Whole Foods' Growth Slows as Competition Heats Up

Whole Foods Market (NASDAQ: WFM  ) has long been a favorite of both health-conscious shoppers and Wall Street, but the company's most recent earnings report was disappointing on multiple fronts. Sales growth at existing stores slowed during the quarter, and the company revised its guidance downward to reflect these developments.

While Whole Foods has plenty of room left to grow, the stock's lofty valuation is becoming difficult to swallow. Smaller competitors like Sprouts Farmers Market (NASDAQ: SFM  ) are nipping at Whole Foods' heels, and traditional grocers like Kroger (NYSE: KR  ) are increasingly offering organic foods. With competition heating up in the organic food market, can Whole Foods continue to grow at its former blistering pace?

A look at the results
Sales increased by 10% year over year, driven by both a 5.4% increase in same-store sales and the opening of 10 new stores during the quarter. Earnings per share came in at $0.42, below analyst expectations of $0.44 and only 7% higher compared to the same quarter last year. The operating margin was 6% for the quarter, with a net income margin of 3.7%.

While the results for the quarter weren't bad, albeit a bit lower than what analysts were expecting, the company's revised guidance paints a picture of slowing growth and shrinking margins. Here's a list of some of the 2014 estimates that were revised by Whole Foods:

  Prior guidance New guidance
Sales growth 11%-13% 11%-12%
Comparable sales growth 5.5%-7% 5.5%-6.2%
Operating margin 6.9%-7% 6.7%-7%
Diluted EPS $1.65-$1.69 $1.58-$1.65
EPS growth 12%-15% 7%-12%

Some of these revisions may not seem all that meaningful. The high-end sales growth estimate was trimmed by just 1%, for example, with the new 12% target still representing a fast rate of growth. The EPS-related numbers are the real issue, though. Earnings-per-share growth of between 7%-12% is a far cry from 12%-15% growth, and it makes the forward P/E ratio of nearly 32, based on the high-end EPS estimate, difficult to justify.

Balancing growth and margins
Whole Foods currently operates 373 stores, and for a long time the goal touted by management was to reach a total of 1,000 stores. This goal was increased to 1,200 stores in the earnings release, matching the ambition of Sprouts, a chain of grocery stores with about 160 locations mainly in the Southwest. Sprouts stores tend to be a smaller format than those of Whole Foods, but the focus on organic, natural foods, as well as high prices on some items, is shared between the two companies.

A new Whole Foods store in Freemont, CA. Source: Whole Foods

The big problem with Whole Foods as an investment is that the company ultimately is just a grocery store. Whole Foods stores work best in areas where both incomes and health-consciousness are high, and there are only so many places like that. As the company expands into new markets, I believe it will have a tougher time charging significantly higher prices than traditional grocers, and this will inevitably take a bite out of margins.

This seems to have already started to happen, as the company stated in its conference call that it was "improving our price competitiveness" by adding non-organic produce and expanding the company's value brand. This may draw more customers in, but it also pushes Whole Foods closer to being a traditional grocer. The grocery business does not carry high margins as a whole, with Kroger, for example, recording a 2.8% operating margin in its previous fiscal year. The more that Whole Foods tries to broaden its customer base with better value, the more both its profits and its reputation are at risk.

Smaller companies like Sprouts pose a big risk to Whole Foods going forward, with both companies vying for the same types of customers. Other threats are traditional grocers that have been increasingly focusing on organic and healthy foods. Kroger, the country's second-largest grocery chain, announced last year the acquisition of Harris-Teeter, a small chain geared more toward healthier foods.

A Kroger supermarket. Source: Kroger

Along with this, Kroger has been upgrading some of its stores in order to differentiate itself from other grocery chains, an effort that has been positively received. Kroger's Simple True line of items is the company's attempt to compete against the organic offerings of Whole Foods, and Kroger CEO Rodney McMullen stated during the company's conference call that Kroger sees a huge opportunity to sell more natural and organic items. It seems that the grocery industry has caught up to Whole Foods, and the result will be more competition and likely lower margins.

The bottom line
Whole Foods is still growing quickly, but the intense competition in the organic food market means that margins are at risk of declining even more. Whole Foods' valuation has always been lofty, but given the lower guidance and the necessary price cuts made by the company, a 30-plus forward P/E ratio for a grocery store doesn't make much sense. There is still plenty of growth potential for Whole Foods, but investors today are paying too high of a price.

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