Whole Foods (WFM) Has LBO Potential But Otherwise May Have Limited Upside and Downside - Deutsche Bank

Deutsche Bank maintained a Hold rating on Whole Foods Market (NASDAQ: WFM) with a price target of $35. Analyst Karen Short doesn't thinks shares will decline further but she also sees limited upside. Short also said an LBO "could work at a $35 take-out" though inability to predict the involvement of outsiders keeps the stock at Hold.

Short explained, "It is tempting to get more constructive on WFM given the significant underperformance YTD (down 36.6% vs. the S&P’s -4.5% decline), and the FY16 EV/EBITDA multiple of 7.0x (the "cheapest" WFM has traded at since July 2010); however, after a detailed risk/reward analysis, we have concluded upside to the stock is limited if mgmt stays the course (increasing capex, limited price investments, declining ROIC), but so is downside because there is always the possibility for an outsider to become involved (ie, an activist, an LBO) - and therefore there is downside protection. We remain at Hold given our inability to predict the involvement of outsiders, which could create value."

Discussing downside in the stock, the analyst said, "1) WFM’s merchandise margins are significantly higher than its peers (some of which is explained by mix), which presents EPS risk if WFM meaningfully addresses its price positioning without finding offsetting savings, 2) WFM anemic traffic is alarming given the 8-10% unit growth (contributing to the comp)– and weak traffic is unlikely to be reversed until pricing is addressed, 3) the 1Q16 comp is up against a very tough compare (+4.5% in 1Q15), and the comp could turn negative unless trends accelerate meaningfully in FY1Q16, 4) strategies implemented in prior years may not work in today’s environment – specifically – WFM is no longer a big fish in a small pond – they are a small fish in a very big and very competitive pond today; 5) it is unclear what WFM’s plan “B” is – more specifically WFM executed on all of its July 2014 momentum-building initiatives, and comps still decelerated – mostly because the most pressing problem – price – was not addressed meaningfully, and 6) WFM stock has an +83% correlation to ROIC, and we think the commitment to a 40-50k size for the legacy format as well as the new ‘365’ format could drive overall ROIC down."

Adding color on upside and a potential LBO, Short said, "Aside from just “cheap” valuation, the case to own WFM is predicated on the involvement of an outsider (ie, activist, LBO) that can enact change. We believe the following could create shareholder value: 1) cut capex until pricing is addressed, 2) focus aggressively on cost cutting and use savings to invest meaningfully in price, 3) reduce sq ft of future units (we believe the larger format is ROIC destructive), 4) abandon the ‘365’ format – or at least test it extensively, and 5) return cash to shareholders once fundamentals have stabilized. We also note an LBO could work at a $35 take-out."

For an analyst ratings summary and ratings history on Whole Foods Market click here. For more ratings news on Whole Foods Market click here.

Shares of Whole Foods Market closed at $31.98 yesterday.

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