Biz Dev in NYC by Rob Tsai

It’s interesting to read the different headlines covering the Whole Foods Q4 results, as they tend to emphasize different parts of the Q4 results and give conflicting impressions on the quality of the quarter.

Marketwatch writes:

Whole Foods posts slip in fourth-quarter profits

while TheStreet.com reports the results as:

Sales Surge at Whole Foods

It’ll be interesting to watch the trading action on Wednesday and next week, as investors pick through the news to see whether these results were positive or negative.

A couple of highlights on the quarter and the conference call:

• Q4 sales increased 25%, comparable store sales were up 8%, identical store sales increased 6%.
• Quarterly dividend was increased 11% to $0.20 per share.
• Store contribution (or operating income prior to corporate G&A, pre-opening expenses, relocation costs, interest, taxes, and one-time expenses ) decreased to 8.6% of sales from 9.1% of sales
• EPS fell from $0.28 in 2006 (12 weeks) to $0.24 in 2007 (13 weeks), so EPS was lower by 14% even though this year had an additional extra week which at equal run rate should generate an 8% improvement in quarter over quarter earnings - so normalizing for the different time period lengths, you get to a miss of 22%.
• Net income margin for the quarter was 1.9% ($33.9m divided by $1,743.4m) compared to 3.1% ($39.8m divided by $1,291m).   Margin numbers aren’t affected by the difference in the quarter lengths since they are normalized.   If about 50 bps of the margin compression is from the Store Contribution change, about 24 bps is from interest expense on the debt issued to finance the Wild Oats acquisition, and the remainder from pre-opening and relocation expenses.
• For forward looking guidance, the company indicated expecting 25% to 30% revenue growth (of which 10% is to come from Wild Oats, comp store sales growth of 7.5% to 9.5%), which I believe leaves new store openings to account for the remainder (using the midpoints from above:   27.5% top line growth less 10% Wild Oats less 8.25% comp store sales nets out at 9.25% from new stores).
• From the Press Release: “The Company does not expect to produce operating leverage in fiscal year 2008 due primarily to a decrease in store contribution as a percentage of sales driven by a higher percentage of sales from new and acquired stores, which have a lower contribution than our existing stores, investments in labor and benefits at the acquired Wild Oats stores, and continued, though more moderate, increases in health care costs as a percentage of sales.  In addition, the Company expects G&A as a percentage of sales to be in line with the 3.3.% reported in fiscal year 2007 due mainly to the temporary costs associated with integrating the Wild Oats acquisition, along with the cost of fully staffing the Company’s three smallest regions which gained the greatest number of stores in the merger.  The Company expects G&A as a percentage of sales to improve sequentially from the first half to the second half of the year.”
• The company targets a 7 year payback period on their EVA analysis for new store openings.

I heard a whole lot of “synnergies” on the conference call - synnergies from getting the Wild Oats stores to the higher Whole Foods 35% gross margin based on better sourcing of “perishables” and a remodeling of the stores to encourage better flow and more sales per square foot.   Whenever you hear the word synnergies, in my opinion, you need to be extra skeptical - as it’s a word bandied about to justify just about any sort of thing, including making overpriced acquisitions.

The company claims they lowered prices at the Wild Oats stores, and yet were able to increase margins.  I don’t know whether I believe this, but that’s what they’re saying. 

For an interesting article on the bear case for WFMI, check out Alan Brochstein’s post on Seeking Alpha.

I don’t know how the Street will react.  The stock was up 7% to $45.18 in after hours trading according to TheStreet.com, but as of this writing (10 pm-ish), it is now up 2.3% according to Yahoo!   It’s not clear to me that the Bulls or Bears will take center stage on this one from these numbers.

I’m staying on the short side of this trade for the time being as I think the earnings miss will play front and center.   I find it hard to believe in a long story over one year out in this economic environment, what with all types of retailers feeling the pain.  Certainly synergies may accrue from the Wild Oats deal, but it’s not a guarantee given the economic climate we’re in.   Risks abound, from inflationary pressures on food and distribution costs, pain in a slowing economy and disappearing wealth from real estate impacting discretionary spend (though it’s debatable whether customers consider their WFMI budget as discretionary).

With a forward P/E of 28, for a company growing idents at 6%, experiencing shrinking margins, offering no guidance on operating leverage for one full year, achieving growth through levering up their balance sheet to acquire a competitor, suggesting synnergies will accrue from better management -  it seems to me that the execution risks outweigh the reward.

Disclosure:  I have a position in the Jan 08 42.5 puts on WFMI