Whole Foods Market (WFMI) is the kind of investment that is nearly impossible to pass up (but you probably should)…  The company is the largest retailer of natural and organic foods in the US and has actually seen its footprint extend beyond national boundaries into Canada and the UK.  The firm has been incredibly successful not only in developing a profitable business, but also in leading an entire culture to value more healthy nutritious food.

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WFMI was one of the few momentum stocks to largely survive the turbulent investment period early this decade, continuing to show investors triple digit profits while technology stocks were tracing the inverse patterns as they traded down to nothing.  Stores were opening at an incredible clip and it seemed no matter how aggressive analysts would set their expectations, WFMI would somehow find a way to pleasantly surprise quarter after quarter.  It’s no wonder the stock soon became one of the most well known ticker symbols even as the store brand became a household staple.

Sadly, all good things must come to an end, and in time Whole Foods stock fell under the weight of heavy expectations along with the eventual turn for the worst in the economy.  Over the course of just under three years, the stock dropped 91% of its value as investors pondered the fate of a “luxury grocery chain” in this new world of illiquidity and unemployment.  As is often the case with Wall Street, the pendulum swung too far towards the fear spectrum and WFMI actually offered a huge opportunity for investors willing to step in and buy this former high-flyer at less than 10 times earnings.

The ensuing rebound made some investors rich as 300% gains have been possible in just nine months time.  Most recently, the company announced statistics for its third quarter (ending July 2) after which the stock rallied more than 15% in a single trading session.  While the numbers for the quarter were not particularly good, investors were relieved to note that sales actually increased ever so slightly over the quarter and earnings were actually up 17% due to aggressive cost cutting.  During the quarter WFMI generated 93 million in free cash flow and is sitting on $448 million in cash and another $335 million available in their credit line.

Once again it appears like the investor sentiment pendulum is swinging and this time it has crossed over center into “overly optimistic” territory.  It’s no secret that ZachStocks has offered little optimism when it comes to retail stocks, or the state of the US consumer.  Unfortunately, while WFMI is an excellent company and I respect management, their values, the company’s growth, and the idea of organic food (ok, I’ve resisted this movement for a while) – I believe the current price of WFMI has significant risk of decline.

The company continues to see a decline in same store sales and is relying on new store openings to sustain a flat revenue trend.  These new openings are expensive and add directly to depreciation costs for future quarters.  According to the tentative model issued by the company, WFMI will open 53 new stores in the next 4 years which will include an additional 8 new markets.  Despite the aggressive schedule, management has yet to issue expectations for 2010 and stated that visibility is expected to be limited when it gives preliminary guidance in November.

The uncertain economic outlook makes it highly difficult to predict future results. Therefore, the Company will provide preliminary assumptions and expectations for fiscal year 2010 in its fourth quarter earnings announcement in early November. ~WFMI Q3 Press Release

Typically the market hates uncertainty, but at this point it appears investors are willing to give the stock the benefit of the doubt.  But with very little certainty for future quarters, and a multiple of 33 times 2009 estimates it appears that owning the stock is more of a gamble at this point than a solid investment opportunity.

Aggressive traders may consider shorting WFMI although timing will be critical.  It wouldn’t surprise me to see the stock trading below $20 sometime this fall, but until momentum is clearly broken a short trade is likely too risky.  A possible strategy would be to set a “sell stop” order which would be triggered only when WFMI crosses below $26.  Or another idea would be to wait until the Retail Holders (RTH) tracking stock breaks below $81 or even $80.  The bottom line is that you want the trend to be in your favor before initiating the trade.

At some point WFMI will be an attractive investment again.  But for the time being, it seems the best course of action is to stalk for a short-term negative movement.

FD: Author does not have a position in WFMI

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