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Is There a Reason to Worry About Whole Foods?

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Even though shares of Whole Foods Market (NASDAQ: WFM  ) have pulled back a little in recent weeks, the organic grocer is still near its all-time high, and business seems to be booming. Sales jumped 12% to $3.1 billion last quarter as same-store sales marched 7.5% higher, generating 21% more in net income. Yet despite the strong performance, there are signs that perhaps stress cracks are forming.

The organic food industry is experiencing unprecedented growth. According to the market researchers at the industry group SPINS, organic products have surged 13% across all retail channels with 63% of all packaged produce being "certified organic."

While the U.S. Agriculture Dept. gives producers a lot of wiggle room when declaring their products certified organic, those that are considered 100% organic -- meaning they contain zero antibiotics and growth hormones, have not had synthetic pesticides or herbicides used, are not genetically modified, and have not been subject to ionizing radiation -- have experienced the greatest growth (up 18%) and command the lion's share of the market (46%).

That, in part, explains Whole Foods' success, but it also underscores why there has been an explosion in organic food outlets. The Fresh Market went public in 2010, Natures Grocers by Vitamin Cottage followed in 2012, and Sprouts Farmers Market joined the fun just this month.

Moreover, traditional supermarkets have realized the potential and bulked up their organic produce sections. The largest chain, Kroger, recently said it was cutting prices as a means of encouraging shoppers to buy organics to save money, and also snatched up regional grocery chain Harris Teeter, which is popular for its own organic selection. Natural and organic produce can also be found at Wal-Mart and Fairway Group Holdings, which went public earlier this year.

And therein lies part of the problem for Whole Foods. Not only is there a wealth of choice for organic shoppers, but many of its rivals boast lower prices for their products. The "whole paycheck" brickbat hurled at the grocer is not unwarranted, and increasingly it has been forced to resort to promotional activity that could, if allowed to continue, undermine the rich margins it's historically enjoyed.

The Wall Street Journal recently ran a story about how Whole Foods has resorted to holding "flash sales" offered via social media to encourage shoppers to stock up on discounted items. Sales lasting just a day or even hours are announced via Twitter or its Facebook page. While sales are nothing new for the grocer -- the recession was the first real call to action for it -- the latest initiatives carry an air of, well, desperation.

Whole Foods is still expanding, but as it moves into markets it hasn't normally been in, it will encounter greater resistance from consumers unwilling to make the choice of paying their mortgage or shopping for groceries. Gimmicky promotions may end up becoming part of its DNA. Although the sporadic sales have yet to eat away at profits -- indeed, over trailing-12-month periods it has actually seen margins rise across the board -- if it keeps up the pace it's going, that might change.

In its 2012 annual report, Whole Foods pointed to "visible value efforts which have positively affected our price image" as the reason for its success. And though its current quarter's comps were still impressive, they are lower than the 8.4% range the organic grocer achieved over the previous two years.

At the moment, Whole Foods still sits atop the organic food chain. Gross, operating, and net margins all surpass every rival except The Fresh Market, which leads the industry, but when you look at Whole Foods' returns on equity and capital, it lags virtually everyone, even Kroger. As these smaller rivals gain more experience and are exposed to more consumers, we may yet see Whole Foods come down a peg or two.

I'm not particularly concerned the organic grocer will wilt like an heirloom tomato plant in a drought, but with shares at all-time highs and a market valuation generally well above the competition, I think it's more likely we'll see shares trend lower than continue the trajectory they've been on.

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9/26/2016 4:00 PM
WFM $28.65 Up +0.13 +0.46%
Whole Foods Market CAPS Rating: ****