Whole Foods Market reported vigorous earnings last week, and the results, coupled with the announcement of a 2-for-1 stock split, lifted shares more than 10% in a single trading session. The market tends to react in knee-jerk fashion to Whole Foods' earnings reports, and last week's stock price movement was a mirror image of February's earnings announcement, at which point the stock fell 10% in a single day.
Aside from supporting Newton's Third Law of Motion (for every action there is an equal and opposite reaction), the varying stock movement between the two most recent quarters shows how difficult it is for investors to decide if Whole Foods' impressive results can be sustained. Let's look at three key takeaways from the company's earnings that point to continued enviable performance.
Record operating margin: no big deal
One catalyst for WFM's stock price pop last week was its operating margin, which came in at 7.5%, a company record. If we peer back one year to the comparable quarter in 2012, however, we see that the company posted operating margin of 7.12%, also a record at the time.
In some ways, the operating margin of Q2 2013 is ho-hum; it's an improvement of roughly four-tenths of 1% over the same period last year. But a larger point will likely rise to the surface for the long-term investor: Whole Foods understands that steady, incremental progress builds long-term value, and it strives to continually expand its margins. Rather than focusing on an incremental "record operating profit" then, it might be interesting to see which levers WFM is pushing to get there. Below is a table I've compiled from data furnished in the company's earnings release:
12 Weeks Ended April 14, 2013
12 Weeks Ended April 8, 2012
Cost of goods sold and occupancy costs
Direct store expenses
Store contribution profit
General and administrative expenses
Operating income before pre-opening and store closure
Relocation, store closure and lease termination costs
Investment and other income, net of interest expense
Income before income taxes
Provision for income taxes
Source: Whole Foods quarterly earnings press release. All dollar figures are in millions.
As you can see, gross profit was virtually unchanged from the comparable prior-year quarter -- the company posted 36.37% gross margin in its second quarter of 2013 vs. 36.33% in the same time period in 2012. All things being equal, the 0.4% improvement in total operating profit came from lower direct store expenses and lower general and administrative expenses. Management's ability to hold administrative expenses in check, even while recording a 13.3% increase in sales vs. the comparable quarter in 2012, is impressive. Discipline like this helps Whole Foods post similar margin numbers to competitor The Fresh Market (which recently achieved a quarterly operating margin of 8.3%), despite being approximately nine times bigger than The Fresh Market on a revenue basis.
Profits in pricing, promotions, and produce
Whole Foods' management loves to study what works and what doesn't. There's growing evidence that the company is bringing its curiosity and natural desire to learn to its pricing mix and promotion strategies. Executive Vice President Dave Lannon mentioned on the earnings call that one-day promotions utilizing social media have produced significant results, including a one-day mango sale across company stores in which 1.2 million mangos were sold. An analyst asked during the call if such promotions would help achieve another company goal -- controlling shrinkage (the amount of produce inventory that is written off when it cannot be sold). As Foolish blogger Adam Levy pointed out in a recent article, CEO John Mackey confirmed this with the most succinct answer on the call: "Absolutely: if you sell, you don't have to throw away."
This is a subtle but very important point for the investor to note. If Whole Foods can move perishable goods on a large scale via in-store promotions, it will increase its top line, but the negative impact of the promotional discount on gross margin will be lessened by movement of inventory that normally would be written off to shrinkage. You can see how Whole Foods will leverage its growing analytical capabilities to identify which products will lure not only the most shoppers into the store on sale promotion days but result in the ideal cost impact.
Keeping assets in fighting trim
Whole Foods' return on invested capital, or ROIC, continues to impress, hitting a record of 16.7% in the quarter. On the call, Mackey mentioned the higher ROIC from older stores, a trend that is worth paying attention to. He specifically identified depreciation as a driver of the higher ROIC. This is a perhaps an overlooked aspect of Whole Foods' operations. The company's ROIC from older stores indicates that it takes very good care of its depreciable assets, from its buildings and leasehold improvements to its equipment.
This is quite evident when you walk into a Whole Foods store. The company tends to keep buildings and assets in service and in peak condition after their economic depreciation has run its course on the income statement. To put this in simpler terms, Whole Foods is squeezing more out of its property and equipment, not less, as time goes on. If you're a shareholder, this is the type of practice you want to see.
More improvement and more volatility to come
If you own Whole Foods stock, expect more optimization of earnings, but also brace yourself for more mercurial stock price movement around earnings releases. The stock is trading at a multiple that is admittedly rich, at nearly 39 times trailing-12-month earnings, although I've argued in the past that the company deserves a premium valuation. If you don't own the stock, you can also use the volatility at earnings time to potentially enter into a position. In either case, the takeaways from the latest earnings report confirm that Whole Foods continues to be a strong candidate for a multiyear investment in many portfolios.
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The article 3 Key Takeaways From Whole Foods' Earnings originally appeared on Fool.com.
Fool contributor Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market. It recommends and owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.