Whole Foods Crashes: Buying Opportunity or Time to Sell?

Source: Whole Foods.

Whole Foods Market (NASDAQ: WFM  )  stock fell by a whopping 19% on Wednesday after the supermarket chain released disappointing results for the quarter ended on April 13. Increased competition from players such as Wal-Mart (NYSE: WMT  ) and Sprouts Farmers Market (NASDAQ: SFM  )  represents a considerable challenge for Whole Foods. On the other hand, the company is still the quality leader in a growing niche.

Is the dip in Whole Foods a buying opportunity for investors, or is this a declining business?

Disappointing numbers
Total sales during the quarter increased by 10% to $3.32 billion, while comparable-store sales grew 4.5% versus the same period in 2013. This was lower than the Wall Street estimate of $3.34 billion in revenue, and also a deceleration in growth versus prior quarters.

Profit margins were under pressure during the quarter: gross profit margin fell by 51 basis points to 35.9% of revenue, while store contribution margin decreased 41 basis points to 10.6% of sales. Earnings per share came in at $0.38, flat versus the same quarter in 2013 and significantly below the consensus estimate of $0.41 per share.

In addition, Whole Foods reduced its guidance for the third consecutive quarter. The company now expects sales growth of between 10.5% and 11% in 2014, versus a previous guidance in the range of 11% to 12%. Guidance for earnings-per-share growth was also cut from between 7% and 12% to between 3% and 6%.

Whole Foods is still performing better than most competitors in the grocery business when comparing sales and profitability. However, considering that this is the third straight quarter in which the company reported disappointing results, recent weakness seems to be more than just a small bump in the road.

Increased competition
Natural and organic foods has been a profitable high-growth niche in the otherwise lackluster groceries business over the last several years, and Whole Foods has benefited significantly from that trend. But success attracts competition, and both traditional retailers such as Wal-Mart and focused players like Sprouts Farmers Market are increasing their competitive pressure.

Wal-Mart has been growing its presence in the segment lately, and recently announced it would relaunch Wild Oats, a line of organic food products that is focused on providing competitively low prices in the category.

Wal-Mart estimates consumers will save nearly 25% on their grocery bill when purchasing Wild Oats products versus other organic brands, and this sounds like a smart proposition considering recent industry trends. While demand for natural and organic food has been steadily growing over the years, one of the biggest disadvantages for consumers is the higher price tag that comes with these products.

Sprouts Farmers Market is materially smaller than Whole Foods, but the company´s slogan, "Healthy Living for Less," is quite clear on the fact that Sprouts is willing to offer lower prices in order to compete for market share.

Sprouts Farmers Market reported earnings for the first quarter of 2014 on Thursday, and the company delivered a big increase of 26% in total revenue to $722.6 million. This was fueled by a 12.8% rise in same-store sales, so Sprouts Farmers Market seems to be succeeding in its attempts to outgrow bigger industry players such as Whole Foods.

Healthy future
Whole Foods management acknowledges that competition is increasing from multiple fronts, and the company plans to tackle the threat by cutting prices and improving the customer experience and overall differentiation.

Wal-Mart has a gross profit margin in the area of 25% of sales, while Sprouts Farmers Market announced a gross margin of 31% for the last quarter. This is considerably lower than the gross margin near 36% reported by Whole Foods in the latest earnings release.

As Whole Foods expands into lower-income areas, the company will need to continue making "price investments" to attract customers, so profit margins will likely remain under pressure in the coming quarters.

Whole Foods is arguably a victim of its own success, attracting competition. There's still a lot of growth left in the industry and the healthy-eating trend is providing a strong secular tailwind for different players.

Management estimates that Whole Foods itself can build 1,200 stores in the U.S. alone, versus a current base of 379 locations.

Whole Foods is doing the right thing by betting on long-term growth opportunities and lowering prices to protect market share and capitalize on the trend toward healthier eating habits, even if this means lower profit margins in the short term.

Foolish takeaway
Whole Foods faces increased competitive pressure; however, the company continues to benefit from growing demand for organic and natural foods. Brand differentiation and a reputation for quality should provide some competitive protection for Whole Foods as the company continues closing the price gap with its competitors. This long-term growth story still looks quite healthy.

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