Should You Add Whole Foods to Your Basket of Securities?

Whole Foods Markets (NASDAQ: WFM) is poised to report second quarter 2011 earnings Wednesday and it's in the news Monday for a resignation letter from an employee who casts aspersions on what he sees as the gap between its values and its practices. Should that stop you from investing in Whole Foods shares?

On July 27, Whole Foods is expected to report EPS of $0.47 per share on revenues of $2.42 billion. Last year, Whole Foods reported EPS of $0.38 on revenues of $2.16 billion in its second quarter. And over the previous four quarters, Whole Foods has beaten analysts' estimates.

Meanwhile, a resignation letter from a Toronto Whole Foods employee casts doubt on the company's sincerity when it comes to acting on its values of caring about the community, the environment, and its team member happiness and excellence, according to Gawker. The letter alleges that Whole Foods treats its people poorly, underpays them, and wastes energy and other environmental resources.

As I wrote in my book, Value Leadership (Wiley, 2003), if there is a gap between a company’s values and its actions, investors should be wary. And this letter raises questions about whether such a gap might exist.
This is hardly the first time Whole Foods has encountered controversy. As I wrote in 2009, Whole Foods' CEO, John Mackey, got into some hot water for writing an op-ed entitled "The Whole Foods Alternative to ObamaCare" which called for health-care savings accounts and declared that health care is not an intrinsic right. The problem was that many of his customers responded by calling for a boycott against Whole Foods.

Despite its controversies, Whole Foods stock has been on a tear. After a 77% rise in the last 12 months, does Whole Foods stock have further to run? Here are two reasons to consider it:

• Out-earned its capital cost. Whole Foods is earning more than its cost of capital – and it’s improving. How so? It produced positive EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales. In 2010, Whole Foods ’s EVA momentum was 1%, based on 2010 revenue of $9 billion, and EVA that improved from negative $49 million in 2009 to $36 million in 2010, using a 7% weighted average cost of capital.
• Strong second quarter earnings. Whole Foods reported EPS of $0.51 for the quarter ending March 30, 2011 -- 11% ahead of the consensus estimate. Revenues for the quarter were up 11.6% to $2.35 billion -- slightly below the $2.37 billion consensus estimate. Mackey announced in May that Whole Foods expected 2011 earnings to be $0.10 higher and that its sales for the year would be up between 11.7% and 12.6%.

Here are two negatives for the stock:

• Rapid growth but deteriorating balance sheet. Whole Foods has grown solidly. Its $9.6 billion in revenues have increased at an average rate of 13.9% over the last five years and its net income of $302 million has risen at a 12% annual rate over that period. To finance acquisitions -- such as its 2007 deal for Wild Oats, its debt has skyrocketed while its cash has grown more slowly. Its debt skyrocketed at 174% annual rate from $9 million (2009) to $508 million (2010) while its cash while its cash rose at a 23.9% annual rate from $196 million to $462 million.
• Expensive stock. Whole Foods price to earnings to growth (PEG) ratio of 2.77 makes it very expensive (a PEG of 1.0 is considered fairly priced). Whole Foods' P/E is 38.2 and its earnings are expected to grow 13.8% to $2.16 in 2012

At its current high price, Whole Foods looks like it is poised to plunge unless it beats expectations again. But despite its public gaffes, it's a solid performer. I'd consider buying it after a market break. And as Washington stumbles on debt-ceiling negotiations, such a break could be at our doorstep.