Wednesday, 4 November 2015

Whole Foods vs. Facebook, an Observation Regarding Excesses in Sentiment

Both Whole Foods and Facebook reported quarterly results after the close today.

The two companies couldn't be more different, but that's what makes the comparison so interesting.

Whole Foods reported results that missed expectations on declining same store sales.  The company earned $.30 per share and gave soft guidance, all good enough to lop almost 7% off market cap in the AH's session.

Out of 24 analysts, average 2015 consensus estimate is $1.67.  I hate looking at consenus estimates, I'm typically drawn to the lowest estimate as a measure of dispersion.  The lowest 2015 estimate is $1.63, and the lowest forward estimate is $1.45.  Using forward estimates, the stock isn't exactly cheap at almost 20x next year's lowest earnings estimate.  Still, $1.45 works out to $500M in profit on sales of about $15B, good for a net margin of 3 1/3% (What do you want!  They sell groceries!)

$1.45 / $1.63 - 1 = -11% in eps yr/yr.

I recall a tidbit from reading The Intelligent Investor whereby Ben Graham modelled out different P/E's for different growth scenarios.  The no growth scenario deserved a P/E between 8x and 13x (if I recall correctly).

At 13 x $1.45, this would suggest that Whole Foods compress to around $19.  Not much of a stretch if the powers of sentiment work their magic.

Facebook on the other hand, reported a whopping profit of $.57 per share (ex-items like stock based comp and other non-significant non-operating costs).  GAAP eps were $.31 per share. The stock is at all time lifetime highs AH's, up close to 4%.

Get this, there are 50 analysts folllowing Facebook (surely this is a good thing).  Consensus estimates for 2015 are $2.07, and $2.74 for 2016.  Low estimates are $1.97 in 2015 and $2.21 in 2016.  The dispersion between low and consensus for 2016 is pretty significant, but then again, what do I know (not much).

And the P/E...drumroll please...52x consensus 2015, 54x low 2015, 40x consensus 2016, and 48x low 2016.

From gurufocus:

The comparative metrics are just hillarious.

Facebook on equal revenue has a market cap 26x that of Whole Foods.  Expectations are pretty lofty in regards to future growth.  I'm not going to go over the remaining valuation metrics as they all tell the same story.  Lofty expectations baked into one, depressed sentiment baked into another.  Which one wins over time?

A brief history of Whole Foods: way way way back in 2005, Whole Foods was a momentum darling.  Wall Street couldn't get enough (neither could Cramer).  Investors paid close to 60x ttm earnings in 2005 in the hopes that the organic food pricing model was perpetually sustainable.

I managed to dig up the following gem on valuing Whole Foods at pretty close to it's peak price, doing a simple google search: "Whole Foods 2005 Cramer".  Apparently, this gentleman was a best-selling author at one point (maybe he still is, unlike me, who's just a schmuck running a blog).

I'm going to copy and paste the entire article circa 2005 (copyright Phil Town):

FEBRUARY 04, 2005

Yes, this was seriously written back in 2005.  So what actually happened between 2005 and today? The exact opposite.  Instead of multiple expansion from an already lofty 60x ttm 2004 earnings, the multiple has compressed over the last decade.  And guess what, it's still compressing.

If anyone has the chance, I avidly follow a gentleman on gurufocus writing under the pseudonym "The Science of Hittting".  A few months ago, he had a great article on Whole Foods, which I'm going to reproduce below.  The post was originally written back in August of this year and speaks to exactly the type of euphoric sentiment prevalent in Mr. Town's forthy article above.  Link here:

Whole Foods: A Lost Decade

August 27, 2015 | About:   
I’ve written in the past about Walmart’s (WMT) crazy valuation around the turn of the century, and how it led to poor long term returns despite solid business performance. Today, I’d like to focus on another retailer: Whole Foods Market (WFM). If you pull up the company’s historic returns, you’ll notice something odd: the stock has gone nowhere over the past decade.

I say that’s odd because it doesn’t mesh with the business results.

Consider that statement in the context of some financial data: in 2004, Whole Foods reported $3.8 billion in sales; in 2014, the total was $14.2 billion – a 10-year CAGR of nearly 14%.

In 2004, Whole Foods reported $1.34 billion in gross profits; in 2014, the total was just north of $5 billion – a ten year CAGR of 14.2%. Again, a solid result for Whole Foods.

In 2004, Whole Foods reported $130 million in net income; in 2014, the total was $579 million – a 10-year CAGR of more than 16%. That’s good for a cumulative increase of nearly 350% over the past decade. On a per share basis, earnings increased at a 13% CAGR over the period, reflecting the impact of a rising share count due to preferred issuance during the financial crisis.

Not surprisingly, the difference between the business and the stock is driven by valuation.

Last year, the company earned $1.60 per share; with the stock trading in the low $30’s, the trailing P/E is roughly 20x. By comparison, the company earned ~$0.50 per share a decade ago – meaning the stock was trading at more than 60x earnings in 2005. As we often see, an absurd valuation has led to poor long-term stock performance despite solid underlying results.

With hindsight, I’m a bit puzzled: when a mid-teens CAGR for sales and EPS over a decade isn’t good enough, what could shareholders have possibly been hoping for? And for our consideration, is there any reason to believe these expectations had any basis in reality?

A quick look at the numbers raises some red flags. A decade ago, Whole Foods was consistently reporting comparable store sales growth of ~10% a year – a truly astounding number. In fact, the number is so astounding that the working assumption for anybody trying to look 5-10 years into the future should’ve been that this can’t go on for much longer.

For example, if the company had maintained ~10% annual comps, the average Whole Foods would currently be selling more per store than an average Walmart Supercenter – despite operating in a box that’s roughly one-fifth as large as the average Supercenter.

Considering that they’re selling food, as opposed to high-priced electronics, that sounds like a stretch to me (every day would be the equivalent of shopping on Black Friday). This is before considering the fact that new stores are likely to be less attractive opportunities long term than earlier additions to the company’s footprint (start with the low-hanging fruit).

Looking at margins (gross, EBIT and net) and new unit growth, it’s difficult to conclude from looking at the 2005 annual report – and the historic results up until that point – that investors should’ve expected much more than what has been actually delivered in the ensuing decade. In addition, nationwide competition should’ve been foreseeable as well; it may have taken longer than some expected, but it looks like selling organic / natural food is a lot like your everyday grocery store – a cutthroat business with few long term winners (look no further than the Fresh Market (TFM) for a company that’s finding trouble in an increasingly competitive environment).

A decade later

As I look at Whole Foods today, the picture looks a lot more interesting: at 20x earnings, you’re buying a business that can grow net units at a mid-single digit percentage (at least) and has grown comparable sales 6% a year (or so) over the past five years. Even with a decent haircut on both of those variables, I think this business can sustainably grow the top line ~8% a year for the next five-plus years. The returns on those new units are pretty attractive, and the balance sheet looks strong as well (current ratio of 1.5x, with ~$700 million in net cash). All in, there appears to be a decent argument for Whole Foods on back of the envelope math.

Taking this a step further, how bad would the next decade need to be to match the returns (roughly zero, not including dividends) of the prior decade? Let’s assume I’m too optimistic on comps and net unit growth: they’re actually +2% and +4% a year, respectively, in the coming decade (call it 5% sales growth to account for impact of new units relative to well performing legacy stores). Let’s also assume that net margins contract from the 4.1% reported in FY14 to the 3.7% trailing five-year average.

Under those assumptions, for WFM to go nowhere over the next decade, the stock would need to be trading at a P/E multiple of 10x – 12x in 2025 (that includes some benefit for uses for excess FCF for repurchases, as they’ve done in recent years). At that point, the company would have just under 600 stores, roughly half of what management believes is a reasonable long-term target for their footprint in the United States. That’s also well below what management has planned for the coming years (they plan to reach 575 units in 2018, well ahead of my estimate).

I always find it interesting to think about how Mr. Market falls in and out of love with certain companies, resulting in stock market returns over long periods of time that share no resemblance with the actual underlying returns of the business.
The real pain from investments like Whole Foods in 2005 (or Walmart in 2000) comes in the form of multiple contraction; if you pay a high price for a business that doesn’t perform even better than what Mr. Market has priced in (if that’s even possible), the result will be painful.
As I tried to show above, the valuation clearly doesn’t look as absurd as it did a decade ago; at the same time, it’s hard to find many people who are pounding the table on WFM as they’ve done consistently in the past. Those two things happening simultaneously is not a coincidence.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves (potentially over a period of years). As this would suggest, I run a fairly concentrated portfolio by most standards, usually with the majority of the value in a handful of names; from the perspective of a businessman, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

I reached out to the author tonight and made the following comments regarding Whole Foods (we've had previous discussions regarding the company):

"So I have watched the earnings reaction to Whole foods today and I think it’s very possible that it gets down to mid or even low $20’s.  Low $20’s things start getting interesting.

At $20, I made the following quick and dirty rough calculations:

2015 FCF of about $880M.  If I treat this as base year FCF with no growth (sort of an initial rule of thumb calculation I start with these days), and discount this stream perpetually at 10%, I get a PV of $8.8B, + surplus cash of say $.6B, gets me an equivalent to market cap comparable value of $9.4B

At $20, mkt cap gets to around $7.2B.

Obviously, this is simplistic, but it’s conservatively simplistic.  There likely will be growth in FCF excess of 0% over at least the short term (5 years), for the most part due to incremental stores.  Not so much based on increases in gross or operating margins though (i.e., minimal pricing power, which we’ve discussed).

But the more I analyze situations, the more I start wanting to look at worst case.

1 - $7.2B / $9.4B = about 25% margin of safety if my required return is 10%

At 12%, I get $7.96B, about a 10% margin of safety if my required return is 12%

If it gets down to below $20, things really start looking interesting…

Anyway, figured I’d follow up on this.  The more I’m a student of all of this, the more I observe that the pendulum seems to swing from excessive (and often unfounded/unbridled) optimism (i.e., WFM at 60x eps) to despair and pessimism (possibly now and in the near future)." 

Concluding Thoughts

One of the strongest points I believe my gurufocus author friend is making is the importance of understanding the mechanics of multiple contraction vs. expansion.  When expectations are unrealistic and a stock is priced for perfection on the expectation of world domination, the probability of multiple expansion diminishes.  Similarly, the probability of multiple expansion seems to improve the lower price, value and expectations regarding sentiment get.  The cheaper a company like Whole Foods gets, the more interested I get, but the valuation has to be right.

I priced perpetual free cash flow using no growth and 10 - 12% discounts rate at $20.  Heck, after hours, it's $28+.  I suspect that $20 will be psychologically important (if the stock gets there), and if it does, I would like to add it to the long term accounts.

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