How Whole Foods' Success Has Come Back to Haunt It

By making organic food a household concern, Whole Foods pushed demand high enough to lure new competitors into the market.

May 12, 2014 at 2:30PM

If you love organic food, it's probably been a pretty good few years for your dinner table. Whole Foods Market (NASDAQ:WFM), the national champion of the organic grocery store, has expanded further than many thought possible. Its success has brought solid returns to early investors, but has also brought more competition to the market. Now, every Tom, Dick, and Jane wants a piece of this $30 billion industry.

As a result, Whole Foods has been punished for its spreading of the gospel. In last week's earnings announcement, co-CEO Walter Robb said that "competition is more intense right now than possibly [Whole Foods has] ever experienced before." The company took it on the chin in its second quarter, and things are starting to look dangerous for the once-mighty business.

Is Whole Foods in competitor denial?
The tone on last week's conference call was tense. During the question-and-answer session, analysts held Whole Foods over the coals, with at least one analyst saying that management didn't sound like it was taking the competition as seriously as many investors were.

"The competition" now includes just about everyone who sells any sort of food whatsoever. Pressure within the stand-alone grocery store business is coming from specialty retailers like The Fresh Market (NASDAQ:TFM) while bigger, generic retailers like Wal-Mart (NYSE:WMT) are also getting in on the action.

The Fresh Market took a knock-on-effect hit from Whole Foods' poor showing, with the stock dropping 10% on Wednesday. That almost sums up the Fresh Market's entire history -- following in the footsteps of Whole Foods. With 156 locations in the U.S., the Fresh Market is expanding into Whole Foods' neighborhood. In the past year, the Fresh Market has pushed into Texas and California, adding to the competitive landscape in those states.

Unfortunately for the Fresh Market, it hasn't done nearly as well as it had hoped. A divided focus among new locations has left it in a weak second place, looking at lost opportunities. Still, its presence has had an impact on Whole Foods, giving customers a second opinion on the cost of organic goods.

Playing its traditional role, Wal-Mart has been redefining the value of organic goods. Earlier this year, the retailer partnered with the Wild Oats organic brand, adding it to store shelves and undercutting other national organic brands. Considering that Wal-Mart operates over 4,000 grocery-carrying stores in the U.S., the introduction is sure to put a squeeze on Whole Foods.

Margins at Whole Foods
One point that came out on the conference call was that Whole Foods has yet to take a hit on margins, indicating that it has some wiggle room with pricing. Gross margin has been on the rise for years, but Whole Foods now sees that it has to come down -- even if only a little -- to keep the company competitive. It said that dropping margins slightly is "sustainable and the right strategy to drive sales growth over the longer term." 

The proof will be in the non-GMO pudding. Investors tend to love two things about Whole Foods: high margins and fast growth. If the company pushes the "value" button too hard, it could lead to a drop in profits that investors aren't comfortable with. Push too gently and customers will flee to cheaper brands. The next year is going to be telling for Whole Foods, but management has succeeded with challenges in the past, and there seems to be no reason to think that, in the long run, it will have trouble with this hurdle.

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John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Andrew Marder has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Whole Foods Market. It 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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