The Whole Story on Whole Foods

Whole Foods Market (WFM:US) has generated a loyal group of health-conscious customers over the years who are willing to spend a little or a lot extra for their groceries. According to Ed Devitt, the shareholders of WFM have been loyal as well, a little or a lot too much. The stock trades at a 20x P/E despite reporting negative same store sales trends and falling earnings per share. Despite recent decisions to address this, Devitt believes management is working in the wrong direction and finds that Whole Foods has no clear path to recovery, especially in the near term.

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SumZero: What about Whole Foods initially caught your attention as a value investor?

Ed Devitt: It was pitched to me as a long idea in 2015. As I began to look at it, I was struck by how bad the underlying fundamentals were, but people continued to like the shares because of the brand. Many Wall Street analysts are WFM’s core demographic. They shop there on a regular basis and hold the company in high esteem. The problem is now WFM must move past this core demographic (urban, wealthy, well educated, willing to pay a lot for groceries) since they have over expanded their footprint. I think there is a bit of the Brexit/Trump phenomena involved where investors only look at the world through their own eyes and cannot appreciate there are a lot of other people out there who do not see things the way they do.

SumZero: What is the market missing and why?

Ed Devitt: The market is clearly focused on the same metric I am – Same Store Sales growth. SSS comparables are negative and everyone recognizes this is a problem. I believe the mistake in the market’s view is that there is this general sense that WFM is a great brand, and at some point, the comparables will improve. However, none of the bulls express a clear path forward as to what will actually turn these comps around. I believe the market underappreciates the fact that this company has just over-extended its footprint. It does not make sense to open new stores today because they cannibalize the old ones. Management understands this to a degree, but they are not taking the right steps to alleviate it, which would be to shut down stores, enabling the economics of the remaining stores to improve.

SumZero: Is WFM still attractive to short at today’s prices?

Ed Devitt: I think good shorts have the following three characteristics listed in order of increasing importance: 1) Unattractive valuations, 2) Overly bullish sentiment, 3) Deteriorating fundamentals.

I believe this short is strongest on the most important factor, deteriorating fundamentals. It also is strong on valuation (forward P/E greater than 20x for a declining business). The weakest part of the short is sentiment, since investors are cautious given the SSS comps. If the stock popped to the mid-$30s on hope that something might turn things around (like the new 365 stores), then I would think all three would be aligned, and it would go from a good short to a great short. Nevertheless, having 2 out of 3 is still an attractive short when you have deteriorating fundamentals.

SumZero: Given WFM has dropped to a five-year low, why do you think management will continue with a strategy of overexpansion rather than reevaluating and taking a new course? Are executives comped simply for opening new stores?

Ed Devitt: Management gave us their answer on the recent earnings call. The co-CEO Walter Robb, who was responsible for day to day operations, is being forced to retire and founder John Mackey is resuming full control as the lone CEO. I think this is a loss for the company as Robb was the prudent business man and Mackey is the visionary founder. On the call, Mackey made an analogy to the Civil War:

When Ulysses S. Grant took over the Union Army, he was always getting criticized, he's always hearing from his generals about what Robert E. Lee was going to do. “Robert E. Lee is doing this, what are you going to do about that?” And one day Grant said, "I'm so sick and tired of hearing what Lee is going to do. Lee needs to worry about what we're going to do." And I think that's how I feel about our competitors. They need to worry about what Whole Foods is going to do.

The problem with this analogy is Mackey is not Grant, he is George Custer. He is going to charge full steam ahead, continue to open stores, and continue to seek growth. For a business that is over-extended, this is like Custer charging full steam at Little Bighorn despite being vastly outnumbered.

SumZero: You mentioned Whole Foods has saturated many of the wealthy urban cities of the United States. Is there any risk Whole Foods expands internationally? What about cheaper Whole Foods “365” brand stores in smaller towns?

Ed Devitt: I think those could be risks, but they are mitigated by the fact that even if they work, it will be hard to move the needle for several years and will likely accelerate decline in the legacy business. WFM has over 450 stores. Each store is around 2-3x as big as the smaller 365 stores. Even if 365 proves successful (and to date management has called the early results “mixed”) they will have to build many stores to be meaningful. I would bet if they built 100+ of these 365 stores, it will only increase cannibalization in the core business.

SumZero: How has online competition like Fresh Direct and Amazon affected WFM?

Ed Devitt: It is hard to say how much. Competition is coming in from so many directions. There are WFM-like competitors who have grown dramatically like The Fresh Market and Sprouts. There are online grocers like you mention. There are new businesses offering meal kits like Blue Apron and Plated. Finally, WFM is competing against themselves as they are clearly cannibalizing their own stores. It’s this intersection of competitive pressure from all directions that will make turning WFM around very difficult.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Ed Devitt: Same store sales comps. Any recovery will have to begin here.

Also, gross margins. WFM has very high gross margins vs. peers and I believe as they are forced to compete for more mainstream customers, their prices will be challenged and margins will decline. This would be devastating for the earnings power of a low margin business like a grocery store.

SumZero: What were the biggest risks associated with the trade in your view?

Ed Devitt: The biggest risk is management actually does the right thing, and that would be to shut down underperforming stores so their best stores face less cannibalization. I believe making Mackey the lone CEO signals they are going to do the opposite.

The other risk would be the consensus bull case, that management figures out some new formula to reinvigorate their stores. Maybe the new 365 concept takes-off. At this point, it really is a “hope trade” because there is little evidence that any of these initiatives are paying off. This could change though.

SumZero: Is this thesis representative of the Ed Devitt investing style?

Ed Devitt: I believe I am particularly good at investing in turnarounds. It does represent a unique skillset that most investors aren’t inclined towards. Turnarounds tend to take time and are often messy. When a turnaround works, you can often make extremely high returns. However, in order for the turnaround to work, there needs to be a clear strategy to improve the business prospects, and from an investment timing perspective, there needs to a dramatic resetting of investor expectations to low levels that management can easily beat. In the case of WFM, I don’t think they have either yet. The strategy must address the negative comps through rationing supply. From an expectations perspective, investors still think WFM is a growth company or can be again someday, which is why it trades >20x earnings.

SumZero: Where else do you see value in the market today?

Ed Devitt: I believe the two most attractive areas of the US market are energy and healthcare. I believe we are entering the sweet spot of the oil cycle. Years of underinvestment are beginning to catch up with the industry and supply and demand are tightening. Prices are still too low to stimulate enough new drilling. People forget how big this industry is. The largest oil company in the world, Saudi Aramco, is likely worth $1.5-2 trillion dollars and only has 12% global market share. Think about that. It is worth more than Google, Facebook, and Microsoft combined but is only one of many global energy giants. The amount of drilling necessary to sustain an industry of this magnitude is well above current levels. Regarding healthcare, I believe you should buy when regulatory fears are the highest. The reality is that reforming healthcare is insanely difficult and these companies continue to adapt to new regulations. The best time to invest in healthcare in recent years was following Obamacare. The consensus view was that Obamacare was going to kill the managed care industry. Guess what? It made them more profitable. From a portfolio perspective, investing in these two sectors is interesting because they are highly uncorrelated. One is economically sensitive, one is defensive. Furthermore, there is zero correlation between drug prices and oil prices.

SumZero: How has your approach evolved over the years?

Ed Devitt: Let me contrast my approach with what I believe is the hedge fund modus operandi. Most hedge funds seek to find low volatility, uncorrelated returns and then leverage those returns to generate solid returns at “low risk.” I think this business model is challenged today. In an environment where stable, low volatility assets are bid up and considered bond proxies and hedge funds crowd into these same trades, the business model becomes very tough. January and February of 2016 proved this point. Low volatility funds suddenly became highly volatile and highly correlated. In contrast, I think people are way too concerned about how much daily volatility you take on. I would argue what really matters is how well you can protect capital in a major downturn like 2008 and whether you can generate high long-term returns for your investors. Basically, what I am describing is the hedge funds of 1990s, which were quite different from their successors of today.

I have heard Stan Druckenmiller, one of the legends of the past, make comments to this effect. He thinks the concept of “risk adjusted” returns that hedge funds use today is a swindle to justify their low returns. Although Druckenmiller never had a down year, he claims his results could still be volatile month to month, which would be unacceptable today. Druckenmiller says the key to money management is “capital preservation and home runs.” I completely agree with this. If you hold 10 stocks, let’s say 8 go nowhere this year, but 2 go up 100%, you earned a 20% return at the portfolio level. If you have a home run or two in your portfolio, it can make up for so many mistakes.

SumZero: Tell me about your investing background and investing mentors and heroes.

Ed Devitt: As mentioned above, I think Druckenmiller is great, maybe the best all-around investor ever. The others I admire I would put into two camps: distressed investors and patient compounders. I respect distressed investors like Icahn or Appaloosa who are willing to jump into the fray when everyone is in abject panic. It’s amazing to me that security prices can go to no-brainer levels, but the majority of investors will convince themselves they shouldn’t play for this reason or that. To this point, Warren Buffett has said, “Investing is simple but not easy.” My sense it is the “career risk” inherent in these situations. Most people don’t want to get involved in a messy situation they think may jeopardize their careers, whereas I play to win and really only care about risk/reward skews. Speaking of Buffett, I admire him as the best of the patient compounder camp. The genius of Warren Buffett is risk management. How many times has he made a major mistake over a career spanning decades? It is an amazing track record. I believe his focus on easy to understand, high quality businesses has been his secret. The best aspect of great businesses is that things rarely go wrong and they steadily compound over time. Bad businesses have things go wrong all the time. Unless you are buying something at a fire sale price, I think it is prudent to follow Buffett’s advice.

My investment philosophy is to hold a Buffett-esque portfolio of high quality compounders to preserve capital and then opportunistically layer in the distressed/turnaround type ideas to provide the home-runs that Druckenmiller references. The ideas I have written up on SumZero have all been the later, but that’s just because I think it is less interesting to write-up a company like Visa where I really don’t have a variant view. I just think it is a phenomenal business.

SumZero: What advice would you give to someone interested in pursuing investing?

Ed Devitt: I think you have to ask yourself, “Why do I want to do this?” If you love markets, love trying to figure out companies, and the love to compete, I think it is a great career. I think the people who thrive in this business are in it for love of the game rather than for financial rewards. It’s a very competitive business and if you don’t have that passion, I think it is hard to compete against the best.