The Grocery Competition You Never Saw Coming

It seems unlikely that The Fresh Market (NASDAQ: TFM  ) and Whole Foods Market (NASDAQ: WFM  ) would have an existing major competitor. After all, most of the other brands out there focus on cheap food and large selection instead of on sourcing and quality. But there's a lurking competitor that's searching out the same demographic, through a very different route -- Costco (NASDAQ: COST  ) .

Costco's management pointed out on its last earning call that foot traffic was being driven by two major factors: gas sales and fresh food. That fresh food portion is going to cut right into the sales at Whole Foods and Fresh Market, and if those companies aren't careful, Costco's going to walk all over them.

It's all about the customer
As early as 2009, Whole Foods saw the competition that was brewing with Costco. At the time, the economic downturn made it abundantly clear that customers were price-conscious, whether companies believed it or not. Whole Foods co-CEO John Mackey gave an interview with The Wall Street Journal in which he highlighted the difficulty that Whole Foods had in competing. While the company was capable of managing the competition from Trader Joe's, Mackey said that it was "harder to match Costco without going bankrupt."

Costco's benefit is clearly the company's store model, which allows customers to browse a huge selection in a warehouse environment. That model is in stark contrast to Fresh Market and Whole Foods, both of which use wood, tiles, and lush signage to make customers more comfortable.

The stripped-down nature of Costco, along with its membership revenue stream, means that the company can compete on those fresh products in a way that Whole Foods just can't. As the organic food machine grows -- generating more than $30 billion in revenue annually -- more organic produce is going to find its way into Costco, and more customers are going to turn to the warehouse for cheaper food.

Well -- it's also about the economy
The original quote from Mackey came at a time when the American economy was near its bleakest. While we've come a long way, there's still time for things to fall apart. Costco is in a position where it benefits as the economy gets stronger, as more people feel like they can afford membership, and when the economy goes downhill, as more families look for bargains.

Whole Foods has had awesome comparable-sales growth, and last quarter its operating margin hit 7.5%, so it's in a good position if things slow down a bit. In my mind, The Fresh Market is really the only business that needs the economy to keep picking up. The company has recently expanded into new areas, like California, and it needs less-price-sensitive buyers to build its brand loyalty. That said, when it works, it works well. The company managed a 9.7% operating margin in the first quarter, which allows for lots of wiggle room.

In the end, I just can't fault the win-win scenario that Costco has gotten itself into. On top of that, the stock trades at a substantial discount to both Whole Foods and Fresh Market, sporting a trailing P/E of 24 versus 36 for both of the high-end brands. While I like all three of the businesses, Costco looks like it's in a position to make a big dent in the traditional grocers' bottom lines.

Food for thought
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  • Report this Comment On June 25, 2013, at 3:56 AM, boethius70 wrote:

    Very different demographics between Costco and Whole Foods certainly however WF has to know it has the well-deserved reputation as "Whole Paycheck" for a very, very good reason. I cringe every time I bring an armload of products to the checkout at WF and wonder if I'm going to overdraw my bank account. While I know grocery is a razor-thin margin business by nature the WF shopping experience punctuated by its crunchy granola awesomeness, the dreadlocked white girl lean vegan babes toting their infant child with their sinewy arms, sashaying along in their peasant skirts, and the hipster cashiers with more holes in their face than Bonnie & Clyde after an FBI shoot-out ultimately doesn't hold water. The "homey" nouveau riche neo-hippie feel is carefully manufactured to distract from the stratospheric mark-up ghost that haunts its aisles. While WF has grown up quite dramatically and successfully with the craze in natural and organic foods that's mushroomed in the last 20+ years Costco and others (Sprouts, for one; TJs for another) is breathing down its neck. At the end of the day we want to pay much, much, MUCH less for our organic fruits and veggies and Costco can certainly deliver for a fraction of what WF sells the same products for. The days of flim-flamming the consumer over "premium" organic pricing is rapidly coming to a close. Organic farming is a very mature industry and it knows the consumers don't want to pay an exorbitant organic tax. The grocery stores are sure to follow.

  • Report this Comment On June 25, 2013, at 11:15 AM, todamo13 wrote:

    The reason mass-produced food is so cheap is because of the way it's produced. For instance, cheap McDonald's beef is 'created' in horrible feedlots, which are basically concentration camps for cows. They are fed corn to fatten them, even though cows did not evolve to eat corn and it makes them sick. So they are given antibiotics which cause a whole host of other problems. Why are they fattened with corn? Because the US government subsidizes industrial mega-sized corn farm corporations, making corn (and High Fructose Corn Syrup, etc) 'cheap.'

    My point is that doing things organically should actually be the baseline. The fact is, factory farmed "cheap" food is cheaper than it should be. The costs of industrial food are not shown in the low price you pay, but are instead externalized onto society - less nutrition, health problems, environmental damage, factory farm pollution, corporate ag subsidies, etc.

    Maybe someday, when pesticides and petrochemical fertilizers and feedlots are banned (if only), and organic isn't a niche but the mainstream, then maybe organic food will be able to become cheaper. And maybe it should be somewhat cheaper now. But it's also a whole system we're talking about here. Organic farmers are making the world better, and solving some bad problems caused by industrialization, and I believe they deserve a good living wage.

    If the vegetables or whatever you are buying are dirt cheap, you know that they are grown in the cheapest possible industrial manner (or in China). That's not good, and maybe we should be willing to pay more for good food. I think so.

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