Whole Foods Gone Wild

Wild times may lie ahead for Whole Foods (Nasdaq: WFMI  ) , which plans to purchase ailing organic-groceries rival Wild Oats (Nasdaq: OATS  ) . Lest we forget amid all the excitement, let's also take a look at Whole Foods' freshly released quarterly numbers.

Whole Foods' first-quarter profit came in lower year over year, but that's nothing new, considering the factors that spooked investors last quarter. Net income decreased 8% to $53.8 million, although adjusted operating income increased 2%, and cash flow from operations jumped by 27%. Sales increased 12% to $1.87 billion.

Whole Foods has always said it prefers to focus on economic value added, or EVA, instead of short-term earnings and comps growth. Peeking at that metric, we see that first-quarter EVA was $10.2 million. That's down 38% on a year-over-year basis, but it does represent an improvement on a sequential basis.

Meanwhile, Whole Foods managed a 7% increase in same-store sales on top of tough comparisons in recent years. Last year's first-quarter comps growth, for example, was 13%.

As expected, margins weakened across the board as Whole Foods attempted to alter its reputation for high prices. In addition to the toll exacted by lower, more competitive prices, lofty health-care costs also ate into its profitability. Gross profit for the quarter, meanwhile, decreased by 24 basis points to 34.3%. (Whole Foods says first-quarter gross profit is historically weak.) Direct store expenses also hit a new high, at 25.8%.

Although I caught at least one news article suggesting that Whole Foods' forecast for 2007 was new information, it's not as fresh as the company's produce. Whole Foods already disclosed last quarter that it expects comps of 6% to 8% in 2007, along with revenue growth of 13% to 17%, so nothing's changed there. Its forecasts do not include the Wild Oats transaction, which isn't expected to close until April. (If you'd like to dig into all of the numbers, check out our Fool by Numbers feature.)

Whole Foods also will increase its debt load with the deal; it said it will pay for the transaction with $700 million in senior-term loans, and it plans to increase its credit facility to $250 million.

Whole Foods' walk on the wild side
When I identified Whole Foods as a candidate for Best Retailer for 2007 in one of our recent Motley Fool CAPS features, I certainly didn't anticipate Whole Foods' plans to buy Wild Oats for $565 million.

The acquisition seems surprising at first blush, given Wild Oats' previously uninspiring performance. But it's hard to be second fiddle in an area where Whole Foods has taken the leadership position, especially as competition from more mainstream grocers encroaches. Those same competitive concerns are part of what knocked Whole Foods' shares for a loop last year. Wal-Mart's (NYSE: WMT  ) high-profile entry into organics caused quite a stir, and you're now beginning to find such wares in the unlikeliest of places. They're appearing not just in specialty retailers such as Trader Joe's, or gourmet stores such as the Northeast's Wegmans stores, but also in your local Safeway (NYSE: SWY  ) and Kroger (NYSE: KR  ) . One of my regular correspondents emailed me just a couple of days ago to report that he had seen organic goods in Shoppers Food Warehouse -- quite an unlikely surprise.

So maybe it's not surprising that Wild Oats has had a hard time wringing out Whole Foods-caliber performance in this environment. In addition to competitive pressures, Wild Oats is still operating with Chairman Greg Mays as interim CEO, while the company's CFO resigned in December. In Whole Foods' conference call, CEO John Mackey pointed out that this seemed like an opportune time for the buyout, given Wild Oats' uncertainty and potential lack of strategic direction following its leadership vacancies.

However, given the tougher environment for organics, it makes sense for Whole Foods to buy up a competitor with its same general focus and culture, even if that purchase lacks its strong financial performance. In the conference call, Whole Foods talked up the "shared intellectual capital" between the two retailers -- what they can learn from one another -- while acknowledging that the financial productivity of Whole Foods' stores is about double that of Wild Oats'. The former company is obviously hoping to meet the challenge of creating similar performance at the latter's stores.

If Whole Foods can work its magic at Wild Oats, it should bode well for the combined company in fending off the newcomers. Plus, Wild Oats will give Whole Foods instant access to markets it wants to enter, as well as an increased presence in existing markets -- not to mention cost reductions as the companies eliminate redundancies. Whole Foods said that although there should be some measurable progress by next year, it might take two years before we see all of the benefits from the deal.

Bear in mind, of course, that Whole Foods will take on Wild Oats' debt, while adding additional debt of its own, in connection with the transaction.

Organic growth by any other name ...
I can't help noting that the big news seems like a bit of a distraction, overshadowing a less-exciting-than-usual quarterly report for Whole Foods. The company advised us to watch for innovation in 2007, but I wouldn't necessarily consider an acquisition "innovative." Combining the two companies could result in some innovative results in their combined niche, but I'm looking forward to seeing what else this year holds.

I admit that I have a bit of a distaste for mergers and acquisitions; growth by acquisition isn't always as impressive as organic growth. And, of course, acquisitions can be distracting and difficult to integrate for the companies. Wading through financial statements also becomes a more complex task for investors.

That said, Whole Foods has acquired smaller, organic, and health-related grocers in the past, including Bread and Circus and Fresh Fields, so the Wild Oats acquisition fits the trend. Its similar business isn't likely to make Whole Foods lose focus, and its addition should help shore up the company's ability to compete with those other encroaching grocers.

Overall, I still feel good about Whole Foods Market and its long-term growth potential. I remain optimistic that it's a well-run business with strong competitive positioning and leadership. The next couple of years may be crucial for the organic foods market, but as long as Whole Foods keeps innovating, its future still seems bright. Should the Wild Oats acquisition go as planned, it may be even brighter.

Grab a helping of related Foolishness:

  • In January, I considered Whole Foods the best, but my colleague David Meier expressed misgivings.
  • Last quarter, I thought it was a good idea to hold on to Whole Foods.
  • However, I wasn't wild about Wild Oats.

Whole Foods Market is a Motley Fool Stock Advisor recommendation. Wal-Mart has been recommended by Motley Fool Inside Value. Check out either service free for 30 days.

Alyce Lomax owns shares of Whole Foods Market. The Fool's disclosure policy is good for you.


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