I speak, of course, of Whole Foods Market (NASDAQ: WFMI) and it’s businessman-philosopher CEO John Mackey.
Whole Foods reported it’s fiscal 3rd quarter after the close today (Mon July 31) and is trading at 52 week lows in after hours trading. It’s down from a high near $80 at the beginning of the year to around $54. That represents a haircut of almost 1/3 – from a market cap of around $11.7 billion then to around $7.9 billion now.
What do the fundamentals look like? Whole Foods has net cash of about $400 million for an enterprise value of $7.5 billion.
Happily, Whole Foods is one of the very few companies that distinguishes between capital expenditures that are for growth and those that are for maintenance allowing us to make a very accurate calculation of the cash being generated by the existing business. It does this by separating out “Development costs of new store locations” and “Other property, plant and equipment expenditures” in the investing section of its Cash Flow Statement. In its fiscal 2005, Whole Foods had free cash flow from its existing business of $294.5 million – $207.8 million of which it plowed back into the business by investing in new store locations. That’s a trailing enterprise value to free cash flow ration of 25.4. To get a sense of if this represents good value we have too see how fast Whole Foods is growing.
In the 40 weeks ended July 2, 2006 Whole Foods had about $4.3 billion in sales compared with $3.6 billion in the 40 weeks ended July 3, 2005 – an increase of 20.4%. Cash flows from operations were $342 million compared to $334 million – a 2.4% increase. Free cash flow was $256 million comparted to $252 million – a 1.6% increase. For fiscal 2005 sales were $4.7 billion compared with $3.86 billion for fiscal 2004 – a 21.6% increase. Operating cash flow were $410.8 million compared with $330.3 million – a 24.4% increase. Free cash flows were $294.5 million compared with $220.6 – a 33.5% increase.
From those numbers, the problem that is driving the stock price down might seem obvious: while sales growth continues to be just north of 20%, operating cash flows and free cash flows seem to have stagnated in the first three quarters of this fiscal year. The increase in sales isn’t dropping down to Whole Foods bottom line the way it has in years past. That would lead you to believe that costs are going up.
Looking through their financial statements, however, it becomes obvious that the whole difference comes down to a change in accounting rules for stock options compared with the previous period. This year SFAS (Statement of Financial Accounting Standards) 123 went into effect, requiring companies to treat stock options compensation as an expense and to treat the tax benefits related to stock options as a financing rather than operating activity. This accounting change is really what is causing the appearance of a slowdown in the growth of operating and free cash flows.
If you use the same accounting used for the previous period, you would add back the $55.5 million tax benefit from the excercise of stock options that Whole Foods is now required by law to subtract from the operating section of the cash flow statement (and add back in the financing section) to get operating cash flow of $397.5 million and free cash flow of $311.2 – representing 19% growth in operating cash flow and 23.6% in free cash flow compared to the previous period. Aha! Whole Foods is in fact continuing to grow operating and free cash flows similar to its historical growth rates. Don’t be fooled by the accounting mirage.
Assuming Whole Foods can continue this approximately 25% free cash flow growth through the next 3 months free cash flows for fiscal 2006 will be $368 million. That gives us an enterprise value to free cash flow ratio for fiscal 2006 of 20.4. That’s a good price for such a high quality company growing the top and bottom lines 20-25%.
Look for Whole Foods to get hammered tomorrow (Tuesday Aug 1) a la Netflix and then look to pick up some of this great company in the next week or two.