What Wal-Mart’s Entry Into Organic Foods Really Means

Wal-Mart Stores'  (NYSE: WMT  )  announcement that it's making a move into organic foods could leave other organic food companies with a feeling of paranoia. But will this entry into the organic market really be a disruption or a game changer for Wal-Mart? Organic foods accounts for less than 5% of total American food sales. However, the organic foods niche is rapidly growing, and the margins are very enticing, hence Wal-Mart's entry into the market.

Wal-Mart's great foray into organics
Wal-Mart has partnered with Wild Oats to sell organic foods at prices up to 35% cheaper than the existing national brands, which brings it in line with traditional food items. This will help the retail giant capitalize on the growing demand for organic foods and provide a boost to its grocery business. One hundred Wild Oats products will be launched in 2,000 outlets over the next few months.

Organic foods are not a particularly large market but have grown faster than the general food market over the last few years. American consumers have shown a preference for organic foods despite the higher prices and should love the prospect of cheaper organic foods. Grocery sales make up more than half the company's revenue, but growth has been negative over the past few quarters. The proposed move into organic foods could have the effect of increasing store traffic and boosting the grocery business.

The organic food business is not as well organized as the non-organic counterpart because the production is low and the supply chain is less developed. Wal-Mart has the ability to work with suppliers and build out a supply chain to bring down prices. This should help it offer cheaper organic foods without affecting its operating margin.

The trend is with Wal-Mart
Consumers are becoming increasingly self-conscious, and the number of Americans turning to organic foods has increased from 13% in 2002 to almost 25% last year. The market in 2012 was $29 billion compared to $9 billion a decade earlier.  

Grocery spending does not have a strong correlation with the broader market. And customers who buy groceries are highly likely to buy other items of general retail. As a result, it makes for effective cross selling and increases the transaction value per customer. This is the reason why Wal-Mart is keen on pushing the growth of its grocery sales. Moreover, organic foods are currently a highly inefficient business where margins are protected because of the shortfall in supply compared to demand. Wal-Mart could help bridge this gap by encouraging suppliers to produce more.

Who benefits from the shift?
It doesn't appear that suppliers will benefit because with Wal-Mart involved prices are likely to come down. For example, Gillette was forced into the arms of Procter & Gamble because of the demands made by Wal-Mart. Other companies, like Coca-Cola and Kraft, have had their share of problems in dealing with Wal-Mart. But there is little doubt that consumers stand to gain.

On the other hand, the increase in demand for organics by Wal-Mart will likely drive the development of new farmland and processing facilities higher. But Wal-Mart can manage the cost of production by dumping suppliers in favor of other suppliers that provide it with small cost advantages. 

How the competition stacks up
Wal-Mart's move into organic foods will have the largest impact on Whole Foods Market  (NASDAQ: WFM  ) and The Fresh Market (NASDAQ: TFM  ) . These guys focus on organic products at premium prices. In 2013, Whole Foods raked in some $12.9 billion in sales, a 10% increase from the previous year. Meanwhile, The Fresh Market brought in $1.5 billion in revenue last year, a 13.7% increase.

But compare those numbers to the $475 billion in revenue that that Wal-Mart brings in annually. Wal-Mart appears to have the size and the buying clout to make life very difficult for these other players. Shares are trading at a P/E of 14 based on next year's earnings estimates. It also offers investors a 2.5% dividend yield. Meanwhile, Whole Foods trades at a 26 P/E and The Fresh Market trades at 19. Neither pay a dividend. 

Bottom line
Although organics are still a small part of total food consumption in the U.S., they're a fast growing part of the market. The Fresh Market and Whole Foods Market are a couple of the best ways to play organic food, but Wal-Mart has the best exposure to the retail market. For investors who would like to get some exposure to the organic food market while also playing the global rebound in the economy, Wal-Mart is worth a closer look.

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