Sales Figures Disprove Thesis That Whole Foods Shoppers Are Fleeing To The Competition

I wanted to briefly follow up my post from yesterday (The Death of Whole Foods Market is Likely Greatly Exaggerated) with a telling chart. The financial media has been reporting that Whole Foods Market (WFM) is being hurt by lower cost natural food grocery stores, thereby implying that the company has less brand loyalty and differentiation than some had previously thought. I would challenge the notion that WFM is losing customers to other stores. While it could happen in the future, the sales data show that WFM’s sales per store are actually continuing to rise:

WFM-AWS-2001-2014

Not surprisingly, the growth in average weekly sales per store peaked in 2007 and dropped 11% during the 2008-2009 period. Customers came back quickly post-recession, however, enabling WFM to reach record sales per store just two years later in 2011. Not only have sales increased every year since, but they are continuing to rise this year. This is definitely a number to watch as times goes on to gauge potential customer defections, but the idea that Whole Foods stores are beginning to really struggle is completely unfounded if you look at the data. It might make for a good story, but it’s not very helpful for investors.

The Death of Whole Foods Market Is Likely Greatly Exaggerated

I am always amused (and oftentimes thrilled) when Wall Street wakes up one day and decides a company’s fate has changed forever, despite very little actual evidence supporting such a view. Severely harsh winter weather earlier this year put a lid on sales and profits at many retailers, and the result has been very poor stock market performance for many consumer-oriented companies. Others have been hit by worries over online-only competition or simply an increase in the number of players competing in the marketplace.

Consider Whole Foods Market (WFM). The pioneer of the natural food grocery business has gone from market darling to growth stock has-been in a matter of months, with investors sending the stock down nearly 20% in a single day after the company released its most recent earnings report, and the shares now sit at multi-year lows. How bad was WFM’s first calendar quarter of 2014? Well, the company reported record sales and record sales per square foot at its stores. Same store sales rose a very impressive 4.5% versus the prior year. But Wall Street focused on profit margins, which narrowed slightly year-over-year and quickly concluded that Whole Foods is dead, a victim of ever-growing competition. After reaching a high of $65 late last year, the shares now trade in the high 30’s.

WFM-2YR

With all of the new competition aiming squarely at Whole Foods, how can they possibly compete effectively and continue to post strong financial results for their shareholders? Recent stock market action is telling us that investors have given up on the company. The media headlines have been extremely negative too. Nonetheless, in the face of extreme pessimism, I am a buyer of the stock. Let me tell you why.

There is no doubt that Whole Foods is facing more and more competition every day. For years people thought the natural foods business was a niche market, but now they are coming to realize that it has gone mainstream in many markets across the country. Not only have traditional grocery stores added natural and organic sections to their stores, but smaller Whole Foods wannabes are popping up too. In fact, many of them are newly public, such as Sprouts Farmers Market (SFM), Fresh Market (TFM), and Fairway (FWM). But guess what? They can all coexist.

As consumers opt for healthier food, natural foods will increase their share of the overall food market and there will be plenty of room for multiple players to operate stores profitably. Witness Whole Foods’ +4.5% same store sales number for last quarter. If people were really leaving Whole Foods and switching to these other stores (the bears say price will be the biggest reason), their sales would not be rising faster than the rate of food inflation. Despite new competition (Sprouts and Fresh Market combined have nearly as many stores nationwide as Whole Foods, and all three are doing very well), Whole Foods has a very loyal customer base and there are few signs that they will abandon Whole Foods.

I think a great way to think about the future of Whole Foods is to compare it to another strong pioneering consumer brand that sells a high-end product to a very loyal customer base and has faced enormous competition over the years; Starbucks (SBUX). The similarities to me are uncanny. Think about how many companies have tried to eat into Starbucks’ growth in the specialty coffee market. Scores of local coffee shops have popped up urging you to support your neighborhood business, and big players like McDonalds (MCD) and Dunkin Donuts (DNKN) have littered the market with me-too coffee options. And what happened? Did Starbucks’ customers flee in favor of a slightly less expensive drink? Not at all. Interestingly, the new players did well too. Both Dunkin and McDonalds sell a lot of coffee, even as Starbucks continues to thrive.

That is exactly how I see the natural foods story playing out. Whole Foods Market will cross the 400 store mark later in 2014. Ultimately they see room for 1,200 stores in the U.S. alone. Their growth is far from over and I expect them to continue to be seen as the leader and industry pioneer for many years to come (just like Starbucks).

Here’s the best part; the stock is cheap and most people don’t realize it. At first blush it doesn’t look undervalued. Whole Foods will earn about $1.50 per share this year and trades at 25 times earnings. A 50% premium to the S&P 500 for a growth company facing stiff competition doesn’t seem like a bargain to most casual onlookers. But you have to dig deeper to see the value.

Since Whole Foods has high capital needs (as it opens new stores at a rapid rate), the company’s operating cash flow dwarfs its reported earnings per share. Depreciation expense last year came to $370 million, or about $1 per WFM share. In fact, WFM generated about $2.70 per share of operating cash flow in fiscal 2013. All of the sudden that 25 P/E multiple comes down to about 14x operating cash flow if you look at actual cash generation.

It gets better. Of that $2.70 of operating cash flow Whole Foods spent more than half of it on capital expenditures, and of that, about two-thirds went towards new store construction. As a result, when we calculate how much cash profit every WFM store generates, we arrive at an impressive $2.25 million. With an expected 400 stores at year-end (which will generate $900 million of free cash flow annually), we can assign a value to the existing WFM store base only, excluding all future development. If we use a very reasonable 15x free cash flow multiple (a discount to the S&P 500), we conclude that the existing store base is worth $13.5 billion.

And that’s the best part of the story. At current prices, Whole Foods trades at an enterprise value of $13 billion ($14.5 billion equity value less $1.5 billion of net cash). That means that investors at today’s prices are buying the existing stores for a very fair price and are getting all future store development for free.

If you share my view of the natural food industry and believe that Whole Foods can continue to be a leader in the market, even in the face of increased competition, then investors at today’s prices are likely going to do extremely well over the next 5-10 years. After all, WFM is only about 1/3 of the way to their goal of 1,200 U.S. stores, and today’s share price does not reflect the likely upside from years and years of future development.

Full Disclosure: Long shares of WFM at the time of writing but positions may change at any time.

Even Great Investors Like Bruce Berkowitz Make Mistakes

I know, I know, the headline above is not earth-shattering news. Every quarter dozens of the world’s best investors disclose their holdings to the world via SEC filings (granted, the data is about 45 days outdated, but it still gets lots of attention). It’s easy for individual investors to follow well-known money managers into certain stocks, figuring that they can piggyback on their best ideas. I can certainly find far worse investment strategies for people to implement, but it is still important to understand that even the best investors make mistakes. And there is nothing stopping the stocks you follow certain people into from being one of the mistakes rather than one of the home runs.

I think this topic fits right in with my previous post on Sears. Not only is Eddie Lampert the company’s CEO and largest shareholder, but he is one of the best hedge fund managers of the last 25 years. It is perfectly reasonable to assume that a billionaire in his position would be primed to create tons of value for investors. And yet, since Lampert orchestrated the merger of Kmart and Sears, which formed Sears Holdings in 2005, the stock price has dropped from $101 the day the deal was announced to $40 a decade later. Adjusted for dividends and spin-offs received over that time, Sears stock has fallen by about 40%, while the S&P 500 index has risen by about 80% during the same period. Eddie Lampert’s ownership and involvement alone has meant little for investors’ portfolios. Simply put, Sears Holdings has been one of his mistakes.

Interestingly, many of the company’s steadfast bulls point to the fact that another very smart and successful investor, Bruce Berkowitz of Fairholme Capital Management, owns 23% of Sears Holdings. That’s right, Lampert and Berkowitz own or control 70% of the company. Berkowitz isn’t new to the Sears investor pool either; he started buying the stock in 2005 just months after Sears Holdings was created. How can both of these guys have been so wrong about Sears for so long? It’s not a tricky question. Neither of them is perfect and they have made (and will continue to make) mistakes. It really is that simple. Since I have written about Eddie Lampert many times since this blog was launched ten years ago, I think it would be interesting to try and figure out why Bruce Berkowitz has been on the losing end of Sears.

Berkowitz’s background is in analyzing financial services companies, which is why you will often find most of his capital allocated to banks and insurance companies. Those industries are his bread and butter. In fact, Berkowitz’s flagship Fairholme Fund had more than 80% of its assets invested in just four companies as of February 28, 2014: AIG, Bank of America, Fannie Mae, and Freddie Mac. If that doesn’t signal his preponderance for financial services companies, I don’t know what would.

Now, Berkowitz has not been shy about why he invested in Sears Holdings; he thinks there is a ton of hidden value in its vast real estate portfolio. Unfortunately, his trading record in Sears (he first bought the stock during the third quarter of 2005 at prices well over $100 per share) shows that real estate might not be one of his areas of expertise. Warren Buffett has popularized the term “circle of competence” and tries very much to only invest in companies he understands very well. That’s why up until recently (his 2011-2013 purchases of IBM shares bucked the trend) Buffett has avoided technology stocks.

I would postulate that real estate investments do not fit squarely into Bruce Berkowitz’s circle of competence. As you will see below, his trading record in Sears underscores this, but we have also seen it with his massive and long-standing investment in St Joe (JOE), a Florida real estate developer.

Below is a quarterly summary of Fairholme Capital Management’s historical trading in Sears stock (I compiled the data via SEC filings). Of the 24.5 million shares Fairholme currently owns, more than 55% (13.6 million) were purchased over a 15-month period between July 2007 and September 2008, at prices averaging about $110 per share. More troubling is that this was when real estate prices in the U.S. were quite bubbly, coming off a string of record increases (most local markets peaked in 2006 and 2007) and Berkowitz was largely investing in the company for the real estate. The timing was quite poor. All in all, if we assume that Fairholme paid the average price each quarter for Sears, the firm’s cost basis is about $85 per share (before accounting for spin-offs).

FAIR-SHLD

St Joe (JOE) has also turned out to be one of his relatively few mistakes. It could certainly be merely coincidence that both the Sears and St Joe investments were made based on perceived (but yet-to-be-realized) real estate value, but I’m not so sure. Like with Sears, Fairholme Capital Management has a very large stake in St Joe. In fact, Fairholme is the largest shareholder (owning about 27% of the company) and Bruce Berkowitz is Chairman of the Board (sound familiar?). Berkowitz started buying St Joe during the fourth quarter of 2007, around the same time he was massively increasing his investment in Sears. His largest quarterly purchase was during the first quarter of 2008 (talk about bad timing), when he purchased more than 9.2 million shares (37% of his current investment).

St Joe’s average trading price during that quarter was about $38 per share, but subsequent purchases have been at lower prices, so the losses here are not as severe as with Sears. By my calculations (see chart below), Fairholme’s average cost is around $28 per share, versus the current price of about $20 each. But again, not only has the investment lost about 30% of its value, but the S&P 500 has soared during that time, so the gap in performance is so wide that it would take a small miracle for either of these investments to outpace the S&P 500 index over the entire holding period, as the returns needed to make up for 7-10 years of severe losses during a rising stock market are significant.

FAIR-JOE

Now, the purpose of these posts is not to point out the few big mistakes two very smart investors have made over the last decade, while failing to mention their big winners. Any of my readers can look at the history of the Fairholme Fund or ESL Partners (Eddie Lampert’s hedge fund) and see that they both have posted fabulous returns over many years. The point is simply to show that sometimes these investors make mistakes, even with companies where they own and/or control a huge amount of the stock. Just because Eddie Lampert and Bruce Berkowitz are involved in a major way (either in ownership, operationally, or both), it does not ensure that the investment will work out great for those who eagerly follow them. Just because they are smart investors does not mean these are “can’t miss” situations. There are plenty of people who are sticking with Sears because of Eddie, or sticking with St Joe because of Bruce. That alone, however, is not necessarily a good reason to invest in something.

I will leave you with one more example of Bruce Berkowitz making a large bet on a stock outside of his core financial services wheelhouse. At the end of the third quarter of 2008 Fairholme Capital Management owned a stunning 93 million shares of pharmaceutical giant Pfizer (PFE). It was an enormous position for him and was featured in many investment magazines. This single $1.73 billion investment represented as much as 24% of end-of-quarter total assets under management for Fairholme, and all of those shares were purchased over a 26-week period in 2008 (more than 3.5 million shares purchased, on average, every week for six months).

FAIR-PFE

Now, given how large of a bet this was, even by Bruce Berkowitz standards, it would have been easy to assume that this investment would be a home run. But as you can see from the trading data above, Fairholme lost money on Pfizer after holding the stock for only about 18 months. During the fourth quarter of 2009 alone, the firm sold more than 73.4 million shares of Pfizer (after having purchased 73.7 million shares during the second quarter of 2008). Perhaps pharmaceuticals aren’t Bruce Berkowitz’s bread and butter either. Fortunately for him and his investors, however, his prowess picking banks and insurance companies has helped him compile an excellent track record since he founded his firm in 1997.

Full Disclosure: No position in St Joe or Pfizer at the time of writing, but positions may change at any time.

Eddie Lampert’s Plan to Keep More Kmart and Sears Shoppers: Help Them Find Out What Appliances Their Friends Have

“How great would it be if you could see what appliances your friends have?”   

— Eddie Lampert, CEO, Sears Holdings

Two weeks ago I flew to Chicago to attend the Sears Holdings (SHLD) annual shareholders meeting. Unlike most of these corporate gatherings, Sears CEO Eddie Lampert takes questions from the audience. Considering that he does not host regular quarterly earnings conference calls or make media appearances, the annual meeting offers attendees a rare glimpse into his thinking as he continues to make the transition from billionaire hedge fund manager to underdog retail executive. While I was not expecting Lampert to divulge many details about his plans to get Sears and Kmart (a merger he orchestrated a decade ago) back to profitability, I did think it would be a chance to try and read between the lines of his comments and determine for myself if he really believes in Sears and Kmart as retailers, or if he simply talks up their prospects because anything else would be un-CEO-like.

The problem I have with Sears Holdings stock, despite the fact that the CEO is the largest shareholder and a self-made billionaire, is that everything that Eddie has done and said over the last decade makes it clear that he believes that he can help turn Kmart and Sears into the relevant retailers they were 20 or 30 years ago. Despite no significant experience in retail, Lampert continues to insist he can “transform” (he likes to make clear that this is not a “turnaround” because the company is changing the way it does business) the company and have it thrive in the most competitive retail environment we have ever seen in the U.S. And this is after a decade of failure in that regard, with sales declining year after year and profit margins negative.

Before taking questions at the annual meeting, Eddie gave a PowerPoint presentation detailing why he is trying to transform Sears and Kmart and how he is going to do it. This is what I was afraid he was going to convey to those of us in attendance; that he is laser-focused on Sears and Kmart as future winners in retail. The plan revolves around four core pillars; incentivizing consumers to shop at Sears and Kmart by offering them Shop Your Way membership points (a rewards card program), offering a Shop Your Way marketplace with millions of items from third party sellers to give members a massive selection of products (think: eBay and Amazon), a social media platform at ShopYourWay.com where members can share advice, research products, and read reviews, and a fast, free shipping program (a cheaper version of Amazon Prime without streaming video).

Lampert’s presentation included a video showing exactly how some of the Shop Your Way products and services are being designed. Among the highlights were e-receipts emailed directly to shoppers, the option to buy online and pick-up in store, curb-side store pick-up where an employee will bring your items out to your car so you don’t have to come inside, employees with tablets helping shoppers in-store, radio frequency identification (RFID) inventory management to ensure stores are stocked appropriately, and digital signs in the store that allow for instantaneous pricing changes and the ability for shoppers to read online reviews as they are looking at the product on the shelf.

He also gave examples of transformation attempts by three other companies; Apple (cost cuts plus successful new products), General Dynamics (divestitures followed by new products), and Kodak (unsuccessful acquisitions that led to bankruptcy). He was quick to state that he was not saying that Sears is like any of those three companies (I would hope not… none of them are retailers). Instead he wanted to point out the sometimes R&D makes sense (Apple), sometimes spin-offs and refocusing on new areas make sense (General Dynamics), and sometimes going on a massive acquisition spending spree because your core product is dying (Kodak, with film) is not the right strategy.

Interestingly, my reaction was somewhat different. I think everybody can point to cases where a certain strategy worked or didn’t work. There are always two sides to every coin and no assurances that a certain path will be successful. The thing I found strange was that he didn’t use any examples in the retail industry. Why not explain why Caldor and Woolworth are no longer in business? Why not talk about how Dayton Hudson was transformed into Target and was a massive success?

Instead, Lampert tried to convince us that he has a vision for where retail is going and Sears is going to lead the industry in getting there. Oddly, this came shortly after he admitted that the reason for the Kmart/Sears merger was to take Sears’ brands off-mall (into Kmart stores as well as new Sears store formats like Sears Grand and Sears Essentials, both of which failed) where retailers like Target and Wal-Mart were expanding. He admitted that was a huge failure and is now actually closing off-mall Kmart stores and renovating Sears stores in the best mall locations they have across the country. His vision was dead wrong back then, but this time around he is going to be right? Why?

He also admitted that all of his retail advisers told him to shut down hundreds more stores after the merger, but he refused and wanted to give them time to get into the black. Now that they are still not making money, he is finally closing them at a faster pace (more than 100 store closures this year are likely, by my math). It just proves that he does not have successful retail experiences to draw from, and as a result is unlikely to turn this ship around.

You may have the same reaction to all of this that I did while sitting through Lampert’s presentation. I couldn’t help but wonder what was different about this shopping experience that Sears was moving towards. Other retailers are already doing these things. In order for Sears and Kmart to really stop the market share losses they have been sustaining for years now, and get back to profitability, they need to be unique. They need to give shoppers a reason to decide that Kmart and Sears really are relevant now, like they were in 1980. Is a rewards card really the answer? What about a third party marketplace just like eBay and Amazon? A social media platform of their own that will compete with other retailers’ presence on Facebook, Twitter, and Pinterest… why will that be successful? Buy online, pick-up in store is not new… and while I don’t know of other retailers who are offering to deliver your items to your car, couldn’t competitors offer that service in a matter of months if they decided to?

The problem with this strategy is that it is not differentiated. If you are a retailer that is not losing market share, you don’t really have to stand out any more than you already do. Your brand is already strong and you have a loyal customer base, so merely matching your competitors in terms of service is good enough to maintain your position. But in the case of Kmart and Sears, they are losing customers because they are seen as old and past their prime. There is no reason to go to Kmart when there is a Wal-Mart down the street, or Sears when there is a Target close by. E-receipts are not going to change this. A rewards card isn’t going to either.

So when the Q&A session began I got up to ask Eddie Lampert that very question; “What are you doing that is different from any other retailer? Why would someone use the Shop Your Way marketplace instead of eBay or Amazon?” I wasn’t a jerk about it, but I honestly wanted to understand why he thought they could start gaining (or at least keeping) their fair share of customers when they have been losing market share to these other stores for years.

Lampert was very reasonable and detailed in his reply. He acknowledged that the things he had discussed were not different or unique on the surface. His explained that his goal is to focus on building relationships with shoppers and do so better than other retailers.  While he knows other stores are doing similar things, he doesn’t think it is a focus for them. If he can do the same things but do them more intensely he thinks he can build a group of loyal Shop Your Way members and return the company to profitability. It is more about keeping the customers he already has ($30 billion of sales in the U.S. in 2013) than it is about getting people to switch from Amazon, eBay, Wal-Mart, or Target.

While answering another person’s question later on, he circled back to my inquiry and simply said “We believe we can build a better mouse trap.” And so that is the strategy going forward; making Sears and Kmart (and the Shop Your Way membership program) a better way to shop by connecting with your customers on a deeper and more helpful level. And that is where his quote about the appliances came in.

“How great would it be if you could see what appliances your friends have?”

Eddie Lampert’s vision is that you will associate appliances with Sears because of the store’sheritage. When you need to buy a new dishwasher you will login to the Shop Your Way web site and use the social platform to see what makes and models your friends have purchased in the past. You will read reviews. You will decide which one you want and buy it online. You will schedule delivery or if you have a truck you can come to the store and pick-it up the same day. You won’t even have to leave your truck, because once you arrive you’ll pull up your Shop Your Way app and tell them you are parked in the dedicated parking space out front. Within five minutes your item will be loaded onto your truck by a Sears employee and you will be on your way back home. Since the item was fairly expensive you’ll earn a bunch of rewards points, which will entice you to shop at Sears or Kmart again soon. The fact that Best Buy, Home Depot, Lowe’s, and HHGregg also sell dishwashers won’t even dawn on you.

In a bubble that all might sound like a great strategic vision with a high likelihood of success. In reality though, I don’t think it is going to work. Kmart competes on the low end with Wal-Mart, Dollar Tree, and Family Dollar. But since they can’t match the prices of those other companies there is really no reason to shop there. The stores are dirty, disorganized, and less stocked. And the online initiatives are easily copied by these other companies (buy online/pickup in store is already a big part of Wal-Mart’s business). On my way to the Sears annual meeting I passed a Kmart with about a dozen cars in the parking lot and about a mile down the street there was a Wal-Mart that was nearly full of cars. Shop Your Way is not going to change that.

Sears has a better chance because they are known for certain categories like tools and appliances. There are a lot of older, loyal customers who have been shopping at Sears for decades. However, the demographics of the U.S. are not moving in Sears’ direction. Younger shoppers aren’t going to be caught dead in a Sears store. They’ll go to Home Depot or Lowe’s instead. And that’s a big part of the problem. The technology that Eddie Lampert is infusing into his retail stores is more attractive to younger shoppers. Many older customers who like Sears today don’t want to use their smartphone to shop (or have one at all). That mismatch is yet another challenge for this “integrated retail” strategy. Going on ShopYourWay.com to see what appliances your friends have bought only works if you are an engaged Shop Your Way member and your friends are also avid users of the Shop Your Way web site. If you are 50 or 60 years old you are not going to find your friends on that site. And you aren’t likely to have the Shop Your Way app downloaded on your phone.

As I left the Sears annual meeting, I realized that nothing I had heard or seen had changed my mind about the likely future success of Sears and Kmart as retailing operations. That said, I was glad I made the trip (it’s not everyday you can ask a billionaire and brilliant stock picker a question and have them take 5 minutes to answer it in depth). It is obvious that Eddie Lampert has moved on to focus on new things in his life. After 25 years as a wildly successful hedge fund manager, he is now interested in running companies more than simply investing passively in them. That explains why he has not used Sears’ cash to invest in or buy other businesses that are not shrinking with each passing day like Kmart and Sears. He is looking to build a new business, not his net worth (which he has already done).

While I hope he succeeds, I don’t like his odds, for all of the reasons explained here. As long as his focus is on Kmart and Sears as retailers, investors are better off allocating their capital to Sears debt (the company is not in financial trouble, despite many media headlines to the contrary) and/or watching from the sidelines for any signs that Eddie is finally admitting defeat and shifting strategies. As long as the bulk of Sears Holdings’ financial performance is linked to Sears and Kmart’s ability to sell products and services to customers at a profit, I would not be bullish.

Stay tuned later this week when I will publish a follow-up post explaining why the very fact that another very good stock picker owns a large chunk of Sears Holdings stock (Bruce Berkowitz of Fairholme Capital) is not a good enough reason on its own to invest in the company, even though Lampert and Berkowitz together control about two-thirds of the company.

Full Disclosure: Long Sears debt at the time of writing but positions may change at any time. Also, I still own the very small number of shares of Sears stock I bought for the sole purpose of being allowed to attend the annual shareholders meeting, but you should not mistake that for a bullish call on the stock.