Ever since I began working on the idea of a
a little over a year ago, I've been enamored with Whole Foods
). In my view, conscious capitalism represents the best hope we
have for sustainable economic prosperity in the world. So, I
absolutely love Whole Foods Market, the company.
But I had never gotten very interested in the stock until May
7th. At that point, I began digging into the issues and trying to
get a sense of the potential value to be found in WFM. The end
result is a 26 page
stock report on Whole Foods Market
(which is available for free at the preceding link).
One thing I noticed early in my research, was that analysts and
writers often pointed to the fact that company management has
indicated they see room for 1,200 stores in the U.S. Given that
there are less than 400 stores now, that means the company is going
to triple in size, offering great returns to shareholders,
Well, it's not quite that simple. Even if they were to triple in
store count and sales, it's likely they will struggle to maintain
those insane gross margins they've been able to generate recently.
Everyone seems to be aware of that issue. But it seemed like there
was one thing no one was talking about: share dilution.
Intuitively, the effect of this impressive store count potential
is somewhat ambiguous to shareholders, if the company has to issue
new shares to achieve that number. Taking the extreme example, if
the company had to triple their share count (through new issues) in
order to raise the cash needed to triple their current store count,
it conceivably wouldn't benefit shareholders at all.
But most healthy companies these days are net buyers of their
own shares, right? I'm not sure, but it's definitely not the case
with WFM. Share dilution has been somewhat concerning in the
(click to enlarge)
Part of the share dilution should be expected to continue, and
part of it should not be expected to continue (more on that below).
This question compels us to come up with a way to model the true
effects of a growing store count for existing shareholders, while
accounting for the share dilution that is likely to be ongoing.
First, we must determine what number to use for valuation purposes.
Should we be concerned with gross profits? Earnings? EBITDA? Free
I chose to model
Owner's Cash Profits
. Owner's Cash Profit is a simple concept that was introduced to me
by Erik Kobayashi-Solomon, Director of Research at YCharts. The
idea is so simple that it's hard to imagine it also being
incredibly useful, but it is. It's built on the premise that a
stock is ultimately worth the cash profits it generates for owners
over time. That makes sense, right?
Well, maybe. If the company never pays out that cash in
dividends, what does it matter to individual investors? You and I
may not be able to gain control of a company such that we can take
advantage of all of the cash profit being generated by a business.
That's why dividends are so important to individual investors. But,
a large company, private equity firm, or other suitor would be able
to purchase a company and extract the full value of cash profits
being generated. So, the value of a company's stock should converge
to the value of OCP over time. Specifically, investors can try to
calculate the present value of estimated future Owner's Cash
But first, how do we measure OCP? We start with the CFO being
generated by the business. Then subtract out our best estimate of
maintenance capex. Maintenance capex is the amount of capital
expenditures the company requires to keep the business running.
Capital expenditures on a new factory or store, for example,
represents growth to investors and is typically classified as
growth capex. Capital expenditures that go to replace worn
equipment or outdated decor are considered to be maintenance capex.
Ongoing operating expenses are already coming out of the CFO
number. But capital expenditures aren't. So, we need an estimate of
maintenance capex to subtract from CFO.
"Total Depreciation and Amortization - Amortization of
Intangibles" is one estimate for maintenance capex over time. It's
at least the best estimate that can be pulled directly from most
financial statements and applied over many different equities. By
the way, if you're interested in exploring this concept in further
detail across various companies, YCharts puts out some
great research reports
on various stocks that even someone like me can easily
When I am initially checking out a company's OCP, I look at
1) OCP yield, which is basically a current yield number measured
as OCP/Market Cap. Obviously, a higher number is better, all else
2) The past trend in OCP. If OCP has been consistently rising
for many years, I view that as a very positive sign.
3) The past growth rate of the company. Obviously, a company
that has been growing rapidly is going to experience higher than
normal depreciation expense. In the case of WFM, it's intuitive
that the depreciation number should begin to go down as growth
levels off. Once they hit their goal of 1,200 stores and capital
expenditures associated with new store openings ceases,
depreciation should decline before leveling off to a sustainable
amount that is associated with remodeling of existing stores,
replacement of worn out or obsolete assets such as machinery and
equipment, relocation of existing stores, etc.
However, the hope is that CFO will not go down, but rather
continue to rise, thus increasing cash profits to owners. So, if
things go smoothly and the company retains its customer loyalty and
affection, WFM could become an absolutely massive cash cow at some
point in the next 15-20 years. Hopefully, that also means they will
be churning out ever increasing dividend payments to shareholders
for many years to come.
But before I get too far ahead of myself, let's look at the
current level of OCP:
(click to enlarge)
TTM OCP Yield is $674.59 million/ $15.21 billion = 4.44%. First
of all, with current market valuations, that's not a terrible
current yield, at least not on a relative basis. I don't have any
way to produce market average numbers for this metric. But, I can
say anecdotally that about half of the stocks I've screened lately
on this metric fall below 3.5%.
Second, OCP is increasing significantly over time.
Third, Total D&A expense is probably overstating maintenance
capex for a company that is in growth mode. As evidence, check out
the following table:
(click to enlarge)
Source: WFM Annual Stakeholders' Reports and 10-Ks, 2004-2013
(dollar amounts in millions)
As you can see, the majority of capital expenditures is going
toward new store development right now. That should be considered
growth capex, as opposed to maintenance capex. WFM is doing a good
job of breaking out what they believe to be the true maintenance
capex versus growth capex. Using their 2013 numbers of $198 million
for "Remodels and other property and equipment expenditures" as
well as $2.4 million for "Relocation, store closure, and lease
termination costs" to estimate maintenance capex, WFM produced
Owner's Cash Profit closer to $838 million last year.
I should note that it's possible that I'm double counting at
least some of the "Relocation, store closure, and lease termination
costs" number. It may be partially accounted for as an operating
expense, but I can also see how relocation costs could get lumped
in with capital expenditures, in which case it would eventually
come out as depreciation. I'm not sure because I'm not a WFM
accountant or auditor, and we've hit my limit for understanding
exactly how they may be accounting for those costs elsewhere. So,
to be on the safe side, I add it back in as an ongoing cash expense
associated with moving store locations. For the record, I should
also note that I've now parted ways with Kobayashi-Solomon's
methodology just because WFM is one of the relatively few companies
that breaks out their own estimate of maintenance capex.
But back to the $838 million, that would make the OCP yield
(using a $15.21 billion market cap) = 5.51%. That's starting to
sound pretty good, especially if this company still has plenty of
If we wish to try to model that version of OCP going forward, we
need to keep in mind that as all of these new stores age, we can
expect "remodels and other property and equipment expenditures" to
rise accordingly. However, I think remodels will start to spike as
the average age of stores gets into the range of 25-40 years. Most
large retail centers can make it to the 20 year mark without
looking very outdated. So, we will assume the current remodeling
trend continues for the next 10 years.
So, let's look at the last 10 years of data to get a baseline
average per store:
(click to enlarge)
Source: WFM Annual Stakeholders' Reports and 10-Ks 2004-2013,
The 10 year average maintenance capex per store is $534,782.
Adjusting each year's number for inflation, using actual CPI from
each year, gives us a baseline proxy for maintenance capex per
store of $605,764 for 2014. This non-growth capex number that WFM
provides should be a nice proxy for maintenance capex.
However, as previously indicated, I think it also makes sense to
try to estimate store relocation expense and add that amount into
forward estimates of maintenance capex. Even after the U.S. market
has become saturated with WFM stores, there will continue to be
significant capital expenditures associated with store relocations.
The desirability of particular areas and particular shopping
centers changes over time. Naturally, this will lead to some store
relocations ongoing each year.
The last 10 years can also give us a baseline for this
(click to enlarge)
Source: WFM Annual Stakeholders' Reports and 10-Ks 2004-2013,
Over the last 10 years, WFM has had to relocate 1.76% of its
stores per year, on average. This number can be affected
dramatically by mergers and acquisitions, but we have no way to
know if and when those will occur. So, we'll have to use 1.76% as a
baseline number going forward. The inflation adjusted cost of store
relocations over the last 10 years has been $3.32 million per
So, we've pretty much got the basic information we need to be
able to model our best estimate of maintenance capex going forward.
But we also need to be able to model CFO. Since we are looking at
everything else on a per store basis, it makes sense to do the same
with CFO. The last 10 years, WFM has delivered an inflation
adjusted average CFO of $2.39 million per store.
As for the number of stores modeled going forward, I use the
midpoint of management estimates for new stores opened over the
next 2 years and then a 9% growth rate thereafter. The other
numbers are adjusted for an inflation factor going forward of 3%
(click to enlarge)
This model is showing an 8.8%, 10 year growth rate in Owner's
Cash Profit (from the current level of my version of OCP, $838
million). That's growth in a number that starts from a relatively
attractive current yield of 5.5% (though my model reverts back to
average, inflation adjusted CFO per store, which means a dip in OCP
for 2014-2015). My model basically assumes that real same store
sales growth, while very strong over the last 10 years, will grind
to a halt, and that CFO per store will simply rise with inflation.
So again, my model is conservative in some ways.
However, the actual result of CFO per store will be highly
sensitive to gross margins staying level at their historical
average, as well as SG&A expenses rising in line with
historical averages per store, adjusted for inflation. If SG&A
expense is not strictly controlled, and/or COGS as a percentage of
sales revenue continues to creep up, this scenario won't look
nearly as positive.
Also, this model assumes no recession in the coming 10 years,
which there almost certainly will be. So, while conservative in
other ways, 9% average annual store count growth might be
considered quite rosy. But the company has grown the store count at
increasing rates the last two years (store count growth was 4.01%
in 2011, 7.72% in 2012, and 8.06% in 2013).
As a relevant aside, I think it's likely that WFM would have to
acquire one of its up and coming competitors in order to reach its
goal of 1,200 stores anytime soon. But I wouldn't feel comfortable
trying to model a hypothetical acquisition. Too many questions
arise. Would they buy a firm that has a complementary footprint?
Does such a firm exist? What would be the effects of
cannibalization? How many stores would have to be closed? Would
they issue stock to make the purchase? Debt? You get the idea.
Also, the company says they don't expect acquisitions to be
material going forward. So let's continue to work on the assumption
of organic growth.
The company estimates the store count growth to be roughly 9-11%
the next two years. Further, they continue to indicate that they
see 1,200 stores in the U.S., long term. They simply aren't going
to get to 1,200 stores in any meaningful time frame without trying
to speed up the growth rate at some point, so 9% as a forward
looking 10 year average could be quite realistic.
Challenges are clearly present. But, WFM has done a great job of
growing its store count while maintaining and even growing gross
margins, controlling high level corporate expenses, and increasing
CFO in the past. There's good reason to believe that while the near
term presents challenges, the company retains competitive
advantages and can produce good operating results in the future. If
they do, and WFM is producing Owner's Cash Profit of $1.9 billion
10 years from now, owners of this stock should be pretty happy.
But there's one remaining problem with this scenario, and that's
the previously mentioned issue of share dilution:
(click to enlarge)
Over the last 10 years, WFM has diluted existing shareholders
through both the issuance of convertible securities, and through
stock based compensation. For example, in 2008, the company issued
425,000 shares of convertible preferred stock that was converted in
November 2009 to a split adjusted 59.4 million shares of common
stock. This is why it's difficult to model total share dilution
going forward. The company has, in the past, been more than happy
to issue new shares to fuel growth. If they were to continue this
policy in the future, that would make it difficult to gauge the
benefit to existing shareholders of the company reaching its goal
of 1,200 stores in the U.S.
However, my model doesn't assume that they will get even close
to 1,200 stores in 10 years. I've tried to model a growth rate in
store count that is reasonable for the company to fund with its own
cash generation. So we're basically assuming that the company won't
issue new shares in order to achieve a higher growth rate in store
count (above 9%), or that if they do, the net effect won't be
The company has said that it plans to use CFO to fuel growth
going forward, at least for the foreseeable future. Indeed, the
company appears to have matured to the point that it is no longer
issuing shares or taking on debt in order to fuel growth. Instead,
it is producing strong CFO, growing without tapping capital
markets, and paying dividends. That allows us to focus on the other
Here are a few relevant excerpts from WFM's most recent Annual
From page 28:
[The Company intends to keep its broad-based stock option
program in place, but also intends to limit the number of shares
granted in any one year so that annual earnings dilution from
share-based payment expense will not exceed 10%. The Company
believes this strategy is best aligned with its stakeholder
philosophy because it limits future earnings dilution from
options and at the same time retains the broad-based stock option
plan, which the Company believes is important to team member
morale, its unique corporate culture and its success.]
From page 30:
[The Company maintains several share-based incentive plans.
We grant both options to purchase common stock and restricted
common stock under our Whole Foods Market 2009 Stock Incentive
From page 26:
[We believe we will produce operating cash flows in excess of
the capital expenditures needed to open the 94 stores in our
current development pipeline.]
So, the company expects new store openings to be funded by
operating cash flows. We're not concerned with modeling any growth
related dilution, such as the issuance of new shares to fund an
acquisition. Further, it's reasonable to assume that much of the
share dilution to be expected going forward will be the result of
WFM's policy of awarding stock to its team members across the
It should be noted that the company is not enriching senior
management at the expense of shareholders. Last year 14,000 team
members exercised options for an average gain of $8,400. Since
inception, approximately 95% of the equity awards granted under
WFM's stock plan have been granted to team members who are not
executive officers. This policy is great for the company, great for
the employees, and great for society. They also allow employees to
purchase stock at a 5% discount to market price, which results in
further share dilution. Personally, I think it makes all the sense
in the world to promote an ownership culture among employees and
award their hard work with shares of the business. But, potential
investors simply have to calculate the effects of this policy when
pricing the security.
Again, the policy in question is the issuance of new shares of
stock due to stock based compensation. In the case of WFM, we can
pull the number "Issuance of common stock pursuant to team member
stock plans" from the Statement of Shareholder's Equity. Using the
average stock price during the year (calculated from YCharts data),
we can estimate the total dollar cost required to offset the
dilution that occurred. That number should encompass the cash
inflow associated with the exercise of options, the employee stock
purchase plan, etc. Basically, we have to add back in the
associated cash inflow to the company, which is highly significant
in the case of WFM. There are many moving parts, but to get our
best estimate of that number, we can pull in the cash inflow
associated with "Issuance of Common Stock" from the Cash Flow
After we pull all of this information and perform the necessary
calculations, we can then account for the dollar cost associated
with offsetting share dilution, as a percentage of CFO:
(click to enlarge)
Finally, we can calculate the present value of estimated future
net Owner's Cash Profit, with the "net" meaning net of the effects
of non-expansionary share dilution (Kobayashi-Solomon uses a
somewhat similar process that results in what he calls Free Cash
Flow to Owners). Then, we can apply the current multiple for net
Owner's Cash Profit (which is 23.2), minus a 20% haircut to get the
future market cap of the company. I think the 20% haircut on the
multiple is appropriate because as the market becomes saturated,
growth expectations at that point are likely to have become
significantly lower than they are today. I use a discount rate of
9.5%, which is in line with the historical average for equities,
and pretty much what I expect to get from investing in stocks. The
result is that the model gives a fair value for the price of WFM
stock to be $44.62.
(click to enlarge)
As you can see, I haven't been able to determine that WFM is
incredibly undervalued at the moment. Of course, there are other
methods of valuation besides the one I've presented here. But even
after accounting for the effects of ongoing share dilution, the
stock is undervalued by about 9% according to this particular
However, as I analyzed and modeled the business, I found that it
is extremely sensitive to small moves in gross margin. If gross
margin drops just a few points from its historical average of
34-35%, the scenario isn't nearly as rosy. Further, competition is
increasing. That's very clear. It's surely not easy for the
management of this company to keep average gross margin in the
range of 34-35%, even without the increased competition. They also
have to work hard at keeping SG&A expense growth from getting
out of control as they grow. There is no doubt this company has
However, they continue to be a market leader. They have a strong
first mover advantage. Their business model and position in the
market place, and their fierce customer loyalty is not easily
replicated. They have sustainable competitive advantages (if you'd
like more detail about that, please check out my full report). The
market for organic and natural foods still has plenty of room to
grow. All of these facts have pretty much led to intense investor
loyalty in the past. So, the recent drop in price does not
necessarily mean that new investors are getting a huge bargain.
Instead, it means that the stock is no longer priced for
perfection. Investors are starting to price in the possibility that
the company will struggle to reach its goals. But that's only one
possibility. Real same store sales growth could continue. They
could grow their store count at a rate greater than 9%. They may
have massive potential internationally. They could continue to
capture more and more fiercely loyal customers as awareness of
their brand and mission continues to increase. There are plenty of
reasons to believe WFM, at the moment, represents ownership in a
great company at a very reasonable price.
There are much worse things you can do with your money than to
buy shares of a great company at a reasonable price. Thank you so
much for reading and best wishes in your investing!
I am long WFM. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
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