Whole Foods Notes PDF

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1. Prepare a competitor analysis. How would you define Whole Foods’ industry? Competitor analysis: Natural & Organic (Direct Competitors): Segment as a whole:

Trader Joes:

Sprouts Farmers Market:

The Fresh Market:

Conventional Grocers (Indirect Competitors): Segment as a whole:

Kroger:

Safeway:

Supervalu:

Supercenters and Wholesalers (Indirect Competitors): Segment as a whole:

Walmart:

Target:

Costco:

Define Whole Foods’ Industry: Whole Foods belongs to a niche segment, natural grocers, within the U.S. Grocery Industry.

Natural Grocers: Despite operating in a competitive and low-growth industry, natural grocers had grown rapidly over the past two decades. Increasingly health-conscious consumers were concerned about the source and content of their food, which fueled natural grocers’ sustained growth (over 20% per year since 1990) despite their comparatively higher prices.4 In 2012, natural and organic products accounted for $81 billion in total sales in the United States, a 10% increase from the previous year.5 Organic products, which were more narrowly defined than natural products, accounted for about $28 billion of these sales and were expected to top $35 billion by the end of 2014.6 As of 2014, 45% of Americans explicitly sought to include organic food in their meals, and more than half of the country’s 18–29-year-old population sought it out.7 By specializing in such products, natural grocers were able to carve out a profitable niche: the three leading natural grocers (Whole Foods, Sprouts, and Fresh Market) had EBITDA margins of 9.5%, 7.7%, and 9.1% respectively, whereas Kroger, the leading conventional supermarket, had an EBITDA margin of only 4.5% As expected, the segment’s attractiveness sparked increasing competition from both new entrants and established players from the other competing segments. Wal-Mart, Kroger, and others launched organic offerings targeted at healthconscious consumers, often at a much lower price point than similar products at natural grocers. While Whole Foods, other natural grocers, independent retailers, and food cooperatives were the primary source of organic products in the 1990s,

by 2006, half of the country’s organic food was sold through conventional supermarkets.9 By 2014, organic products were available in over 20,000 natural food stores and nearly three out of four conventional grocers.1 Even in the face of this competition, Whole Foods maintained a position as the market leader for the natural and organic industry. As many grocers joined the natural and organic bandwagon, Whole Foods defended against misrepresentative claims. Whole Foods had recently introduced a system to rate fresh produce on a number of criteria, including sustainability and other characteristics important to natural and organic customers.11 The company’s website listed over 75 substances that were prohibited in all of its products and published additional measures for meat, seafood, and produce selection to ensure consumers had insight into the quality of their food. Whole Foods was the only U.S. retailer that labeled genetically modified foods, an area of some concern to health-conscious consumers. Despite its remarkable growth, the natural and organic industry was not without its critics. Several academic and government studies had concluded that organic products were not significantly more nutritious than nonorganic goods and claimed that the inefficiency of organic production could harm the environment. Moreover, the continuing lack of official legal definitions of terms such as “natural” arguably made them effectively meaningless: one botanist argued the segment was “99% marketing and public perception.”

Conventional Grocers: Conventional grocers remained the primary destination for shoppers, but competition from Wal-Mart, wholesalers, and other low-price vendors had driven down conventional grocers’ share of food dollars for over a decade;

Supercenters: Wal-Mart was the largest food retailer in the United States in 2014, with 25% market share.

U.S. Grocery Industry as a whole: The U.S. grocery industry as a whole had historically been a low-growth industry, and, as a result of fierce competition, had typically maintained low margins. In 2012, the industry recorded over $600 billion in sales, a 3% increase from the previous year.1 Real demand growth was strongly tied to population growth, and consensus estimates for nominal long-term growth rate were between 2% and 3%.2 Key segments included conventional grocers such as Kroger, Publix, Safeway, and

Albertsons; supercenters such as Wal-Mart and Target; natural grocers such as Whole Foods, Sprouts Farmers Market (Sprouts), and The Fresh Market (Fresh Market); and wholesalers such as Costco and Sam’s Club. The narrow margins and limited growth opportunities favored large competitors that could leverage efficiencies in purchasing and distribution to pass savings on to the consumer. As a result, many small competitors had been acquired or forced to close. Consumers were extremely price conscious and came to expect promotions (which were largely funded by manufacturers), and most shoppers did not have strong attachments to particular retail outlets. Given this environment, companies relentlessly searched for opportunities to achieve growth and improve margins. Many grocers had implemented loyalty programs to reward repeat shoppers, and most were trying to improve the in-store customer experience, for instance by using self-checkout lines and other operational adjustments to reduce checkout times, a source of frequent complaints. Given the high percentage of perishable goods in the industry, supply chain management was essential, and companies were using improved technology to more efficiently plan their inventories. Grocers also began promoting prepared foods, which could command higher margins and reach consumers who did not regularly cook their own meals. Finally, most major grocers offered private-label products, which allowed them to offer low prices while still capturing sufficient margins.

2. Who are Whole Foods’ competitors?

Natural & Organic Grocers (Direct Competitors): Trader Joes, Sprouts Farmers Market, The Fresh Market

Conventional Grocers (Indirect Competitors): Kroger, Safeway, Supervalu

Supercenters and Wholesalers (Indirect Competitors): Walmart, Target, and Costco

3. How would you describe Whole Foods’ strategy?

Text: The company had consistently maintained high growth throughout the new century by increasing same-store sales and expanding its store count; same-store sales grew more than 5% in every year except 2008 and 2009, when the global financial crisis brought America into a severe recession. By 2013, the company’s growth strategy had moved away from acquisitions, and management saw improving same-store sales and continued new openings as its primary growth opportunities.14 Same-store sales—the most important growth criteria Wall Street used to evaluate retailers— had grown by at least 7% every year since 2010, far above other established grocers’ growth rates even after it began expanding its natural and organic offerings. The company had done all of this with no debt financing. Looking forward, Whole Foods management planned to eventually operate over 1,000 stores, up from the 362 it operated as of the end of fiscal year 2013. Whole Foods positioned itself as “the leading retailer of natural and organic foods” and defined its mission as promoting “the vitality and well-being of all individuals by supplying the highest quality, most wholesome foods available.”16 The company’s sole operating segment was its natural and organic markets and nearly 97% of its revenues came from the United States. By 2013, the average Whole Foods store carried 21,000 SKUs and approximately 30% of sales outside the bakery and prepared-food segments were organic. Whole Foods reported $551 million in net income on $12.9 billion in sales in 2013, making it the clear leader of natural and organic grocers even though its numbers were still rather small compared to Kroger’s net income of $1.5 billion on more than $98 billion in sales. Facing increased competition in the segment, many analysts believed that Whole Foods’ biggest challenge was its reputation for high prices. For instance, Whole Foods charged $2.99 for a pound of organic apples, compared to $1.99 at Sprouts and even less at Costco.18 Indeed, many consumers derisively described the store as “Whole Paycheck,” and the company had historically opened its stores in highincome areas. In response to this image, the company had already begun marketing private labels (365 and 365 Everyday Value), begun competitive price matching and promotional sales, and launched a printed value guide (The Whole Deal) that featured coupons, low-budget recipes, and other tips for price-conscious consumers.19 Additionally, many Whole Foods supporters often pointed out that they were willing to pay a premium price for a premium product.

4. How attractive is Whole Foods’ current market position?

5. Is it sustainable?

6. What do the financial ratios in Exhibit 4 tell you about the past operating performance of Whole Foods? Average Sales Growth:

Average EBITDA Margins:

7. How informative are the historical ratios for Whole Foods’ prospective performance?

8. Examine Exhibit 7 in detail. How important are each of the underlying financial assumptions in the “return on capital” forecast? LOOK BELOW 9. What assumptions (i.e., margins, asset turnover, growth) play the biggest role in driving the anticipated improvements in “return on capital”? Return on Invested Capital = NOPAT / Total Invested Capital Answer: Return on Capital or Return on Invested Capital (ROIC) = NOPAT / Total Invested Capital. ROIC gives insight into whether the firm is making

profitable investments for the future. If ROIC is greater than the WACC, then the firm is creating value in the business. If it is less, then they are diminishing value with their investment choices and should make adjustments. All the underlying assumptions in the return on capital forecast is important in accurately forecasting the future projected performance of Whole Foods. In making forecast it is important to develop a sales growth forecast, NOPAT Margin Forecast, Working Capital to Sales Forecast, LongTerm Assets to Sales Forecast, Capital Structure Forecast, and Cash Flow Forecast. Through developing these forecasts, we can then disaggregate ROIC to determine what assumptions play the biggest role in driving the anticipated improvements in return on capital. These assumptions (that can be seen in the below breakdown of disaggregating ROIC) include the forecasted: NOPAT, EBIT, Tax Rate, NOPAT Margin, EBITDA, Depreciation and Amortization Expense, Sales, EBITDA Margin, Sales Growth Rate, Stores, Annual Depreciation and Amortization per Store, Store Growth Rate, Beginning Shareholders’ Equity, Net Operating Assets, Beginning Net Working Capital, Beginning Net Long-term Assets, Current Assets, Current Liabilities, Current Asset Turnover, Net Operating Long-term Assets Ratio, and Net PP&E. 1) NOPAT: NOPAT is after-tax operating cash generated by a company and available for all investors (both shareholders and debtholders). Forecasted Net operating profit after taxes (NOPAT) = Forecasted Earnings Before Interest and Taxes (EBIT) * (1-tax rate) or Forecasted NOPAT = Forecasted Sales x NOPAT Margin. Forecasted EBIT, Forecasted tax rate, and Forecasted NOPAT Margin play the biggest role in driving Forecasted NOPAT. a. EBIT: Forecasted Earnings Before Interest and Taxes (EBIT) = Forecasted Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) – Forecasted Depreciation and Amortization Expense. Forecasted EBITDA and Forecasted Depreciation and Amortization Expense play the biggest role in driving EBIT. i. EBITDA: Forecasted Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) = Forecasted Sales x Forecasted EBITDA Margin. Forecasted Sales and Forecasted EBITDA Margin play the biggest role in driving forecasted EBITDA. 1. Sales: Forecasted Sales = Previous Sales * (1+Sales growth rate). Previous Sales and the Sales Growth Rate play the biggest role in driving forecasted sales.

a. Sales Growth Rate: Sales growth rate = (Sales – Prior Year’s Sales) / Prior Year’s Sales. ii. Depreciation and Amortization Expense: Forecasted Depreciation and Amortization Expense = Forecasted Stores x Forecasted Annual Depreciation and Amortization per Store. Forecasted Stores and Forecasted Annual Depreciation and Amortization per Store play the biggest role in driving Forecasted Depreciation and Amortization Expense. a. Stores: Forecasted Stores = Ending Stores * (1 + Forecasted Store Growth Rate). Ending Stores and Forecasted Store Growth Rate play the biggest role in driving forecasted stores. i. Store Growth Rate: Forecasted Store Growth Rate = (Ending Stores - Beginning Stores) / Beginning Stores. The Ending and Beginning Stores in the previous period plays the biggest role in driving forecasted store growth rate. b. Annual Depreciation and Amortization per Store: Forecasted Annual Depreciation and Amortization per Store = Forecasted Depreciation and Amortization Expense / Forecasted Stores. Forecasted Depreciation and Amortization Expense and Forecasted Stores play the biggest role in driving forecasted Annual Depreciation and Amortization per Store. b. Tax Rate: Forecasted Tax Rate is determined by the forecasted EBIT. Forecasted EBIT plays the biggest role in driving forecasted Tax Expense. c. NOPAT Margin: Forecasted NOPAT Margin = (Forecasted Net Income + Forecasted Interest Expense after Tax) / Forecasted Sales. 2) Total Invested Capital: a. Net Capital: Forecasted Net Capital = Forecasted Beginning Net Debt + Forecasted Beginning Preferred Stock + Forecasted Beginning Shareholders’ Equity. Beginning Net Debt, Beginning Preferred Stock, and Forecasted Beginning Shareholders’ Equity play

the biggest role in driving forecasted Net Capital. However, since Whole Foods has no debt or preferred stock, we will exclude these from potential drivers. i. Shareholders’ Equity: Forecasted Shareholders’ Equity = Forecasted Net Operating Assets – Forecasted Beginning Net Debt – Forecasted Beginning Preferred Stock. Forecasted Net Operating Assets, Beginning Net Debt, and Beginning Preferred Stock play the biggest role in driving forecasted Shareholders’ Equity. However, since Whole Foods has no debt or preferred stock, we will exclude these from potential drivers. 1. Net Operating Assets: Forecasted Net Operating Assets = Beginning Net Working Capital + Beginning Net Long-term Assets. Beginning Net Working Capital and Beginning Net Long-term Assets play the biggest role in driving forecasted Net Operating Assets. a. Beginning Net Working Capital: Forecasted Beginning Net Working Capital = Previous Ending Current Assets – Previous Ending Current Liabilities. Forecasted Current Assets and Forecasted Current Liabilities play the biggest role in driving forecasted Beginning Net Working Capital. i. Current Assets: Forecasted Ending Current Assets = Forecasted Sales * Forecasted Current Asset Turnover. Forecasted Sales and Forecasted Current Asset Turnover play the biggest role in driving Forecasted Ending Current Assets. b. Beginning Net Long-term Assets: Forecasted Beginning Net Long-term Assets = Forecasted Sales x (Forecasted Beginning Net Operating Long-Term Assets / Forecasted Sales) or Forecasted Beginning Net Long-term Assets = (Forecasted Net PP&E / Forecasted Stores) x Forecasted Stores. Forecasted Sales and Forecasted Beginning Net Operating LongTerm Assets Ratio or Forecasted Net PP&E and Forecasted Stores play the biggest role in driving forecasted Beginning Net Long-Term Assets. i. Sales:

Forecasted Sales = Previous Sales * (1+Sales growth rate). Previous Sales and the Sales Growth Rate play the biggest role in driving forecasted sales. 1. Sales Growth Rate: Sales growth rate = (Sales – Prior Year’s Sales) / Prior Year’s Sales. ii. Beginning Net Operating Long-term Assets Ratio: iii. Net PP&E: iv. Stores: Forecasted Stores = Ending Stores * (1 + Forecasted Store Growth Rate). Ending Stores and Forecasted Store Growth Rate play the biggest role in driving forecasted stores. 1. Store Growth Rate: Forecasted Store Growth Rate = (Ending Stores - Beginning Stores) / Beginning Stores. The Ending and Beginning Stores in the previous period plays the biggest role in driving forecasted store growth rate.

10. Do you agree with the existing financial assumptions in the Deutsche Bank forecast? If so, why? If not, what adjustments would you make to the model? Be prepared to defend the basis of your forecast for Whole Foods’ performance. **Sensitivity Analysis **Consider adjusting growth rate lower due to slow in expected population growth between Text: Bears’ perspective

From the bears’ perspective, the natural and organic market was becoming saturated as more companies offered organic products at lower cost. This competition would soon compress Whole Foods’ margins, while at the same time stealing market share and causing same-store sales to slow or even decline.20 Several analysts had downgraded Whole Foods after the company issued its disappointing quarterly results.21 A report put out the previous week by another bank noted that 85% of Whole Foods’ stores were within three miles of a Trader Joe’s—a privately owned natural grocer—up from 44% in 2005; similar overlap with Sprouts had grown from 3% to 16% and with Fresh Market from 1% to 14%. Moreover, Whole Foods was running out of dense, highly educated, high-income neighborhoods to open new stores in, which could either force the company to rely more on low-price offerings or slow its rapid expansion.22 Such a shift in strategy could take the company into uncharted territory and risk its reputation as a premium brand. Finally, the bears were concerned that the new competitive reality would cause the market to fundamentally revalue Whole Foods. The company had long traded at a substantial premium, at times exceeding Kroger’s market value, despite the latter company’s substantial size advantage (compared to Whole Foods, Kroger had 7.3 times as many stores that generated 7.6 times as many sales and 3.6 times as much EBITDA). Such a premium could only be justified if Whole Foods could continue growing, both at its existing stores and in terms of its overall footprint. The team noted that even if it cut the price target from $60 to $40, Whole Foods would still trade at a premium to its competitors in the conventional grocers’ segment.

Bulls’ Perspective: The bulls believed the combination of Whole Foods’ leadership in natural and organic offerings, shifting consumer preferences, and organic food’s small but rapidly growing market provided ample runway for sustained growth at high margins.23 As the clear leader in the segment, Whole Foods was well positioned to benefit from consumers’ increasingly health-conscious decision making. Moreover, Whole Foods was not just another retailer that offered natural products; it was the standard bearer and thought leader for the industry, making it top of mind for anyone interested in the type of healthy products Whole Foods brought into the mainstream. Its competitors were merely imitating what Whole Foods pioneered and continued to lead, giving the company a sustainable advantage.24 While competition could put downward pressure on some of Whole Foods’ prices, the company had the stature to maintain its margin targets even with competitive price cuts by driving sales toward higher-margin categories like prepared foods, where the grocer could more readily differentiate its products. Moreover, the company’s high prices gave it more room to adjust prices on goods where it directly competed with lower-cost retailers; past work by Short’s team had shown that Whole Foods could match Kroger...