Krause Fund Research Spring 2017 Whole Foods Market, Inc. (NASDAQ: WFM) Recommendation: SELL Consumer Staples April 17, 2017 ANALYSTS Yue Li [email protected] Current Price: $34.52 Hannah Hendricks Target Price Range: $25.00 – $28.00 [email protected] Rachel Langholz U.S. LARGEST ORGANIC GROCER [email protected] CHALLENGES COMPANY OVERVIEW • Intensifying Competition: Due to a growing number Whole Foods Market, Inc. (NASDAQ: WFM) is of retailers entering the organic food market, WFM has recognized as the nation’s leading natural and organic experienced a stark decline in store traffic and same-store foods grocer within the broader food retail industry. sales. Considering WFM’s recent sluggish performance, we With the unique designation as the first “Certified forecast fewer new stores openings going forward, Organic” supermarket, WFM primarily operates within decreasing from 24 in 2016 to 18 in the CV year. the continental U.S. with smaller presences in Canada • “365 by Whole Foods Market”: Given a shift in and the United Kingdom. The firm largely competes consumer preferences, we anticipate this lower-cost store within its perishable and non-perishable verticals on the format to be the dominant driver of future revenues, basis of product leadership, which relies on high quality accounting for over 80% of additional stores opening in the standards and strong product differentiation. CV year. However, it may not prove to be a viable source Furthermore, WFM has introduced a newer, low-cost for long-term organic growth. store model “365 by Whole Foods Market” to increase • Stock Underperformance: While the S&P 500 its engagement with a broader customer base and increased 15% over the last 12 months, there was only a 4% rebuild its market share lost to large-scale food retailers. gain in WFM, which lost over 50% of its value since October 2013. STOCK PERFORMANCE HIGHLIGHTS • Increased Stake by Activist Investor: Jana Partners 52 Week High $35.58 built an 8.8% stake in WFM to urge accelerated operational 52 Week Low $27.67 improvements to better compete with large-scale grocers. Beta Value 0.89 The dissemination of this news caused WFM’s price to Average Daily Volume 5.70 m surge over 10% on Monday, April 10, 2017. SHAREHIGHLIGHTS ONE-YEAR STOCK PERFORMANCE Market Capitalization $11.00 b Shares Outstanding 318.56 m Book Value per share $10.34 EPS (Trailing Twelve Months) $1.38 Trailing P/E Ratio 24.92 Dividend Yield 1.60% Dividend Payout Ratio 39.13% COMPANY PERFORMANCE HIGHLIGHTS ROA 8.19% ROE 13.58% Sales $15.81 b Source: Yahoo! Finance EXECUTIVE SUMMARY annual rate of 2.1%, as compared to the prior preliminary estimate of 1.9%. iii This upward revision is largely Our team is issuing a SELL rating for Whole Foods supported by higher-than-expected consumer spending. Market, Inc. (NASDAQ: WFM) for the Krause Fund As the economy continues to grow, we expect real GDP portfolio due to the ambiguous prospects ahead of WFM. to reach an annual growth rate of 2.3% in six months. We As the nation’s first and largest organic food grocer, further believe real GDP will experience slow yet steady WFM has long been facing incremental competition from growth to an average annual growth rate of 2.5% into traditional supermarkets, specialty stores, and online 2020. This would lead to a sustainable economy that is retailers entering this niche market. Especially, the recent favorable for corporate operations and employment deteriorating customer traffic and troubling same-store conditions yet not trigger unnecessary concerns over sales have presented the company with a host of potential inflation. challenges. In addition to refining growth strategy to focus on strengthening customer loyalty, WFM has also As the overall economy is expected to strengthen going launched a value-based smaller-size store format named forward, we believe that moderate real GDP growth 365 by Whole Foods Market aiming to regain market indicates a healthy economic environment where share as a response. Although we expect that the unemployment is low and inflation is minimal. Low implementation of these two tactics would mitigate the unemployment would be translated into higher wages, unsatisfactory performance to some degree, it may not be and thus people would demand higher standards of living. sustainable in the long-term. Incorporating all these Minimal inflation would lead to increased buying power, factors into our valuation model, we generated a target which is viewed postively by both consumers and price range of $25.00 – $28.00. While the recent news of producers. All these factors would create a favorable the activist investor seeking potential takeover of WFM consumption environment, enabling companies within the implies upside potential in share price, we believe WFM sector to achieve higher growth in corporate revenues. is overvalued from a fair market value perspective, leading to our recommendation of selling the stock. Inflation Inflation is the upward movement in prices for goods and services and the corresponding depreciation in purchasing ECONOMIC ANALYSIS power.iv It is an important driver since moderate inflation is healthy for the consumer staples sector. v Consumer Gross Domestic Product Price Index (CPI) and Producer Price Index (PPI) are two Real gross domestic product (GDP) is a measurement of indicators widely used to gauge inflation at the retail level the inflation-adjusted value of all goods and services and the wholesale level, respectively. produced by a country within a year.i Given that more than three-fifths of the total GDP is contributed by personal consumption expenditures, of which 30% is spent on nondurables,ii real GDP is an important indicator to consider when evaluating the consumer staples sector. Source: Bureau of Labor Statistics According to the latest news release from the Bureau of Labor Statistics, the CPI is up by 2.4% over the 12-month period ending March 2017, which is higher than the Source: Federal Reserve Economic Data average of 1.8% over the last decade.vi Despite that the PPI Finished Goods fluctuates for the past few years, it Since the recovery from the financial crisis in 2009, there generally keeps the pace with the CPI, as evidenced by has been a steady growth in the U.S. real GDP. In the the graph above. With that being said, consumer staples fourth quarter of 2016, real GDP has increased at an companies are capable of passing on input price increases 2 to consumers over the last two years, relieving them from income to earn higher interests. Additionally, higher sole cost absorption. interest rates create a more expensive environment for capital expenditures. In view of the growing U.S. economy, we believe that the CPI will continue to increase by 0.2% in six months, Unemployment eventually reaching an annual inflation rate of 2.5% in Although firms operating within the consumer staples two to three years. We interpret this level of inflation as a sector produce fundamental goods and services, a steady good sign for the consumer staples sector. Given that demand for their respective products is largely ensured by food, beverages, tobacco, household and personal a reliable source of discretionary income from consumers. products are necessities that are less price elastic, a Consumers spend more on high-margin products when marginal increase in price would not impose a negative they have a higher proportion of disposable income effect on customer demand. Therefore, companies within available. x Hence, low unemployment serves as an the sector are able to maintain units sold while charging important factor in sector performance, as it translates to more for products, ultimately realizing higher revenues. consumers having additional income. Furthermore, a healthy employment environment can ensure lower input Interest Rate prices and in turn lower product prices for end consumers. The Federal Funds Rate, the interest rate charged on inter- bank overnight loans,vii is used by the Federal Reserve to The U.S. has seen a steady decline in the unemployment influence the U.S. economy through adjusting the money rate since the recessionary period ending in 2009. The supply in the market. It sets the benchmark for the cost of most recent measurement for March 2017 exhibited borrowing, which matters to both businesses and further downward movement on a monthly basis, as rates consumers in the consumer staples sector. fell to 4.5%. This represents an annual 0.5% negative change and a 0.2% decrease from the beginning of 2017.xi The economy is currently close to full employment and continues to steadily expand, which leaves minimal room for downward movement in the unemployment rate in the short term. xii In the next six months, unemployment is expected to remain within 0.3% of the current 4.5% level. On a long-term basis, unemployment may hover between 4.6% and 5.0% aided by protectionist economic policies expected to be implemented by the current federal administration. Source: Federal Reserve Economic Data While the Federal Reserve has maintained the rate at record lows since the Great Recession in 2008 as a resort to combat the financial crisis, it appears to slowly recover over the past year, reaching a range of 0.75% to 1.00% currently.viii Based on the optimistic prospect of President Trump’s economic plans, we expect two hikes in the Fed Funds Rate within six months. In the long run, we believe that the rate will continue to hike, but the pace is unforeseeable as a result of uncertainty surrounding the Source: Bureau of Labor Statistics economy outlook under Trump’s governance.ix Additionally, an increasingly stringent immigration A higher Fed Funds Rate is triggered by reducing the stance is expected to impact long-term employment money supply in the open market.