Is Wal-Mart About to Crush Smaller Organic Sellers?

Smaller organic food sellers may find it hard to compete with an increasing number of organic food options and lower prices available at Wal-Mart and Target.

Apr 23, 2014 at 7:00AM

One reason why organic food has lagged in sales, compared to conventional products, is its higher price. And the excuse used by many that organic food is too expensive is about to change.

As the ink dries on a recent deal with Wild Oats, low-cost retailer Wal-Mart Stores (NYSE:WMT) has decided to partner with the organic grocer to develop 100 organic food products. The plan is to sell these organic selections 25% cheaper than national brands. This could potentially be bad news for smaller organic markets, like The Fresh Market (NASDAQ:TFM) and Sprouts Farmers Market (NASDAQ:SFM), which now have to watch their pricing more closely or risk losing customers to a rival with cheaper prices.

Wal-Mart currently carries 1,600 organic food items in its stores and, as the biggest grocer in the U.S., last year it derived more than half of its $279 billion in U.S. sales from groceries. The company mentioned it wants to increase access to organic products for its customers by rolling out the new items to 2,000 of its stores. The news came fresh after another big-box rival, Target (NYSE:TGT), announced it was introducing a line of 120 organic and natural products, ranging from kitchen cleaners to baby food.

Removing the "premium" from organic prices
Interest in organic food has grown significantly in the past 10 years. In 2002, according to the Organic Trade Association, sales were $8 billion; fast-forward to 2012 and organic food sales totaled $29 billion. Research conducted by Wal-Mart reveals that 91% of consumers are willing to buy organic products that are affordable and available. Organic producers say that the premium associated with organic items is due to the scarcity of most of these products, not because they cost more to produce.

With Wal-Mart and Target showing more interest in the organic segment, supplies are bound to increase, which should eventually bring prices down. Wal-Mart is limiting the initial rollout of its new organic products to only 2,000 stores to be certain it can meet the demand expected.

For Target, tweaks are constantly being made regarding the items it puts on its food shelves. And new trends, like organics, gaining popularity are considered as possible additions to Target's food inventory. The company will be stocking more environmentally friendly products from its current brands due to research showing that 97% of Target customers would buy "natural, organic, or sustainable" products.

How are smaller organic grocers performing?
Meanwhile, small grocers are mobilizing their operations to improve profitability. The Fresh Market reported some headwinds during the fourth quarter of fiscal 2013 due to cautious spending, a shorter holiday period, and bad weather. During the fourth quarter of fiscal 2013, net sales increased 15.1% to $425.8 million and comp-store sales rose 3.1% versus the prior period.

The company made a decision to close four stores in fiscal 2014 to slow the pace of expansion and maintain historical returns. The Fresh Market is also looking at ways to keep costs under control and to be more efficient by eliminating redundant expenses, reducing non-merchandise purchasing, and keeping pre-opening expenses for 2014 flat with 2013. Cost control will be important for the company to stay price competitive against bigger rivals.

At Sprouts Farmers Market, net sales for the fourth quarter of fiscal 2013 saw a 27% increase from 2012 to $608 million. Comp-store sales grew 13.8%. The increase in comp-store sales occurred for the 27th consecutive quarter. Adjusted diluted earnings per share rose to $0.07 versus EPS of $0.04 reported in 2012. Adjusted earnings before interest, taxes, depreciation, and amortization increased by 31% compared to the company's pro forma number in 2012 of $37.7 million.

Instead of closing stores like its rival The Fresh Market, Sprouts opened 19 stores in 2013, which led to a record performance in terms of net sales and net income. After discounting a pre-tax loss on an asset disposal, direct store expenses grew by 10 basis points to 20.4% of sales. Escalating expenses are something the company should watch for to keep its prices competitive with its larger rivals and also as a way to manage its aggressive store expansion goals.

My Foolish conclusion
The latest reports show that retail sales have picked up speed as the winter weather has drawn to an end. This should fare well for all the companies mentioned. Wal-Mart and Target are the best values of the group, priced at about 13 times 2016 earnings. Sprouts Farmers Market and The Fresh Market are interesting buys with higher valuations -- The Fresh Market trades at 18 times 2016 earnings and Sprouts trades at 41 times 2016 earnings -- and they have higher growth potential than their big-box rivals.

However, as Target and Wal-Mart move in on their business, it could become very difficult for these smaller grocers to compete in terms of price. Investors in this sector are encouraged to watch for signs of how these grocers counterattack to stay profitable.

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Eileen Rojas has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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