First, a disclaimer: I’m probably a terrible source on that will be “hot” in any short, arbitrary period of time (like 2007, for instance), and I will never make the claim that any company or industry I mention will beat the market in that same arbitrary period of time. In fact, there’s a great chance that everything that follows will indeed underperform in 2007. But that wouldn’t necessarily be a bad thing. Actually, it will make both more attractive purchases. Nonetheless, I wanted to highlight to two industries and one company in particular that I think investors may want to consider. I’ll weigh some of the risks and rewards for the long term (if not 2007).

ORGANIC FOODS – WHOLE FOODS, WHOLE PORTFOLIO?

Spotlight on:

Whole Foods Market (WFMI)

It was the S&P500’s worst stock for 2006. Wall Street beat up its share price last year as expectations met the reality. Believe it or not, same-store sales can’t grow to the sky.

Whole Foods’ CEO John Mackey has also taken a beating, going from hailed industry titan and organic food guru to one of BusinessWeek’s “Worst Leaders of 2006” and the subject of ridicule for the size of his paycheck (though he’s now paid just a $1 token salary).

But Wall St.’s fickleness is sometimes cause for investor celebration as great companies get hammered, providing bargain purchases for the contrarians. So that brings me to the point of this Whole Thing: is Whole Foods a bargain?

I’ll approach the risks and rewards in list format as best I can before delving into the valuation. Here goes:

PROMISE

- Great business with strong management, lots of room to grow, enjoying an expanding market for its industry.

- Perfect example of “People, People, People” article (management pay improved, one of the most respected leaders in the business in John Mackey, strong attention paid to the customer and shareholder, ranked as one of greatest places to work, most of the executive team has been with the company for over 10-15 years)

- Stores profitable from day one, 88+ stores in the works (with leases signed). Only ~180 now, operating in just 34 states, D.C., the U.K., and Canada. Lots of room to grow.

- Is increasing its brand awareness very successfully. The company is the largest and most well-known of its kind, and customers are willing to pay a little extra for service and experience.

- As they expand in size and brand loyalty, they can benefit from both economies of scale and pricing power, taking advantage of covering costs through higher volume of fresh foods while leveraging their brand and incessant focus on the customer’s experience to charge a premium. This is a competition killing two-punch combo, leading to both higher returns with wider margins over time.

- Their management has been very good at building a competitive moat – with an obsessive focus on the customer, the employees, and the shareholders, along with strong and increasingly growing brand awareness, the company is investing successfully in marketshare of mind, creating a culture that many will benefit from and many will be loyal to. Oh, and did I mention cost savings from economies of scale?

- As Charlie Munger has said, taking a competitive advantage to the extreme often benefits the company and insulates it from competitive pressures. Just as Costco took cost-savings to the extreme, Whole Foods takes its culture and people-friendliness to the extreme. That is their advantage.

- Many compare it to Starbucks in that company’s early days (check out Yaser Anwar’s article).

RISKS

- The question we have to ask is whether the company can really beat the burgeoning competitive landscape – Walmart, Wild Oats Markets, etc — and remain at the top of the industry to actually enjoy those competitive advantages for an extended period of time. Currently, Whole Foods is more successful than any competitor, and given the culture and lifestyle it is forming, I can foresee this being the case for a long time into the future.

- Another related, yet altogether different, question is whether the industry will continue growing given that there is some, though probably small, chance that it’s all a fad.

- Speaking of fads, America’s blitzkrieg on trans-fats, the obesity epidemic, and mounting health issues continue to open new market potential as customers become more educated and grow in number. It is difficult to tell whether this is a lasting societal change or an extended trend that will either be temporarily lived or overcome by another. If the former, the chances are high that growth will continue at a rapid pace over the next ten to fifteen years plus for this outstanding company.

- Though I’m not confident enough to place much money on it (at least not yet), I believe that the industry and the company are in good shape and will stick around in full force for the foreseeable future.

- Despite the big pullback from the $80 per share days, the company still trades at a high PE around 32. We’ll talk about this further in the valuation section.

OTHER PROS/CONS (aka THINGS I LIKE, AND THINGS I DON’T LIKE)

- Stock option plans

PRO – With its generous payouts, employees are digging it and staying happy, which trickles down to the customer

CON – Dilution. The size of the stock option plans mean current investors won’t have as big a claim on future income as otherwise possible.

[Optional Note on Options: Though the grants are expensed on the income statement, I always question the wisdom of valuing them based on the Black-Scholes model. Though this is clearly not the company’s doing, but rather SFAS guidelines, I think the Black-Scholes model is great for pricing short-term options, but poor for pricing LEAPS. Whenever you have a company that is expected to do well and whose share price will increase over the long-term, assumptions like volatility and interest rates that enter into the Black-Scholes model can lead to wide errors in what those options are truly worth (usually understating the value and hence understating the expense while partially hiding the dilutive effect). The company mentions that it intends to avoid dilution greater than 10% in any one year. But even so, that’s still a lot, and with an increase in shares outstanding of around 5% annually over the last few years, it’s something for investors to keep in mind.]

- Returns

The company’s average returns on capital over 5 years are high relative to the grocery industry (around 12% versus the industry’s 9.6%). They do this with basically no debt, save for some small line items. Capital has historically been internally generated cash flow that is reinvested in the business along with equity from the issuance of shares to “team members.” These returns are not objectively very high, but for grocers it is.

VALUATION

I’ll try to keep this as simple and short as possible. Let’s assume that the company’s free cash flow of $215 million in last FY (Net inc of $204 + Depreciation of $156 – Maintenance Capex of $145) will continue to grow at 15% over the next ten years. After that, the company will grow FCF at 5% per year. Assuming a WACC of around 10% (probably high), we get a value for the company of $9.8 billion (its current market cap is around $6.6 billion). That would represent a 33% discount from intrinsic value.

But is this realistic? Well, again, that depends how you weigh the risks and likelihood that the company continues its growth trajectory as we know it.

The company is ambitious in opening new stores and is aiming for sales of $12 billion by 2010. With a (simplistic) calculation that this would mean earnings of around $420 million (based on the company’s consistent net profit margin around 3.5% and not accounting for the possibility that this margin could improve based on economies of scale and pricing power, as mentioned above), which would, in turn, mean that the 15% growth rate may be low.

But, on the other hand, if the competition, big and little, starts eroding market share and pressing margins and operating results, a value near $10 billion might well be as good as from thin air.

While this may seem anticlimactic, this brings me to an important point. DCF, multiples analysis, or any other valuation method is pointless unless we first size up the business’s true long-term potential. Whole Foods is a promising enterprise, with great management, a solid business model, and strong financials. It seems reasonable (though not necessarily a no-brainer), that the company can justify its high PE and, in fact, still be a bargain.

Because it doesn’t strike me (yet) as a no-brainer, I personally have no money in it.

That said, I will be watching Whole Foods very closely in 2007, and if prices begin to leave investors with a wider margin of safety, you can rest assured I’ll be on it.

[Another Optional Note: if investors wish to get really fancy and want to bet on Whole Foods dominance vis-à-vis competitors, as distinct from Whole Foods being undervalued per se, they may wish to take a look at the fact that competitors like Wild Oats (OATS) and Hain Celestial (HAIN) trade at PEs close to WFMI. By shorting competitors and buying WF (or buying calls on WFMI and puts on competitors), investors could, in theory, still make money if WFMI underperforms, so long as OATS and HAIN underperform even more. This is pretty risky and I wouldn’t do it, but for someone looking for a nifty trade, it’s a thought…]

THE HOMEBUILDERS – BUYING WHEN NO ONE WILL

Let’s cut to the chase: Everyone hates the homebuilders now, and the short-term outlook isn’t good. Many pundits predict the market has yet to bottom, and given their already hugely out-of-favor standing and un-promising future, their stock prices have suffered big-time in the last year. You know what that means for me: take a look for bargains.

Since I just chewed your ears off with Whole Foods, I’m going to keep this discussion short, and instead provide a link to someone who describes the opportunity better than I could. Though the link is from August, much of it is still relevant to today. Also, although the Absolutely No DooDahs links are no longer active, the post is informative and I highly recommend it.. Suffice it to say that I agree with him, as I seem to on many things.

Scroll down to the “On Homebuilders” article and read:

http://www.gannononinvesting.com/2006/08/

One Final Note: I do not own shares in any company mentioned in this article.