Whole Foods Market, Inc. Has a Very Big Problem

Source: Counse on Flickr

Whole Foods Market (WFM) has a very big problem. The stock got destroyed after the company reported disappointing earnings and slashed guidance, falling by as much as 20% the next day, but it was the tone of management during the conference call that was the most concerning.

Management laid out a five-year vision for the company, planning on rising margins and accelerating earnings-per-share growth, but this plan is at odds with the explosion of competition that is occurring in the natural foods market. Whole Foods is no longer the only game in town, and with other specialty grocers like Sprouts Farmers Market (SFM 0.21%) as well as traditional grocers jumping on the organic and natural foods bandwagon, maintaining its industry-leading margins will not be an easy task.

Overly optimistic
Co-CEO John Mackey admitted on the conference call that the company had been overly optimistic in regard to 2014 results, and pointed to a difficult comparison to a record 2013 as well as a rapidly changing competitive landscape. The company lowered guidance for the year across the board, with reductions in operating margins and EPS growth driving the stock, which traded at around 34 times earnings at the beginning of May, down 20% the next day. The company now expects EPS to grow by 3-6% in 2014, down from the previous guidance of 7-12%.

The theme of Whole Foods' conference call was that the company is getting more aggressive on lowering prices, but at the same time trying to ensure that the natural and organic foods market doesn't become a race to the bottom with regards to profit margins. Management stated that the company's focus on quality is what differentiates Whole Foods, but that is becoming a more difficult argument to swallow.

Trouble in Austin for Whole Foods
Austin, TX, the city where Whole Foods got its start and where the company's flagship store is located, offers an illustration of the competitive issues facing the grocer. HEB, a regional supermarket that Whole Foods explicitly mentioned during its conference call, has been ramping up its organic and natural food offerings. HEB also operates higher-end Central Market stores, which are very similar to Whole Foods locations.

Source: Mike Mozart on Flickr

Trader Joe's, also mentioned explicitly by management, has also recently opened a store in Austin and it plans to open two additional stores in the city very soon. Trader Joe's is notable for its vast collection of private label products, and the stores have somewhat of a cult-like following.

Sprouts, which went public last year and plans to rapidly increase its store base, also has three stores in Austin. Sprouts locations are smaller than those of Whole Foods, but the company shares the drive for quality food, as well as high prices. Sprouts grew its revenue by 22% in 2013 to $2.4 billion and managed a 5.7% operating margin which, while not quite as high as that of Whole Foods, is still well above those of traditional grocers. Sprouts plans to increase its store count by 14% in 2014, and the company currently has 167 locations to Whole Foods' 379.

Sprouts is notable because it shows that Whole Foods is not as unique as management seems to believe. It turns out that other companies can focus on quality and manage to be nearly as profitable. In fact, Sprouts had a slightly higher operating margin in 2013 than Whole Foods' operating margin in 2011. Sprouts seems to be following directly in Whole Foods' footsteps. The competition from Sprouts, combined with competition from traditional grocers, Trader Joe's, and all of the other specialty grocers, leads me to believe that organic and natural foods are inevitably going to become a commodity.

Lofty goals
Whole Foods is now getting more aggressive with its price cuts, it should be no surprise, then, that company expects this to lower its margins in 2014. The five-year vision laid out by management includes a steady increase in operating margin starting in 2015, along with consistent double-digit EPS growth. However, how the company expects to achieve this is unclear to me. The competition is only going to get worse for Whole Foods, and yet management is betting that five years from now margins will be at all-time highs.

Foolish Takeaway
Whole Foods is in a very different situation today compared to where it was even just a few years ago. Natural and organic foods have gone mainstream, and the days of little to no real competition are over. Co-CEO Walter Robb said during the conference call:

"So I think for a long time Whole Foods had the field to ourselves, pretty much. That was nice. But we don't any longer."

This sums up Whole Foods' big problem. Competition is going to drive down prices, and the plan to get the operating margin up to 7% by 2018 doesn't mesh with reality. Management admitted to being overly optimistic about this year, and then they turned around and were overly optimistic about the next four.