Whole Foods Market: Natural Questions

Investors in Whole Foods Market are faced with a dilemma similar to one routinely faced by grocery shoppers every day -- is the bruised produce discounted enough to make it a bargain? Or is it too far past its prime?

The discounted produce we're talking about here is stock in Whole Foods itself, the nation's largest chain of natural foods supermarkets.

After the close of trading on November 2, the company announced fiscal fourth-quarter earnings that were about in line with what analysts expected, on sales that were slightly below expectations. But executives stunned Wall Street by pointing toward slower growth ahead. The Austin, Tex.-based organic food purveyor said a three-year streak of double-digit sales growth in stores open at least a year -- a key measure for retailers -- would end as same-store sales growth comes in closer to 6% to 8% in 2007. The company projected overall sales growth at 13% to 17%, down from the more than 20% annual growth the retailer has averaged over the past five years. CEO John Mackey called 2007 a "transition year" and said in a separate announcement that he'd cut his salary to $1 and forgo any future stock-option awards because he'd "reached a place in my life where I no longer want to work for money."

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The stock (symbol WFMI) plunged more than 20% the day following the company's announcement, to $46, a new 52-week low. On November 7, the shares climbed 2.2%., to close at $47.47.

Presumably, Whole Foods' shareholders, unlike CEO Mackey, still want to invest for money, so the question is this: Is Whole Foods, at its core, still a market-dominating powerhouse whose shares just got more attractive? Or is the company, or at least its stock, transitioning to something fundamentally different?

Whole Foods opened its first store in Austin in 1980. The company now has 188 stores in the U.S., Canada and Britain, and for the fiscal year that ended in September it raked in $5.6 billion in revenues, well ahead of its nearest natural-foods competitor, Wild Oats Markets (OATS). Known for exotic fruits, whole-grain breads and premium produce, Whole Foods has both inspired and profited from a quest among Americans to enjoy healthier lifestyles.

With earnings also growing at an average annual rate of more than 20% over the past five years, it's little wonder investors latched on to the Whole Foods story in a big way. The stock reached a high of nearly $80 a share last year, having risen from less than $15 at the start of the decade. Before its recent tumble, the stock traded at more than 40 times projected earnings, the kind of premium price-earnings ratio commanded by only the choicest growth stocks.

Now though, Whole Foods is facing real competition. Mainstream grocers, such as Safeway (SWY), have started to stock organic foods, as have discounters, most notably Wal-Mart (WMT), which recently announced that it would add more than 400 organic items to its grocery shelves. Meanwhile, specialty grocers such as Trader Joe's and Wegmans are vying for upscale shoppers. Market watchers have interpreted the company's comments to indicate that future growth may well be decent, but it's not likely to be meteoric -- and that has some Wall Street analysts forecasting a different path for Whole Foods’ stock.

Standard & Poor's changed its recommendation from buy to hold and lowered the price it sees the stock attaining over the next year from $65 to $48. Zacks Equity Research also downgraded the stock, from buy to sell and said it expects the stock to trade at $30 a share within the next six months. "The real risk," writes analyst Robert Plaza, "is that the company's growth rate has peaked and will never see 20% annual sales growth again."

Following the company's fourth-quarter report, Plaza lowered his estimate for fiscal 2007 earnings from $1.65 a share to $1.54 a share, and fiscal 2008 earnings from $1.89 a share to $1.73. Plaza expects earnings to grow at an average annual rate of 17% over the next five years. "That's just not enough" to support the premium price-earnings ratio Whole Foods once commanded, says Plaza. Nor is the markdown the stock has taken already enough to make it a bargain. At $47.45, the stock trades at nearly 31 times estimated fiscal 2007 earnings. That compares with an average P/E ratio of 22 for the industry. As growth-focused investors look elsewhere, expect Whole Foods' P/E to drift closer to 20 times projected earnings -- hence Plaza's $30 target.

Hedge fund manager Filippo Zucchi, who runs Washington, D.C.,- based Zebra fund, says he won't be surprised if the stock bounces a bit higher, but he's betting that longer-term, the direction is downward. "This is one of those fad things, but at some point it has to grow up into a regular company. At the end of the day this is just a grocery store." And it's not quite on sale yet.