole Foods Markets was in a position of enviable strength. In 2013, it was earning $551 million in profits, had operating margins of 10%, and had a trailing ten-year record of tripling earnings from $0.41 per share to $1.47 per share. Better yet, the company only had $26 million in debt, something it could flick off the shoulders of its balance sheet as it only amounted to two weeks of profit. The stock was one of the best investments you could have made during this time frame, as every dollar put into the stock ended up quintupling in value over a ten-year span.

In the past few years, Whole Foods Markets seems to have gotten away from its formula for creating shareholder wealth–open a large location in a wealthy area, and see if you can get 5% sales growth and 7% earnings growth out of the existing locations. The new stores add a point or two, and you can nine percent earnings growth for the long haul.

But in the past three years, Whole Foods Markets has strayed away from the foundations of its success.

It has decided to open new mini-stores under the brand name “365” in California, Washington, and Oregon with the focus on affordable organic food. By the end of this year, 60 out of its 500 stores will be these smaller 365 locations. My criticism of these stores is the same as my criticism of the Wal-Mart Express and mini-Targets–they don’t get good foot traffic, the items aren’t that profitable, and there is no strong base of demographic support that can propel profit growth for this business model.

Recently, Whole Foods Markets has indicated that it is doubling down on this concept, as it is now opening up new Whole Foods locations in the low-income areas of New Orleans, Chicago, Detroit, and Newark N.J.

The WSJ has indicated the length to which Chicago has lived up to the stereotypes of its political culture to facilitate the expansion of Whole Foods into parts of downtown Chicago where the annual income is only $20k, including the sale of $3.1 million in government real estate for a dollar, as well as $10.3 million in tax subsidies which gives this a location an unfair advantage of the competition in that it won’t have to be a net contributor of taxes for the foreseeable future.

Specifically mentioned in the Wall Street Journal: “Mr. Emanuel’s office sold the land on which the Whole Foods and about five other stores stand to develops for a dollar rather than the $3.1 million market value. The $20 million development also received $10.3 million in tax subsidies, slashing the store’s expenses… ‘This isn’t realistic,’ Willa Gilland, a 63 year-old Englewood resident, who noted during the opening of the Whole Foods in her neighborhood that chicken prices were much higher than at a nearby outlet of German discounter Aldi.”

According to a WSJ poll, a little over 54% of customers who belong to households that generate at least $85,000 per year in income stated that they don’t shop at Whole Foods because they consider the store’s food options to be too expensive. If a majority of people in that income range don’t feel that they can afford Whole Foods, what do you expect people earning one fourth of that to think? You’re either going to have to lower price and earn lower margins or you’re going to have a small customer base that won’t let the business model work without subsidies.

This intuition–that smaller stores and expansion into high-poverty areas won’t propel profits–has shown up in the numbers in the three years since Whole Foods has been pursuing this outreach. Absolute profits are down from $550 to $500 million and profit margins are down 20% over the past three years.

Whole Foods has leveraged up its balance from nothing to over $1 billion in the past three years so that it could repurchase 60 million shares of stock. The share count has gone down from 370 million to 310 million, and this is why earnings per share have shown a slight uptick forward from $1.47 to $1.50 despite profits at the parent entity declining by $50 million during this three-year time frame.

The bright spot is that Whole Foods is moving into home delivery, improving its loyalty program, and launching digital coupons which has a fair chance of getting volume up.

But I think margins are going to take a hit under the present strategy. With the exception of the home delivery option, the coupons and loyalty program are meant to keep current customers by giving up some profit margins. These small store concepts do not have a strong record of being anything other than a failure that gets closed quietly a few years later. And the plans to move into high poverty areas, when even the middle and upper class exhibits some restraint in its willingness to pay Whole Foods prices, does make me hopeful that Whole Foods will succeed when I study the move from the perspective of the human experience, but it makes me conclude that Whole Foods will probably learn the harsh realities of why other high-end grocery stores haven’t succeeded in these areas when I study it from the perspective of an investment analyst.

I’m agnostic on whether the stock is a good deal right now. It has come down quite a lot from $65 to $28 in the past three years. And it does have the ability to roll out new stores which can augment overall earnings. And it has financed its debt at very low rates. But I can’t help but think that Whole Foods management has something on its mind these days other than creating shareholder value, and it has been showing in the numbers for three years straight now.