Whole Foods Market, Inc. Delivers Record Sales but Earnings Continue to Slide

It's too early to measure how much 365 will matter to Whole Foods, but the early results have been promising. Image source: Whole Foods Market. 

When Whole Foods Market, Inc. (WFM) reported third-quarter earnings on July 27, there was some optimism that the company might finally start turning its profit engine back on after nearly a year of declines. Unfortunately investors got another quarter of falling profits, though revenue continued to grow as the company's store base expanded. 

And while it's arguable just how bad the quarter was for Whole Foods, there's no getting around this reality: It's been a year since comparable store sales increased, and management said on the earnings call that comps were down to start its fourth quarter. Let's take a closer look at the results.

The numbers

Revenue and net income in millions. Data source: Whole Foods.

Keys to the quarter

• Revenue was up 2%, driven entirely by new store openings, as comps fell 2.6% and transactions fell 2.7%.
• The comps decline did decelerate slightly, down 45 basis points from the second quarter due to items per order growth offsetting price cuts. 
• The company continues to focus on cost improvement, with a plan to reduce annual costs by $300 million by 2017, but healthcare cost pressure so far this year has negatively impacted its costs. 
• SG&A increased to 28.5% of sales, 11 basis points higher than one year ago, even after lowering wage expense by 82 basis points in the quarter.
• Whole Foods opened its first 365 by Whole Foods store in the third quarter, and its second location only two weeks ago. 
• While it's early management was notably excited on the earnings call about the early results at these stores, saying repeatedly that they are attracting customers who are new to Whole Foods. 
• Sales results also appear to be stronger than anticipated, both in traffic and in average basket. This has let the company to already make changes to the front end of the 365 stores, including larger check-out stations to accommodate bigger orders. 
• Gross margin was down 89 basis points to 34.7%, but this is part of the company's strategy to lower prices. Management has said it expects gross margins to fall about 200 basis points over the next year as part its competitive strategy. 
• Whole Foods has repurchased 31.2 million shares of stock in 2016 for $929 million. That's an 11% reduction in the share count, at an average price below $30 per share. 
• Year-to-date, Whole Foods has opened 26 new stores, and plans to open two more by year-end. On a square-footage basis, this will increase Whole Foods' size by 7%. 

What management said

Let's start with this comment by Co-founder and Co-CEO John Mackey, addressing competition and how it's more than just traditional grocers offering organics:

I mean, it's not a big secret, is it? There's a lot more competitors in the marketplace and there's a lot of new formats in the marketplace, from home meal replacement to meal kits, fast casual restaurant growth. More entrants in the natural and organic food space. ... These are all factors.

Whole Foods Market being the leader, having very high sales per square foot, we probably feel the brunt of it as there's a bit of a regression to the mean, as we lose customers from a convenience standpoint. People don't drive as far as they used to drive, because there's good enough alternatives in many cases close by to them.

Co-founder and co-CEO Walter Robb on the early results of the company's first two 365 by Whole Foods stores:

We're attracting a new customer. We are broadening the import and the effective Whole Foods Market in the marketplace through these stores. We're reaching customers that we historically have not reached. That's clearly what the data shows.

Whole Foods also looks to be getting in the meal kits business. In response to an analyst question, Robb said the company has "huge interest." VP of operations Ken Meyer said the following:

(W)ith the creation of our culinary team led by Tien Ho, who's now put together a really great group of leaders for us in the company. And it's part of what we're looking at with what we call our meal solution spectrum, which we're really excited about because it's going to address all aspects in which we want to bring food to our customers. ... We're not going to announce anything today. But, we will say that we are committed to this category. 

CFO Glenda Flanagan, on how technology will play a big role in Whole Foods managing its costs going forward:

For example, auto-replenishment is going to be a big one when we get to that, because we have a lot of people in the stores who are buyers and we have no buyers in the 365 stores. All the inventory is automatically ordered. So, that's a big one that's going to happen for us at some point.

Technology is also playing a big role in customer engagement, CIO Jason Buechel said that the company is approaching 1 million mobile coupon redemptions, and that the company has seen a huge acceleration in downloads of its app, following the launch of its 365 stores and the accompanying discounts via the app. 

Looking ahead

Increased competition and ongoing efforts at Whole Foods to be more competitive and reverse traffic trends have changed the landscape, and management sees the need to be more conservative with guidance until their efforts start to bear fruit. So for now, its guidance will be based on recent trends. With a 2.4% decline in comps to start the fourth quarter and higher healthcare costs as seen so far this year, revenue would grow 2% and diluted EPS would be $0.023-$0.24 in the fourth quarter.  

Additionally, the company is moderating its expansion plans, and will grow square footage 6% in 2017, less than this year. This is because, as, Walter Robb said on the call, they want to take a measured approach to the 365 rollout, and focus resources on priorities including cost reductions and promotional efforts for now, and reevaluate growth based on how those efforts, as well as what they learn from the early 365 openings, pay off. 

We are yet to see any measurable benefit to the company's efforts so far, but there's no doubt that management is committed to taking this approach to revitalizing Whole Foods' growth prospects. Frankly, it could be another year before we really start to find out how well it's working out. 

For now, the company remains solidly profitable, and has the resources -- and the time -- to implement its changes and adapt based on what it learns. It may seem like the best is over for Whole Foods, and it has been a pretty bad year. But considering that the company is less than halfway to its goal of 1,200-plus stores and the early results of its new store format look very promising, it's probably too early to give up just yet.