WFM

Whole Foods Market, Inc. (WFM)

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Whole Foods Market, Inc. (WFM)

Q1 2013 Earnings Conference Call

February 13, 2013, 05:00 PM ET

Executives

John Mackey - Co-Chief Executive Officer, Director

Walter Robb - Co-Chief Executive Officer, Director

Glenda Flanagan - EVP and Chief Financial Officer

A. C. Gallo - President, Chief Operating Officer

David Lannon - EVP, Operations

Jim Sud - EVP of Growth & Development

Ken Meyer - EVP of Operations

Cindy McCann - Vice President of Investor Relations

Analysts

Priscilla Tsai – JPMorgan

Karen Short - BMO Capital Markets

Sean Naughton - Piper Jaffray

Jason DeRise - UBS

Kate Wendt - Wells Fargo

Stephen Grambling - Goldman Sachs

Mark Wiltamuth - Morgan Stanley

Presentation

Operator

Good day, everyone and welcome to the Whole Foods First Quarter Earnings. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the Q&A session. (Operator Instructions)

It is now my pleasure to turn the conference over to Cindy McCann. Please go ahead.

Cindy McCann

Good afternoon and thank you for joining us. On today’s call are John Mackey and Walter Robb, Co-Chief Executive Officers; A.C. Gallo, President; Glenda Flanagan, Executive Vice President and Chief Financial Officer; Jim Sud, Executive Vice President of Growth & Development; and David Lannon and Ken Meyer, Executive Vice Presidents of Operations.

As a reminder, all forward-looking statements on this call are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions discussed today. This may be due to a variety of factors, including the risks outlined in our Company’s most recently filed Form 10-K.

Please note our press release and scripted remarks are available on our website. We assume you have read our press release, so we will use this time to focus on highlights from the quarter as well as our future outlook.

I will now turn the call over to Walter Robb.

Walter Robb

Thank you, Cindy. Good afternoon everyone. In Q1, we produced a 20% increase in earnings per share on a 14% increase in sales, delivering another quarter of strong sales and earnings growth. We opened 10 new stores, more than we ever have in a single quarter, and reported record Q1 results including a 22 basis point increase in gross margin to 35.0%; a 30 basis point decrease in direct store expenses to 25.4% of sales; a 52 basis point improvement in store contribution to 9.6% of sales; a 48 basis point increase in operating margin to 6.1%; a 41 basis point improvement in EBITDA margin to 8.8%; and a 24 basis point improvement in return on invested capital to 13.1%.

Our solid performance and capital discipline generated $148 million in free cash flow during the quarter. We produced $316 million in cash through a combination of $303 million in cash flow from operations and $9 million in proceeds from team member stock option exercises. We invested $155 million in new and existing stores, repurchased $26 million of common stock, and returned $397 million in dividends to our shareholders, including a special dividend of $371 million. We ended the quarter with cash and investments of $1.2 billion and $446 million in share repurchase authority.

Turning to sales, our identical store sales increased 7.1%, or 15.3% on a two-year basis, in line with the idents we reported for the first five weeks of the first quarter. We saw a 5% increase in transaction count and 2% increase in basket size. The moderation in our sales trends since the fourth quarter was broad-based across regions, store departments, and store age classes, which we attribute in part to a decline in consumer confidence and the macro environment.

We also had a tougher comparison in transaction count, as we saw a nearly 200 basis point sequential increase in our transaction count growth from Q4 of 2011 to Q1 of 2012. On a two-year basis, our 11% transaction count increase this quarter was approximately in line with last quarter. Transaction count increases continued to drive our growth, and the increase in our basket size was driven entirely by a higher average price per item, as we selectively passed through some product cost increases and as customers continued trading up. In keeping with what we’ve reported over the last two years, we saw year-over-year shifts in sales towards exclusive brands and organic products, higher-priced tiers, and several discretionary categories, as well as a meaningful increase in $50 plus sized baskets.

We are continuing to find ways to further differentiate our product offering. Following last fall’s successful launch of 70 new exclusive brand frozen products, in January we launched the Engine 2 Plant-Strong product line. Developed in collaboration with Rip Esselstyn, author and founder of “The Engine 2 Diet,” these products complement our Health Start Here initiative, offering plant-based foods that are low in fat and sodium, contain minimal to no added sugar, and no animal products or added oils.

During the quarter, we opened nine stores in Ontario, Canada; Davis, California; Littleton, Colorado; Cheltenham, England; Tampa; Boise; Orland Park, Illinois; Columbia, South Carolina; and Virginia Beach; and we relocated one new store in Tucson. This is the first quarter ever where we’ve opened stores in three different countries. Our new stores range in size from 20,000 to 43,000 square feet and are located in a mix of urban and suburban areas, as well as new and existing markets, demonstrating the breadth of opportunity for Whole Foods Market stores across the U.S., U.K. and Canada. Please check out the Beyond the Numbers section of our Investor Relations webpage for additional information about our new stores, Engine 2 products and more.

Fiscal years 2001 and 2002 were the two of the very best years in our company's 33-year history. And our outlook for 2013 reflects a better year of healthy comparable store sales growth, continued operating margin improvement and record new store openings.

Based on the year-to-date results, we have fine-tuned our fiscal 2013 ranges for cost and idents, keeping the midpoint approximately in line with our prior guidance. We are maintaining a $2.83 to $2.87 range for EPS, which implies $2.05 to $2.09 for the remainder of the year. The high end of this EPS range would require a meaningful acceleration in comps to the high end of our ranges.

As reflected in our guidance, we do not expect to produce the same level of EPS growth on the remainder of the year as we produced in the first quarter. We know that one of the keys to broadening our appeal when growing our sales over the longer term is to improve our relative value positioning.

Last year we produced record gross margin results, particularly in Q2 and Q3 of 36.3% and 86% respectively. While we do expect to continue to deliver strong results, the ongoing strategy that we have communicated is that we intend to expand our value offerings across the store and improve our competitive price positioning. As such, we are not forecasting an improvement in gross margin this year and given our Q1 results, this implies lower year-over-year gross margin in Q2 through Q4.

We remain on track to open a record number of new stores over the next two fiscal years. In terms of pre-opening and relocation expense, this translates to a back-ended loaded fiscal 2013. For the fourth quarter, we expect the significant year-over-year increase in pre-opening and relocation expense reflecting the opening of 10 to 12 new stores in the quarter along with a high number of openings in the first quarter of 2014 as well.

We remind investors that fiscal year 2013 is a 52-week year comparing its 53 weeks of fiscal year 2012 with the extra week falling in the fourth quarter of last year. Since our fourth quarter earnings release, we have signed 11 new leases averaging 39,000 square feet in size. With 29 new stores opened and 48 new stores signed over the last four quarters, we are demonstrating our ability to execute on our accelerated growth plans while paving the way for that growth to continue.

We currently have 85 stores in development, totaling 3 million square feet and representing 24% of our operating store base. Our new stores are delivering healthy returns. For the last seven quarters on average, our new store class has consisted of 23 stores open for approximately six months. At 37,500 square feet in size, they have produced average weekly sales of $554,000 translating to sales per square foot of $764, and have generated the contribution margin of just over 5%.

These results combined with our lower average capital investment and pre-opening expenses per store enabled us to deliver another quarter of high return on invested capital. For the quarter, our 23 comparable store sales less than two years old produced an ROIC of 14%, the strongest quarter one result we have reported in eight years.

For the 16th year in a row, we were recognized by the Fortune magazine as one of the 100 Best Companies to Work For in America and we are very proud to have accreted over 7,800 jobs over the past year and are seeing low turnover and high morale as our team members embrace the advancement opportunities that our growth offers.

Each week, over 6 million customers visit our 345 stores in 40 states and three countries. We are well positioned to internally fund our expansion plans and have the pipeline and infrastructure in place, our ending square footage growth to accelerate through 2014 and hopefully beyond.

We believe we will maintain our leadership position and continue to gain market share as we step up our new store openings, improve our relative value proposition, further differentiate our shopping experience and reinforce our standing as America's healthiest grocery store.

We will now take questions. Please limit yourself to one question at a time so that everyone has an opportunity to participate. Our call will end at 4:30 Central time. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). We'll go first to Ken Goldman with JPMorgan. Please go ahead.

Priscilla Tsai - JPMorgan

Hi, good afternoon. This is Priscilla Tsai in for Ken today. So you took that in your guidance as a percent of sales from new stores from 6% to 7% to now just 6%. So I'm just wondering if you can have to understand what drove this change and is it just the timing of store openings this year or it is something different you’re expecting from new store productivity?

Glenda Flanagan

There is nothing written significantly different that we’re expecting. It’s just fine tuning our results now that we have 19 weeks behind us.

Priscilla Tsai - JPMorgan

Okay. And could you give us any more color on any impact from Nemo or the counter shift on the quarter to date comp number that you report in?

David Lannon

This is David Lannon. Our north Atlantic region was the region that was most impacted. We’ve gained so much experience with dealing with storms with super storm Sandy, what happens in hurricanes in Norlands and the one we were able to nearly get all of our stores reopened. We only had one store without power. The challenge was is customers couldn’t get to the stores for up to three years. So it is definitely an impact for our stores in throughout New England as well as into New York. We are still kind of qualify – quantify what that number is, but we’re really pleased with our efforts to how quickly we’re able to reopen the stores and that’s kind of what happened.

Priscilla Tsai - JPMorgan

Okay. Thanks.

Operator

Thank you. We will go next to Karen Short with BMO Capital Markets. Please go ahead.

Karen Short - BMO Capital Markets

Hi just following on that, you commented on a holiday shift. Can you just clarify what exactly the holiday shift is and then I had another question.

Walter Robb

The Valentine’s Day happened earlier this year – last year, than this year. So that’s the leap year.

Cindy McCann
Yeah, Karen this is Cindy. The Valentine’s Day was on Tuesday last year, so we would have expected to see sales on Sundays from that. And then it’s making it hard to quantify the impact of the storm as right now we’re seeing the negative impact of that shift week today.

David Lannon

And we’ve only got three weeks in the second quarter number so far. We’ve been affected by Valentine’s Day and the storm. So personally, I wouldn’t read too much into those three weeks, it’s too early to tell anything.

Karen Short - BMO Capital Markets

Okay, great. That’s helpful. And then I’m just curios, I know you kind of think cautious in your comments on, I guess, forward looking gross margin et cetera. And it seems like to me that caution is maybe conservative, because things are really going very well for you guys that turning specifically to gross margin, it seems like your price gap has really narrowed versus your competition and, I guess, I’m wondering given the quality of your offering, and everything that you guys have been working towards in terms of price investments. Do you really need to keep investing in price?

David Lannon

Yeah, we’re going to keep investing in price. You say the gaps narrowed, that’s true. We would like to eliminate it while maintaining high quality. We think that’s a competitively very strong position to be in. So, yeah we're going to continue. This is very important. We think that – we think our competition is increasing around the country and we think that we’re going to continue to invest – in price we’re going to continue to try to improve our value proposition while continuing to differentiate and evolve our product mix. We are going to do both.

Walter Robb

Let me add a little, this is Walter, I’m going to say that, Karen it’s a really moving environment out there, and we want to give our self the room to be able to continue to improve our position and the bigger price here that, I know you shared this view is that the – the market is getting bigger and we’re going for the big price which is, those folks that are not eating as healthy. The fresh healthy food market is very large, and we think by continuing to improve our position we have actually got a much bigger market than we’re currently serving. So, this is an important point that giving our self the room to continue to do this.

Glenda Flanagan

And we do just want to remind everyone that the gross margins that we had last year in Q2 and Q3 were extremely strong and as we said at that time, we did not think that level of margin was sustainable. So, while in our own forecasting we’re projecting sequential increases in Q2 and Q3 as we would normally see. Seasonally we’re not projecting year-over-year increases like we saw in Q1.

Karen Short - BMO Capital Markets

But just to clarify, is it fair to say you don’t really see any change in the environment from a competitive or consumer perspective, you just think this is an opportunity to continue to gain share?

David Lannon

That’s what we’re thinking. That’s our strategy. Yeah, that’s how we see it.

Karen Short - BMO Capital Markets

Okay. Thanks.

Operator

Thank you. We’ll go next to Sean Naughton with Piper Jaffray. Please go ahead.

Sean Naughton - Piper Jaffray

Hi; just one clarification and then I have another question. Given the impact of Sandy was about $3 million from spoilage and other things. Should we expect something similar in the second quarter from Nemo; and then secondly just looking at the comps by the vintage it looks like some of the biggest declines were in some of your younger stores sequentially. Is there anything changing in the new store productivity curve that we should be thinking about in our modeling? Thanks.

Glenda Flanagan

This is Glenda. With regard to the first question about the impact of the storm, Sandy was a much bigger storm than Nemo was. So, we wouldn’t expect probably the same degree of earnings per share impact. It's harder to say the same thing about sales, because as David pointed out earlier the difference is that customers were unable to actually get to the stores this time around versus last time around. So, that’s the first question.

David Lannon

Regarding the second question, it's kind of what I’ve said actually many times on these calls which is, don’t make too big a deal on a one quarter, and there’s nothing that fundamentally changed or shifted at Whole Foods Market. Some stores are into the comp base each quarter and some stores drop out of the comp base each quarter. So, if you go back and look at previous quarters you will see that, it's not, I mean, other than the older the stores generally there lower the comps are, although you still have very good parts for stores that are 15 years of age or older. So, it could be very different next quarter, because the mix of stores is dynamic. It continues to change in a while so I wouldn’t read too much into one quarter’s results.

Glenda Flanagan

There was not any one thing across that age group, it was due to a variety of factors.

David Lannon

Exactly.

Sean Naughton - Piper Jaffray

Okay, thanks.

Operator

Thank you. We’ll go next to Jason DeRise with UBS. Please go ahead.

Jason DeRise - UBS

Hi, thanks for taking my questions. I just wanted to touch on the comp sales and the gross margin together. First it's been said in the past that Whole Foods just does an 8% comp and that’s what the average has been aside from the financial crisis and now that's sort of the upper end of the range. And I'm wondering if the gross margin investment is expected to get the comp sales back up to that range?

Glenda Flanagan

Well, we have never said anything about a crisis but it is true that historically our comps have averaged about 8% and without any long-term evidence to the contrary, we do believe that that is at this time the best prediction of our future longer term results that if you see our guidance, we are -- the 8% is within the range that we're predicting for the year although that is higher than what we saw in the first quarter. But we -- ident range for the remainder of the year is 6% to 8%.

John Mackey

And it's also true that the current macro environment's a little uncertain, a little unsteady and we won't know exactly what that is, it's hard to quantify. I think it’s hard for anybody to really quantify what we’re currently in right now with uncertainty. But again, the bigger picture here is where we're trying to go over the medium to long term in terms of continuing to grow the company. And we think that an incremental path to gross margin investments is what gets us, they’re the best to continue to grow our company, continuing on our sales and our costs.

Glenda Flanagan

We're not saying anything different about gross margins than what we've been saying for many quarters, and our guidance has not changed from what it was previously.

Jason DeRise - UBS

Can I ask a follow-up on that, because I mean the pricing is really set very locally and I think in the comments you mentioned that's a -- the basket is actually driven by, I guess, mix and price. So are the store managers buying into it as comp sales slowed? I mean what can you, I guess, add about how the company thinks about it at lower levels?

John Mackey

It's a big inaccurate to say that the prices are set locally and that the store managers set the pricing. A lot of the pricing…

Jason DeRise - UBS

I guess regionally.

John Mackey

Well, a lot of the pricing guidance does come from the global office and they work together with the regional folks to set the pricing. You'll notice there are a few local items where the price is set locally. But if you look around the country, you'll see that for the most part, the pricing is very similar in most regions and stores in our company. Expect for maybe a couple of items, it might be unique to those markets.

David Lannon

This is David. The only thing I would say is we're real bullish on our value programs and our promotional activity that we are doing mainly because we had such excellent expense control and cost of goods control that we're continuing to push with our regions and our regional operators reduction in shrink and loss and then that gives us some more runway to do more promo and do more value items. It's also clear that this is an environment where value is important to customers and I think we're stepping into that along with the quality and differentiations.

John Mackey

It's easy to sit and look and say, well, this quarter the margin's up, this quarter the margin's down. But it's not -- the marketplace is way more dynamic than that and things happen. You've been in situations where in a quarter -- this happened to us last year in Q2 and Q3, several things came together. There was good weather. There wasn't a lot of loss. There was no freezes in the produce growing areas. A lot of things will fall favorably and we had a couple of quarters of strong margins. But we know that you can't expect that it is going to revert back to what our norm has been over time.

This year, we're dealing with freezes and cold weather in California. It has really affected produce margins. Some commodity prices were up and there were a lot of things that affect margins. So all we can really say is that on a year-to-year basis, we're going to hit -- it's going to be the average. Some quarters it's going to go above, some quarters it's going to go down but there is no great change in our pricing philosophy. It just works out this way sometimes.

Jason DeRise - UBS

Thank you. I appreciate it. Thanks.

Operator

We'll go next to Kate Wendt with Wells Fargo. Please go ahead.

Kate Wendt - Wells Fargo

Hi. Thanks. So you talked a lot about price and last quarter, you provided some data in terms of your pricing gains relative to competitive set. I wanted to see if you could provide an update on that as well as any gains in new customers? I know that last quarter, you mentioned you gained 22% more new customers and I'm wondering whether the benefit in that increase will just take longer to play out as you try to convert them to more regular customers?

John Mackey

It's fair to say in this particular quarter, Kate that we went sideways on that index. We did not make additional progress. We saw a lot of movement from our competitors ongoing down and it’s better to say that we did make a progess we hope to make this quarter. So out of what percent here is that we continue, we’re on that path and that’s why we didn’t really bring that point out for this particular quarter.

Kate Wendt - Wells Fargo

Okay. And anything on the new customers, how we should think about that in terms of how that typically plays out when you first acquire them until you can potentially convert them to more frequent customers?

Walter Robb

I don’t know, we don’t really have an update on that for you. We do the work with Nielsen on the new loss retain study and we’re continuing that – there wasn’t any material different in this particular quarter that we’d highlight for you right now. So, I don’t think we have anything to add in this particular quarter on that.

Kate Wendt - Wells Fargo

Okay. Thanks so much. (Indiscernible).

Walter Robb

The biggest thing in this quarter was the decline in transaction count which we referenced in the script and we have been running 80-20 for the last sort of two years. We are running sort of 65-35 in this and we kind of talked about in the script, that’s the biggest change in this particular quarter.

Kate Wendt - Wells Fargo

Okay. Got it. Thank you.

Operator

We will go next to Stephen Grambling with Goldman Sachs. Please go ahead.

Stephen Grambling - Goldman Sachs

Thanks for taking my question. I’m not to beat a dead horse here, but just was hoping to get a little more granular on some of the gross margin commentary you’ve had in the past, specifically on rent leverage shrink and then lower day’s inventory on hand. Those seem like they had been actually a big benefit in the past and is there anything that’s changing on those line items that we should be aware of going forward?

Glenda Flanagan
We saw those same benefits in the current quarter leverage in those line items.

David Lannon

Yes, this is David, I would say that we’re accelerating our efforts on shrink. We are essentially scaling in our shrink of cost to entire Company at this point. So all of our losses are moving from – we’re fully recording everything at this point. We are moving to a more detailed forecasting, so in other words we don’t have to throw it away, if we don’t have to order it in the first place. So we’re making the efforts in shrink and those are accelerating, which again gives us more runway to focus on value.

Ken Meyer

This is Ken. The other aspect is the analytics that we’ve really been tapping into across regions on a global level, provide an incredible way for us to be more precise with how we price and more surgical with what we’re doing and that’s just – that translates in some better promotional and pricing image in the stores and it’s been a very strong focus on the evolution for the Company.

David Lannon

And again just a final, if you look at the numbers, the cost of the cost of goods reduced actually 22 basis points from the quarter, and if you look at some of the (indiscernible) produce with the meat diaries we have seen significant gains in our leverage on the global buying office, I think we’ve navigated well through some of the potential beef increases it didn’t have all that, maybe potentially could have happened and we did an excellent job on froze buying using our skill set there. So, I think that was also a contributing factor to the number.

Stephen Grambling - Goldman Sachs

And I guess just a quick follow up there is just on the rent side, it looks like rent per square foot was actually down year-over-year, maybe I’m calculating that wrong, but is that also something that should continue going forward?

Glenda Flanagan

That can vary significantly just depending upon the rent vary so much from market-to-market that it can vary depending upon where the concentration in stores happens to be and what movement we’re seeing there, so …

Stephen Grambling - Goldman Sachs

I mean, I guess with the leases that you’ve signed, is there anything to be aware of?

Walter Robb

Well, we’re definitely seeing lower rents on the leases, that we’re signing and the opportunities that we’re continuing to see. So, I think it’s definitely a positive trend for us and on the rent that I believe will continue.

Stephen Grambling - Goldman Sachs

That’s very helpful. Thanks so much.

Operator

Thank you. We will take our final question from Mark Wiltamuth with Morgan Stanley. Please go ahead.

Mark Wiltamuth - Morgan Stanley

Hi. I want to ask about the comment in the release about square footage growth accelerating. You’ve been 8.5% square footage growth here on this quarter. Do you think you’re going to be above that 9% range for 2014 or just give us some comments on what’s going on with the real estate right now?

Walter Robb

Ken?

Ken Meyer

Well, we’ve given the guidance for our new store open for 2013 and 2014. There is no change to that. I’m not sure that how that affects our square footage growth.

Glenda Flanagan

We did make the comment that we hope to see square footage growth accelerate beyond 2014 and obviously we’re very excited about all the opportunity we see out there. We’re very excited about all the diversity in terms of the markets that we can go into. So that's what that comment alluded to.

David Lannon

This is David. Also, we're really excited our recent acquisition of Foodmaster in Boston, we're going to be opening all those stores over the course of the balance of the year. So, we're excited about that acquisition and we're looking for others.

Mark Wiltamuth - Morgan Stanley

Okay. While most of your analysts are over here in London, any stores we should check out that you guys opened recently over here?

David Lannon

Piccadilly stores, it's a fantastic store. It's very reflective of what we've done in the States and actually I think it's a notch above in some ways. And it's an exciting environment to go into with very unique offerings in prepared foods and in Whole Body and its great. And also the newly remodeled Kensington store is another place you should visit because they've done some great evolution of their prepared foods programs and you can really see that. So that movement in the UK being very, very strong and focused forward.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you very much.

John Mackey

All right. Thank you everybody for listening in. Please join us in May for our second quarter earnings call. A transcript of the scripted portion of this call along with the recording of the call is available on our website. Thank you very much for listening and take care everybody.

Operator

This concludes today's program. We do appreciate your participation. You may disconnect at any time and have a great day.

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