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Whole Foods Market 10-Q 2008
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Qx Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the period ended April 13, 2008; or
o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to .
Commission File Number: 0-19797
WHOLE FOODS MARKET, INC. (Exact name of registrant as specified in its charter)
550 Bowie St. Austin, Texas 78703 (Address of principal executive offices)
512-477-4455 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes o No x
The number of shares of the registrant’s common stock, no par value, outstanding as of April 13, 2008 was 140,207,814 shares.
Whole Foods Market, Inc. Form 10-Q Table of Contents
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Whole Foods Market, Inc. Consolidated Balance Sheets (unaudited) April 13, 2008 and September 30, 2007 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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Whole Foods Market, Inc. Consolidated Statements of Operations (unaudited) (In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
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Whole Foods Market, Inc. Consolidated Statements of Shareholders’ Equity and Comprehensive Income (unaudited) Twenty-eight weeks ended April 13, 2008 and fiscal year ended September 30, 2007 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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Whole Foods Market, Inc. Consolidated Statements of Cash Flows (unaudited) (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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Whole Foods Market, Inc. Notes to Consolidated Financial Statements (unaudited) April 13, 2008
(1) Basis of Presentation The accompanying unaudited consolidated financial statements of Whole Foods Market, Inc. and its consolidated subsidiaries (collectively “Whole Foods Market,” “Company,” or “We”) have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis, the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2007. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation. Interim results are not necessarily indicative of results for any other interim period or for a full fiscal year. The Company reports its results of operations on a fifty-two or fifty-three week fiscal year ending on the last Sunday in September. The first fiscal quarter is sixteen weeks, the second and third quarters each are twelve weeks, and the fourth quarter is twelve or thirteen weeks. Fiscal year 2008 is a fifty-two week and fiscal year 2007 was a fifty-three week fiscal year. We operate in one reportable segment, natural and organic food supermarkets. Where appropriate, we have reclassified prior year financial statements to conform to current year presentation.
(2) Summary of Significant Accounting Policies Derivative Instruments The Company accounts for derivatives pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS No. 133.” SFAS No. 133 and SFAS No. 138 require that all derivative financial instruments are recorded on the balance sheet at their respective fair value.
The Company currently utilizes an interest rate swap agreement to manage well-defined interest rate risks. The Company does not use financial instruments or derivatives for any trading or other speculative purposes.
Income Taxes On October 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, as amended, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax positions recognized in the financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on measurement, classification, interest and penalties associated with tax positions, and income tax disclosures. See Note 8 to the consolidated financial statements, “Income Taxes,” for further discussion of the impact of adopting FIN 48.
(3) Business Combination Effective August 28, 2007, the Company completed the acquisition of Wild Oats Markets, Inc. (“Wild Oats”), a leading natural and organic foods retailer in North America, in a cash tender offer of $18.50 per share, or approximately $565 million plus the assumption of approximately $148 million in existing debt. At the date of acquisition, Wild Oats had 109 stores in 23 states and British Columbia, Canada operating under four banners: Wild Oats Marketplace nationwide, Henry’s Farmers Market (“Henry’s”) in Southern California, Sun Harvest in Texas and Capers Community Market in British Columbia. To fund the transaction, we entered into a five-year $700 million senior term loan agreement. We also signed a new five-year $250 million revolving credit agreement that contains a $100 million accordion feature, which replaced our existing $200 million revolver. Wild Oats results of operations are included in our consolidated financial statements for the period beginning August 28, 2007 through April 13, 2008. In connection with the acquisition of Wild Oats, the Company separately entered into an agreement to sell certain assets and liabilities, consisting primarily of fixed assets, inventories and operating leases, related to all 35 Henry’s and Sun Harvest stores and a related distribution center in Riverside, CA to a wholly owned subsidiary of Smart & Final, Inc., a Los Angeles-based food retailer for approximately $165 million. This sale was completed effective September 30, 2007. During fiscal year 2008, the Company finalized the sale price, which effectively reduced total proceeds by approximately $1.1 million. Regarding the other 74 Wild Oats and Capers banner stores the Company acquired in the Wild Oats Markets transaction, the Company has closed thirteen stores, including one that re-opened in May after an
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extended renovation period, and currently intends to close an additional ten stores as existing Whole Foods Market sites in development open through fiscal year 2010.
Whole Foods Market and Wild Oats have similar missions and core values, and the Company believes the synergies gained from this business combination will create long term value for our customers, vendors and shareholders as well as exciting opportunities for our new and existing team members by making us better positioned to compete in this rapidly changing food retailing environment. All of our 11 operating regions gained stores in the acquisition, with three of our smallest regions, the Florida, Rocky Mountain, and Pacific Northwest regions, gaining critical mass. The acquisition provided us with immediate entry into five new states: Arkansas, Indiana, Oklahoma, Tennessee and Utah, and 14 new markets: Bend, OR; Cincinnati, OH; Indianapolis, IN; Lexington, KY; Little Rock, AR; Memphis, TN; Naples, FL; Nashville, TN; Reno, NV; Salt Lake City, UT; Tampa, FL; Tucson, AZ; Tulsa, OK; and Westport, CT.
The purchase price of the acquired operations was comprised of (in thousands):
Direct Costs of the Acquisition Direct costs of the acquisition include investment banking fees, legal and accounting fees and other external costs directly related to the acquisition.
Preliminary Purchase Price Allocation The acquisition was accounted for under the purchase method of accounting with Whole Foods Market treated as the acquiring entity in accordance with SFAS No. 141, “Business Combinations.” Accordingly, the consideration paid by Whole Foods Market to complete the acquisition has been allocated preliminarily to the assets and liabilities acquired based upon their estimated fair values as of the date of the acquisition. The purchase price allocation is preliminary and is subject to future adjustment during the allocation period as defined in SFAS No. 141. The primary areas of the purchase price allocation that could be subject to future adjustment relate to the valuation of store closure reserves, pre-acquisition legal contingencies and residual goodwill. Additionally, the Company is in the process of making assessments in other areas that could affect the final purchase price allocation. The excess of the purchase price over the estimated fair values of assets acquired and liabilities assumed was recorded as goodwill. Goodwill is non-amortizing for financial statement purposes and is not tax deductible.
The following summarizes the fair values of the assets acquired and liabilities assumed at the acquisition date, as revised (in thousands):
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The purchase price adjustments relate primarily to the completion of evaluations of the physical and market condition of acquired locations as of August 28, 2007, resulting in the Company’s decision to close five additional Wild Oats store locations and adjustments to the fair values of certain assets and store closure reserves. The store closure reserves related to Wild Oats locations were reduced by approximately $25.1 million as discussed in Note 5 to the consolidated financial statements, “Reserves for Closed Properties.”
Estimated fair values of intangible assets acquired are as follows (in thousands):
Amortizing intangible assets are amortized on a straight-line basis over their remaining expected useful lives of approximately one to 32 years.
In connection with the acquisition, the Company recognized liabilities totaling approximately $8.4 million for estimated costs associated with plans to involuntarily terminate certain team members of Wild Oats, contract termination fees and other legal reserves, as revised, totaling approximately $11.4 million, and estimated costs to close certain store locations, as revised, totaling approximately $67.8 million. There have been no adjustments to date to the team member termination liabilities. Estimated contract termination fees and other legal reserves increased approximately $2.4 million during fiscal year 2008. As of April 13, 2008, team member termination liabilities and contract termination fee reserves were approximately $0.4 million and $9.6 million, respectively, as a result of adjustments and payments made during the fiscal year. We expect involuntary team member terminations and contract termination activities to be substantially completed by the end of fiscal year 2008. Store closure reserves are discussed further in Note 5 to the consolidated financial statements, “Reserves for Closed Properties.”
The Company assumed debt totaling approximately $148 million in the acquisition consisting primarily of convertible subordinated debentures and capital lease obligations. The estimated fair value of the debt assumed by the Company was approximately $134 million. Excluding capital lease obligations, all debt assumed as part of the Wild Oats acquisition was fully repaid by the end of the first quarter of fiscal year 2008. Debt is discussed further in Note 6 to the consolidated financial statements, “Long-Term Debt.”
The estimated values of operating leases with unfavorable terms compared with current market conditions totaled approximately $1.5 million. These leases have an estimated weighted average life of approximately 14 years and are included in other liabilities.
Henry’s and Sun Harvest Divestiture In connection with the acquisition of Wild Oats, the Company separately entered into an agreement to sell certain assets and liabilities, consisting primarily of fixed assets, inventories and operating leases, related to all 35 Henry’s and Sun Harvest stores and a related distribution center in Riverside, CA to a wholly owned subsidiary of Smart & Final, Inc., a Los Angeles-based food retailer for approximately $165 million. This sale was completed effective September 30, 2007. During the first quarter of fiscal year 2008, the Company received proceeds totaling approximately $165 million. As of September 30, 2007 the proceeds receivable are included on the accompanying Consolidated Balance Sheets under the caption “Proceeds receivable for divestiture.” As part of purchase accounting for the Wild Oats acquisition, the Henry’s and Sun Harvest net assets were adjusted to fair value and therefore no gain or loss was recognized related to this divestiture. During fiscal year 2008, the Company finalized the sale price, which effectively reduced total proceeds by approximately $1.1 million.
Transition Services Agreement In connection with the sale of the Henry’s and Sun Harvest stores, Whole Foods Market entered into a transition services agreement (“TSA”) with Smart & Final under which Whole Foods Market has and will continue to provide certain general
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and administrative services for the 35 stores for up to two years. The TSA provides for payments to the Company calculated for each service area as a certain percentage of total monthly sales of the Henry’s and Sun Harvest locations, initially totaling 1.75% of total monthly sales for all services provided under the agreement. The Company anticipates that the revenue associated with the agreement will be approximately equal to its incremental cost of providing the support. During the twelve and twenty-eight weeks ended April 13, 2008, the Company earned approximately $1.3 million and $3.3 million, respectively, in TSA fees which are included on the accompanying Consolidated Statements of Operations under the caption “General and administrative expenses.” At the end of the second quarter of fiscal year 2008, services related to the support agreement were substantially complete except for private label support, which will end June 30, 2008, and licensure of the Wild Oats private label brand, which will end no later than September 29, 2009.
Unaudited Pro Forma Financial Information The following pro forma financial information presents the combined historical results of the operations of Whole Foods Market and Wild Oats as if the Wild Oats acquisition and the sale of the Henry’s and Sun Harvest stores had occurred at the beginning of fiscal year 2007. Certain adjustments have been made to reflect changes in depreciation, amortization and income taxes based on the Company’s preliminary estimates of fair values recognized in the application of purchase accounting, and interest expense on borrowings to finance the acquisition. These adjustments are subject to change as the initial estimates are refined over time.
Due to differences in accounting calendars, the second quarter of fiscal year 2007 pro forma results of operations combines the twelve weeks ended April 8, 2007 for Whole Foods Market with the thirteen weeks ended March 31, 2007 for Wild Oats and the year-to-date pro forma results of operations for fiscal year 2007 combines the twenty-eight weeks ended April 8, 2007 for Whole Foods Market with the thirteen weeks ended December 30, 2006 and the thirteen weeks ended March 31, 2007 for Wild Oats. Pro forma results of operations are as follows (in thousands):
This pro forma financial information is not intended to represent or be indicative of what would have occurred if the transactions had taken place on the dates presented and are not indicative of what Whole Foods Market’s actual results of operations would have been had the acquisition and sale been completed on the dates indicated above. Further, the pro forma combined results do not reflect one-time costs to fully merge and operate the combined organization more efficiently, or anticipated synergies expected to result from the combination and should not be relied upon as being indicative of the future results that Whole Foods Market will experience.
(4) Goodwill and Other Intangible Assets Goodwill and indefinite-lived intangible assets are reviewed for impairment annually on the first day of the fourth fiscal quarter, or more frequently if impairment indicators arise. We allocate goodwill to one reporting unit for goodwill impairment testing. There were no impairments of goodwill or indefinite-lived intangible assets during the twenty-eight week period ended April 13, 2008.
Definite-lived intangible assets are amortized over the useful life of the related agreement. We acquired definite-lived intangible assets totaling approximately $0.9 million, consisting primarily of acquired leasehold rights, during the twelve and twenty-eight week periods ended April 13, 2008. During the twelve and twenty-eight week periods ended April 8, 2007, we acquired definite-lived intangibles, consisting primarily of acquired leasehold rights, totaling approximately $11.4 million and $17.6 million, respectively. Amortization associated with intangible assets totaled approximately $2.8 million and $6.9 million for the twelve and twenty-eight week periods ended April 13, 2008, respectively, and approximately $0.5 million and $1.0 million, respectively, for the same periods of the prior fiscal year.
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The components of intangible assets were as follows (in thousands):
Amortization associated with the net carrying amount of intangible assets at April 13, 2008 is estimated to be $5.9 million for the remainder of fiscal year 2008, $6.6 million in fiscal year 2009, $6.5 million in fiscal year 2010, $6.4 million in fiscal year 2011, $6.3 million in fiscal year 2012 and $5.3 million in fiscal year 2013.
(5) Reserves for Closed Properties The Company maintains reserves for retail stores and other properties that are no longer being utilized in current operations. The Company provides for closed property operating lease liabilities using a discount rate to calculate the present value of the remaining noncancelable lease payments and lease termination fees after the closing date, net of estimated subtenant income. The closed property lease liabilities are expected to be paid over the remaining lease terms, which generally range from one to 17 years. The Company estimates subtenant income and future cash flows based on the Company’s experience and knowledge of the market in which the closed property is located, the Company’s previous efforts to dispose of similar assets, existing economic conditions and when necessary utilizes local real estate brokers. Adjustments to closed property reserves primarily relate to changes in estimated subtenant income or actual exit costs differing from original estimates. Adjustments are made for changes in estimates in the period in which the changes become known.
Following is a summary of store closure reserves during the twenty-eight week periods ended April 13, 2008 and April 8, 2007 (in thousands):
The beginning balance of fiscal year 2008 includes approximately $92.7 of stores closure reserves for Wild Oats locations that were recorded in connection with the acquisition during the fourth quarter of fiscal year 2007. During the twenty-eight week period ended April 13, 2008, the Wild Oats store closure reserves were adjusted by approximately $25.1 million as part of the revised preliminary purchase price allocation. The purchase price adjustments relate primarily to the completion of evaluations of the physical and market condition of acquired locations as of August 28, 2007, resulting in the Company’s decision to close five additional Wild Oats store locations and adjustments to the fair values of certain assets and store closure reserves.
(6) Long-Term Debt During fiscal year 2007, the Company entered into a $700 million, five-year term loan agreement to finance the acquisition of Wild Oats Markets. The loan bears interest at our option of the alternative base rate or the LIBOR rate plus an applicable margin, 1% as of April 13, 2008, based on the Company’s Moody’s and S&P rating. Our term loan does not give rise to significant fair value risk because it is a variable interest rate loan with revolving maturities which reflect market changes to interest rates.
As of April 13, 2008 and September 30, 2007, the Company had $81 million and $17 million, respectively, drawn under its $250 million revolving credit facility. The credit agreement contains an accordion feature under which the Company can increase the revolving credit facility to $350 million. The amount available to the Company under the agreement was effectively reduced to $89.1 million by outstanding letters of credit totaling approximately $79.9 million and amounts drawn at April 13, 2008. At April 13, 2008 and September 30, 2007, we were in compliance with all applicable debt covenants. Subsequent to the end of the second quarter of fiscal year 2008, the Company made additional draws on the line and currently has $88.0 million outstanding and approximately $82.1 million available on its revolving credit facility.
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During the twenty-eight week periods ended April 13, 2008 and April 8, 2007, approximately 250 and 10,000 of the Company’s zero coupon convertible subordinated debentures, respectively, were converted at the option of the holders to approximately 6,000 and 215,000 shares, respectively, of Company common stock. The Company assumed convertible debentures totaling approximately $115.0 million in the Wild Oats acquisition, of which approximately $21.8 million were outstanding at September 30, 2007 and were repaid during the first quarter of fiscal year 2008. The zero coupon convertible subordinated debentures had a carrying amount of approximately $2.6 million and $24.5 million at April 13, 2008 and September 30, 2007, respectively.
(7) Derivative Instruments During the first quarter of fiscal year 2008, the Company entered into a three-year interest rate swap agreement with a notional amount of $490 million to effectively fix the interest rate on $490 million of the term loan at 4.718%, excluding the applicable margin and associated fees, to help manage exposure to interest rate fluctuations.
The Company had accumulated net derivative losses of approximately $14.8 million, net of taxes, in other comprehensive income as of April 13, 2008, related to this cash flow hedge. During the first quarter of fiscal year 2008, the Company recognized approximately $0.1 million of additional interest expense related to the ineffectiveness of this cash flow hedge due to a difference in the reset dates of the underlying interest rate between the original loan and swap agreement. The reset dates were aligned during the second quarter of fiscal year 2008, resulting in an effective swap.
(8) Income Taxes On October 1, 2007, the Company adopted FIN 48, which clarifies the accounting for uncertainty in income tax positions recognized in the financial statements in accordance with SFAS No. 109. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on measurement, classification, interest and penalties associated with tax positions, and income tax disclosures.
The cumulative effect of applying FIN 48 has been recorded as a decrease of approximately $1.3 million to the Company’s fiscal 2008 opening retained earnings. The Company also recorded an increase of approximately $7.2 million to income tax assets, and increase to income taxes payable of approximately $8.4 million. As of the date of adoption the Company’s gross unrecognized tax benefits totaled approximately $20.6 million of which approximately $15.8 million, if recognized, would affect the effective tax rate.
The company and its subsidiaries are subject to income tax in the U.S. federal jurisdiction, multiple state and local jurisdictions, Canada and the United Kingdom. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for fiscal years prior to 2003.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits within its global operations as a component of income tax expense. The total amount of interest and penalties accrued as of October 1, 2007 is approximately $3.6 million, which is included as a component of the $20.6 million gross unrecognized tax benefit noted above. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision.
We are currently under audit by various tax authorities. However, based on the status of these examinations, and the protocol of finalizing audits by the relevant tax authorities, which could include formal legal proceedings, it is not possible to estimate the impact of such changes, if any, to previously recorded uncertain tax positions. There have been no significant changes to the status of these examinations during the quarter ended April 13, 2008.
During fiscal year 2008, there have been no changes in any uncertain tax positions that would have resulted in a material adjustment to our unrecognized tax benefit at April 13, 2008.
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(9) Shareholders’ Equity Dividends Following is a summary of dividends declared during the twenty-eight weeks ended April 13, 2008 and fiscal year 2007 (in thousands, except per share amounts):
(1) Dividend accrued at April 13, 2008
The Company will pay future dividends at the discretion of the Board of Directors. The continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depend on many factors, including the results of operations and the financial condition of the Company. Subject to these qualifications, the Company currently expects to pay dividends on a quarterly basis.
Treasury Stock The Company’s Board of Directors has approved a stock repurchase program of up to $300 million through November 8, 2009. At September 30, 2007, the Company held in treasury approximately 4.5 million shares of common stock. The average price per share paid for shares held in treasury at September 30, 2007 was $43.98, for a total of approximately $200 million. During the first quarter of fiscal year 2008, the Company retired all shares held in treasury. The Company’s remaining authorization under the stock repurchase program at April 13, 2008, is approximately $100 million through November 8, 2009. The specific timing and repurchase of future amounts will vary based on market conditions, securities law limitations and other factors and will be made using the Company’s available resources. The repurchase program may be suspended or discontinued at any time without prior notice.
(10) Comprehensive Income Our comprehensive income was comprised of net income, unrealized losses on marketable securities, unrealized losses on cash flow hedge instruments, and foreign currency translation adjustments, net of income taxes. Comprehensive income, net of related tax effects, was as follows (in thousands):
At April 13, 2008, accumulated other comprehensive income consisted of foreign currency translation adjustment gains of approximately $11.8 million and unrealized losses on cash flow hedge instruments of approximately $14.8 million, net of approximately $10.0 million of income tax expense.
(11) Earnings per Share The computation of basic earnings per share is based on the number of weighted average common shares outstanding during the period. The computation of diluted earnings per share includes the dilutive effect of common stock equivalents consisting of common shares deemed outstanding from the assumed exercise of stock options and the assumed conversion of zero coupon convertible subordinated debentures.
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A reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations follows (in thousands, except per share amounts):
The computations of diluted earnings per share for twelve and twenty-eight week periods ended April 13, 2008 does not include options to purchase approximately 13.7 million shares and 11.6 million shares of common stock, respectively, due to their antidilutive effect and approximately 10.6 million shares and 10.8 million shares, respectively, for the same periods of the prior fiscal year.
(12) Share-Based Payments Our Company maintains several stock based incentive plans. We grant options to purchase common stock under our Whole Foods Market 2007 Stock Incentive Plan. Under this plan, options are granted at an option price equal to the market value of the stock at the grant date and are generally exercisable ratably over a four-year period beginning one year from grant date and have a five-year term. The market value of the stock is determined as the closing stock price at the grant date. At April 13, 2008 and September 30, 2007 there were approximately 6.2 million and 5.5 million shares, respectively, of our common stock available for future stock option grants.
Unrecognized share-based payments expense related to nonvested stock options, net of estimated forfeitures, was approximately $22.4 million as of April 13, 2008, related to approximately 2.5 million shares with a per share weighted average fair value of approximately $9.14. We anticipate this expense to be recognized over a weighted average period of approximately 1.4 years.
Share-based payments expense recognized during the twelve and twenty-eight week periods ended April 13, 2008 totaled approximately $2.3 million and $5.4 million, respectively, and consisted entirely of stock option expense. Share-based payments expense recognized during the twelve and twenty-eight week periods ended April 8, 2007 totaled approximately $1.7 million and $6.5 million, respectively, and consisted of stock option expense of approximately $1.6 million and $6.3 million, respectively and team member stock purchase plan discounts of approximately $0.1 million and $0.2 million, respectively. Included in stock option expense for the first quarter of fiscal year 2007 was a $2.4 million charge related to the acceleration of stock options in September 2005, to adjust for actual experience.
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Share-based payments expense was included in the following line items on the Consolidated Statements of Operations for the periods indicated (in thousands):
(13) Recent Accounting Pronouncements In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” as amended. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and requires additional disclosures about fair value measurements. SFAS No. 157 applies to fair value measurements that are already required or permitted by other accounting standards, except for measurements of share-based payments and measurements that are similar to, but not intended to be, fair value and does not change existing guidance as to whether or not an instrument is carried at fair value. SFAS No. 157 is amended by Financial Statement Position (“FSP”) No. FAS 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13,” which excludes from the scope of this provision arrangements accounted for under SFAS No. 13, “Accounting for Leases.” The provisions of SFAS No. 157, as amended by FSP No. 157-2 are effective for the specified fair value measures for financial statements issued for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years for items within scope. SFAS No. 157 is effective for the Company’s first quarter of fiscal year ending September 27, 2009. We are currently evaluating the impact, if any, that the adoption of SFAS No. 157 will have on our consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 applies to all entities that elect the fair value option. However, the amendment to SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities” applies to all entities with available-for-sale and trading securities. The provisions of SFAS No. 159 are effective for fiscal years beginning after November 15, 2007. SFAS No. 159 is effective for the Company’s fiscal year ending September 27, 2009. We are currently evaluating the impact, if any, that the adoption of SFAS No. 159 will have on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which replaces SFAS No. 141, “Business Combinations,” and applies to all transactions or other events in which an entity obtains control of one or more businesses, including those sometimes referred to as “true mergers” or “mergers of equals” and combinations achieved without the transfer of consideration. SFAS No. 141R establishes principles and requirements for how the acquirer recognizes and measures identifiable assets acquired, liabilities assumed, any noncontrolling interest and goodwill acquired. The Statement also provides for disclosures to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The provisions of SFAS No. 141R are effective for fiscal years beginning after December 15, 2008 and are applied prospectively to business combinations completed on or after that date. SFAS No. 141R is effective for the Company’s fiscal year ending September 26, 2010. We will evaluate the impact, if any, that the adoption of SFAS No. 141R could have on our consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133.” SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” by establishing, among other things, the disclosure requirements for derivative instruments and hedging activities. This Statement requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The provisions of SFAS No. 161 are effective for fiscal years and interim periods beginning November 15, 2008, with early application encouraged. SFAS No. 161 is effective for the Company’s second quarter of fiscal year ending September 27, 2009. We are currently evaluating the impact, if any, that the adoption of SFAS No. 161 will have on our consolidated financial statements.
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In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets.” FSP No. FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The intent of the position is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141R, and other U.S. generally accepted accounting principles. The provisions of FSP No. FAS 142-3 are effective for fiscal years beginning after December 15, 2008. FSP No. FAS142-3 is effective for the Company’s fiscal year ending September 26, 2010. We will evaluate the impact, if any, that the adoption of FSP No. FAS 142-3 could have on our consolidated financial statements.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
General Whole Foods Market, Inc. and its consolidated subsidiaries own and operate the largest chain of natural and organic foods supermarkets. Our Company mission is to promote vitality and well-being for all individuals by supplying the highest quality, most wholesome foods available. Through our growth, we have had a large and positive impact on the natural and organic foods movement throughout the United States, helping lead the industry to nationwide acceptance. We opened our first store in Texas in 1980 and, as of April 13, 2008, we operated 271 stores organized into 11 geographic operating regions: 259 stores in 37 U.S. states and the District of Columbia; six stores in Canada; and six stores in the United Kingdom. We operate in one reportable segment, natural and organic foods supermarkets.
Effective August 28, 2007, the Company completed the acquisition of Wild Oats Markets, Inc. (“Wild Oats”), a leading natural and organic foods retailer in North America, in a cash tender offer of $18.50 per share, or approximately $565 million plus the assumption of approximately $148 million in existing debt. At the date of acquisition, Wild Oats had 109 stores in 23 states and British Columbia, Canada operating under four banners: Wild Oats Marketplace nationwide, Henry’s Farmers Market (“Henry’s”) in Southern California, Sun Harvest in Texas, and Capers Community Market in British Columbia. In connection with the acquisition of Wild Oats, the Company separately entered into an agreement to sell certain assets and liabilities, consisting primarily of fixed assets, inventories and operating leases, related to all 35 Henry’s and Sun Harvest stores and a related distribution center. This sale was completed effective September 30, 2007 and the Company received net proceeds totaling approximately $164 million in fiscal year 2008. The Company closed 12 Wild Oats stores during the first quarter of fiscal year 2008, including one that re-opened in May after a major renovation. The Company closed one store during the second quarter of fiscal year 2008 and three additional Wild Oats stores subsequent to April 13, 2008 and currently has 59 continuing Wild Oats stores. The Company is making investments to raise the Wild Oats stores up to our high standards, including investments in repairs and maintenance of the stores, lower prices, an expanded perishables offering and increased labor. Wild Oats results of operations are included in our Consolidated Statements of Operations for the twenty-eight weeks ended April 13, 2008 and are not included in our Consolidated Statements of Operations for the twenty-eight weeks ended April 8, 2007.
Our results of operations have been and may continue to be materially affected by the timing and number of new store openings. Stores typically open within 12 to 24 months after entering the store development pipeline. New stores generally become profitable during their first year of operation; although some new stores may incur operating losses for the first several years of operation.
The Company reports its results of operations on a fifty-two or fifty-three week fiscal year ending on the last Sunday in September. The first fiscal quarter is sixteen weeks, the second and third quarters each are twelve weeks, and the fourth quarter is twelve or thirteen weeks. Fiscal year 2008 is a fifty-two week year and fiscal year 2007 was a fifty-three week year.
Executive Summary Effective August 28, 2007, the Company completed the acquisition of Wild Oats, a leading natural and organic foods retailer in North America. We completed the conversion of all Wild Oats stores to our purchasing and information systems during the second quarter of fiscal year 2008, and have so far rebranded 27 Wild Oats stores. We are making up-front investments in labor, pricing and repairs and maintenance to raise the Wild Oats stores up to our standards, and these costs are in advance of what we expect to be a significant long-term improvement in sales. We continue to expect store contribution in the Wild Oats stores to improve in the second half of the fiscal year.
Sales for the second quarter of fiscal year 2008 increased approximately 27.6% to approximately $1.9 billion over approximately $1.5 billion in the second fiscal quarter of the prior year. Comparable store sales growth was 6.7%. Sales in identical stores increased approximately 5.1% for the twelve weeks ended April 13, 2008 over the same period of the prior fiscal year. Identical store sales exclude four relocated stores and two major store expansions from the comparable calculation to reduce the impact of square footage growth on the comparison.
Food cost inflation is currently greater than four percent in the United States, and we are impacted by rising food costs as are all food retailers. We tend to follow the market in terms of passing on or absorbing these higher costs, but our retail price increases in the second quarter were below the U.S. average.
General and administrative expenses as a percentage of sales increased to 3.6% in the second quarter of fiscal year 2008 over 3.1% for the same period of the prior fiscal year. This increase was largely due to the costs of integrating and supporting the Wild Oats stores, as well as front-loaded general and administrative expenditures to support our 2008 and 2009 growth.
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Net income for the second quarter totaled approximately $40.0 million and diluted earnings per share was $0.29.
Our capital expenditures for the quarter totaled approximately $105.6 million, of which approximately $61.3 million was for new store development and approximately $44.3 million was for remodels and other additions, including approximately $9.8 million related to Wild Oats locations. During the second quarter, we opened two new stores in Scottsdale, AZ and Glastonbury, CT, and closed one Wild Oats location in St. Louis, MO, ending the quarter with 271 stores totaling approximately 9.5 million square feet. Subsequent to the end of the quarter, the Company opened one new store in Tanasbourne, OR, re-opened one acquired store in Medford, MA after a major renovation, and closed three acquired stores in Phoenix, AZ; Albuquerque, NM; and Portland, OR. The Company currently has 270 stores totaling approximately 9.4 million square feet.
At the end of the second quarter of fiscal year 2008, the Company had total debt of approximately $827.7 million, including $81 million in borrowings on the Company’s revolving line of credit.
On March 10, 2008, the Company’s Board of Directors approved a quarterly dividend of $0.20 per share, totaling approximately $28.0 million that was paid subsequent to the end of the second quarter on April 22, 2008 to shareholders of record on April 11, 2008.
Results of Operations The following table sets forth the Company’s statements of operations data expressed as a percentage of sales:
Figures may not add due to rounding.
Sales increased approximately 27.6% and 29.7% for the twelve and twenty-eight weeks ended April 13, 2008, respectively, over the same periods of the prior fiscal year. Comparable store sales increased approximately 6.7% and 8.2% for the twelve and twenty-eight weeks ended April 13, 2008, respectively. Perishable product sales accounted for approximately 66% of our total retail sales during the second quarter of fiscal year 2008. Acquired stores will enter the comparable store sales base in the fifty-third full week following the date of the merger. As of April 13, 2008, there were 194 locations in the comparable store base. Identical store sales for the twelve weeks ended April 13, 2008, which exclude four relocated stores and two major expansions, increased approximately 5.1%. Identical store sales for the twenty-eight weeks ended April 13, 2008, which exclude five relocated stores and three major expansions, increased approximately 6.2%. The sales increase contributed by stores open less than fifty-two weeks totaled approximately $169.0 million and $410.4 million for the twelve and twenty-eight weeks ended April 13, 2008. Sales at Wild Oats stores totaled approximately $175.4 million and $414.2 million for the twelve and twenty-eight weeks ended April 13, 2008. The Company believes the continued integration of the acquired Wild Oats stores into our operations and new store openings will drive strong sales growth and comparable store sales growth in future periods. For fiscal year 2008, on a 52-week to 52-week basis, the Company expects sales growth of 25% to 30% and comparable store sales growth of 7.5% to 9.5%.
Gross profit consists of sales less cost of goods sold and occupancy costs plus contribution from non-retail distribution and food preparation operations. The Company’s gross profit as a percentage of sales for the twelve and twenty-eight weeks ended April 13, 2008 was approximately 34.9% and 34.2%, respectively, compared to approximately 35.2% and 34.7%, respectively for the same periods of the prior fiscal year. Our gross profit may increase or decrease slightly depending on the
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mix of sales from new stores, seasonality, the impact of weather or a host of other factors, including inflation. Due to seasonality, the Company’s gross profit margin is typically lower in the first quarter than the remaining three quarters of the fiscal year. Gross profit margins tend to be lower for new stores and increase as stores mature, reflecting lower shrink as volumes increase, as well as increasing experience levels and operational efficiencies of the store teams.
Direct store expenses as a percentage of sales were approximately 26.6% and 26.4% for the twelve and twenty-eight weeks ended April 13, 2008, respectively, compared to approximately 25.9% for each of the same periods of the prior fiscal year. Direct store expenses as a percentage of sales tend to be higher for new and acquired stores and decrease as stores mature, reflecting increasing operational productivity of the store teams. The Company does not expect to leverage direct store expenses in fiscal year 2008 due to a higher percentage of sales from new and acquired stores, which have a lower contribution than existing stores, anticipated investments in labor and benefits at the acquired stores and continued, though more moderate, increases in health care costs as a percentage of sales.
General and administrative expenses as a percentage of sales were approximately 3.6% for both the twelve and twenty-eight weeks ended April 13, 2008 compared to approximately 3.1% and 3.0%, respectively, for the same periods of the prior fiscal year. This year-over-year increase is due mainly to the costs of integrating and supporting the Wild Oats stores, including an increase in headcount in the global and regional offices related primarily to the cost of fully staffing the Company’s three smallest regions which gained the greatest number of stores in the merger as a percentage of their existing store base; and an increase in legal and professional fees as a percentage of sales.
Pre-opening costs include rent expense incurred during construction of new stores and other costs related to new store openings, which include costs associated with hiring and training personnel, supplies and other miscellaneous costs. Rent expense is generally incurred for six to 12 months prior to a store’s opening date. Other pre-opening costs are incurred primarily in the 30 days prior to a new store opening. Relocation costs consist of moving costs, remaining lease payments, accelerated depreciation costs and other costs associated with replaced stores or facilities. Store closure costs, including interest accretion related to store closing reserves of approximately $0.8 million and $3.2 million for the twelve and twenty-eight weeks ended April 13, 2008, respectively, are also included in relocation costs. Pre-opening and relocation costs as a percentage of sales were approximately 0.6% and 0.7% for the twelve and twenty-eight weeks ended April 13, 2008, respectively, compared to approximately 1.1% and 1.0%, respectively, for the same periods of the prior fiscal year. The numbers of stores opened and relocated were as follows:
Interest expense for the twelve and twenty-eight weeks ended April 13, 2008 increased approximately $8.4 million and $20.0 million, respectively, over the same periods of the prior fiscal year due primarily to interest expense related to the $700 million term loan to finance the acquisition of Wild Oats Markets and increased borrowings on the Company’s revolving line of credit.
Investment and other income for the twelve and twenty-eight weeks ended April 13, 2008 totaled approximately $1.2 million and $3.9 million, respectively, compared to approximately $2.6 million and $6.6 million, respectively, for the same periods of the prior fiscal year due primarily to lower interest income earned based on lower average short-term investment balances.
Share-based payments expense recognized during the twelve and twenty-eight weeks ended April 13, 2008 totaled approximately $2.3 million and $5.4 million, respectively compared to approximately $1.7 million and $6.5 million respectively, for the same periods of the prior fiscal year. Included in total share-based payments expense for the first quarter of fiscal year 2007 is a $2.4 million charge related to the acceleration of stock options in September 2005 to adjust for actual experience.
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Share-based payments expense was included in the following line items on the Consolidated Statements of Operations for the periods indicated (in thousands):
The Company expects share-based payments expense of approximately $4 million to $5 million per quarter in the second half of the year following the Company’s annual grant date early in the third quarter, when the majority of options are granted.
The Company intends to keep its broad-based stock option program in place, but also intends to limit the number of shares granted in any one year so that annual earnings per share dilution from share-based payments expense will not exceed 10%. The Company believes this strategy is best aligned with its stakeholder philosophy because it limits future earnings per share dilution from options and at the same time retains the broad-based stock option plan, which the Company believes is important to team member morale, its unique corporate culture and its success.
Liquidity and Capital Resources and Changes in Financial Condition We generated cash flows from operating activities totaling approximately $156.5 million during the twenty-eight weeks ended April 13, 2008 compared to approximately $179.0 million during the same period of the prior fiscal year. Cash flows from operating activities resulted primarily from our net income plus non-cash expenses and changes in operating working capital.
Net cash used in investing activities was approximately $108.4 million for the twenty-eight weeks ended April 13, 2008 compared to approximately $162.9 million for the same period of the prior fiscal year. During the twenty-eight weeks ended April 13, 2008 the Company received net proceeds totaling approximately $163.9 million from the sale of certain assets and liabilities related to the 35 Henry’s and Sun Harvest stores and a related distribution center in Riverside, CA acquired in the purchase of Wild Oats Markets. Our principal historical capital requirements have been the funding of the development or acquisition of new stores and acquisition of property and equipment for existing stores. The required cash investment for new stores varies depending on the size of the new store, geographic location, degree of work performed by the landlord and complexity of site development issues. Capital expenditures for the twenty-eight weeks ended April 13, 2008 totaled approximately $267.3 million, of which approximately $163.4 million was for new store development and approximately $103.9 million was for remodels and other additions, including approximately $9.8 million related to Wild Oats locations. Capital expenditures for the twenty-eight weeks ended April 8, 2007 totaled approximately $254.8 million, of which approximately $177.8 million was for new store development and approximately $77.0 million was for remodels and other additions. The Company expects total capital expenditures for fiscal year 2008 to be in range of $575 million to $625 million. Of this amount, approximately 65% to 70% is expected to relate to new stores opening in fiscal year 2008 and beyond, and approximately 7% to 8% is expected to relate to remodels of acquired Wild Oats stores.
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The following table provides additional information about the Company’s store openings in fiscal year 2007 and fiscal year-to-date through May 13, 2008, leases currently tendered but not opened, and total leases signed for stores scheduled to open through fiscal year 2012:
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