Whole Foods Market: Expansion, Starbucks Partnership, and a Stockpile of Cash

Whole Foods Market  (NASDAQ: WFM  ) is the largest natural and organic specialty grocer in the U.S. With 351 locations throughout the U.S and the U.K, the company has enjoyed success by being the first mover in its field. According to company estimates, the natural and organic industry is growing by more than 20% per year, making the company an excellent long-term investment.

Who is fueling growth?
Whole Foods benefits from two groups of consumers. The first group is the natural and organic devotees who chose to live a more sustainable way of eating. The second group happens to be "foodies" who seek specialty offerings such as cheeses, oils, and international options that cannot easily be obtained at grocery stores.

Whole Foods demographics skew to the mid to upper income shopper, as prices tend to carry a premium. In the current economic recovery, consumer confidence has been more robust for upper income shoppers,  which is reflected in company shares that have seen out-performance relative to retailers that rely on lower income consumers.  

Michael Bloom, COO of Family Dollar, confirmed this thesis by stating "While many higher-income consumers are feeling better and more confident about the future, our core customer continues to struggle." Shares of Family Dollar have under-performed both Whole Foods and the S&P 500 in the last year. According to the company CEO, 2014 will also present challenges for low income consumers: "Given the uncertainty of the operating environment and the near-term challenges our customer continues to face, we have taken a cautious approach to fiscal 2014."   

At least a decade of growth ahead
Although Whole Foods is the most established of the organic/natural grocers, the company still has many years of growth ahead of it. Management estimates that it can reach 1,000 stores in the U.S over the coming years.

Many companies and industries have similar growth trajectories. What separates Whole Foods from others is its ability to recover quickly from economic downturns.

Whole Foods emerged from the 2008/2009 lows with lessons learned that were vital to surviving. After going through a large store phase in the early 2000's (50,000-60,000 square feet) the company has been shrinking its average store size. Since 2008 Whole Foods has focused on building stores that are sized appropriately for the local market. For example, the smallest Whole Foods is located in Brookline, Mass in an 8,000 square foot building. This is part of the company's strategy to expand into smaller markets with smaller stores.

Such a strategy is unique in the sense that many other grocers can not duplicate it. Costco (NASDAQ: COST  ) also caters to shoppers who have higher disposable incomes and share similar ethical values. For example, Costco pays relatively high wages to its associates.  In no way can Costco match the pace of Whole Foods' growth trajectory over the years and its entry into small markets. In the example above, Brookline Mass has a population of just over 58,000, which is not nearly large enough to support a Costco.

Recently, Costco reported a $0.06 miss ($1.40 earnings per share came in short of the consensus of $1.46) for the first time since 2011, due to higher SG&A costs. Whole Foods, on the other hand, has been consistently lowering its SG&A expenses since 2008, and analysts believe this trend will continue until 2015. While one quarter certainly does not make or break a long term investment thesis, investors can likely find better returns in Whole Foods than Costco, which has performed almost identically with the S&P 500 over the past two years.

Differentiating itself
Whole Foods has a partnership with Starbucks (NASDAQ: SBUX  ) in which Starbucks will sell its Evolution Fresh juice and Evolution Harvest snack bars across thousands of Whole Foods locations. Starbucks has been diversifying its business to include retail space within grocery stores as the company continues its evolution from a coffee company to a consumer product giant.

The partnership is a huge opportunity for Starbucks as the company gains recognition in the health conscious and organic consumer market. The juice is not heated when bottled and it uses a high pressure technology that helps retain the vitamins in the fruits and vegetables, which naturally commands a higher price tag. David Vinjamuri, president of ThirdWay Brand Trainers and renowned branding expert, is a big believer in Starbucks partnering with Whole Foods: "Evolution Fresh gets the endorsement of a taste-maker for health-conscious consumers...Whole Foods is, perhaps, the only mainstream retailer that can pass along the high price points of the Evolution Fresh line."

Added bonus: Free cash flow
As Whole Foods is self-funding, it is virtually debt free, with a cash balance that has been building up to the tune of $1 billion (after lease obligations) even after a one time special dividend of $370 million in late 2012. If management decides against further hikes in dividends or against aggressive buyback activity over the coming quarters, cash levels will only increase over time. This is a significant quality that shareholders crave because this cash can be deployed at any time to increase dividends. There is also huge potential for EPS surprises if the company vastly expands its repurchase program.

Conclusion
Whole Foods is an extremely unique company that is still in its infancy despite already achieving tremendous success and a strong brand image. As the organic and natural food industry continues to grow, Whole Foods will encounter competition but will emerge a winner. While a new crop of natural and organic grocery IPOs have sprouted, Whole Foods offers the ultimate risk/reward ratio backed by a positive past performance, solid growth trajectory, a strong balance sheet, and most importantly a loyal clientele that has income to spend.

Whole Foods isn't the only strong retailer out there
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


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