How is the Popularity of Organic Food Impacting Whole Foods?

As consumers gobble up organic foods in increasing numbers, many food retailers are expanding their organic selections and forcing specialty grocer Whole Foods to rethink its pricing strategy.

May 16, 2014 at 9:00AM

Specialty grocer Whole Foods Market's (NASDAQ:WFM) latest quarterly report showed the company may be at a crossroads in determining the appropriate next steps that will continue to grow its business. Competitive pressures seem to be coming from all directions, like specialty grocers Sprouts Farmers Market (NASDAQ:SFM) and The Fresh Market (NASDAQ:TFM) and supermarkets and retailers like Kroger and Wal-Mart, which have all jumped on the organic and natural food bandwagon.

As the selection widens across different retailers, prices for many natural and organic foods have dropped, putting pressure on a high-end grocer like Whole Foods, which hasn't been able to shed its "Whole Paycheck" reputation.

The second quarter ended April 13 showed that total sales grew 10% to a $3.3 billion. Higher cost of goods sold led to a decline in gross profit of 51 basis points to 35.9% of sales. Whole Foods' outlook for the remainder of fiscal 2014 shows the business is experiencing a slowdown, while the number of new and acquired stores, capital expenditures, and operating expenses are increasing.

Changing FY 2014 Outlook

Prior Outlook

Current Outlook

Sales growth

 11%-12%

10.5%-11%

Comp-store sales growth

5.5%-6.2%

 5%-5.5%

Number of new and acquired stores

33-38

36-39

Operating margin

6.7%-7%

6.5%-6.6%

EBITDA

$1.32-$1.37 B

$1.29-$1.32 B

Diluted EPS

$1.58-$1.65

$1.52-$1.56

EPS growth

7%-12%

3%-6%

Capital Expenditures

$600-$650 M

$675-$725 M

Source: Whole Foods Market second-quarter press release

The company continues to focus on developing its square footage. In the first quarter, eight new stores were added in six new markets; in the second quarter, three new stores were opened. With a current store count of 379 locations, Whole Foods believes the U.S. market has sufficient demand for 1,200 stores. The company is working to keep expenses stable while it invests in technology improvements that will deliver convenience and flexibility to the customer experience.

Management stated that it is looking more closely at Whole Foods' cost structure and plans to continue its value strategy to bring down the gross margin to a 34% to 35% range. The value strategy is more important than ever as more competitors enter the organic and natural food space. The market reacted negatively to the company's latest results despite management's claims that it has a "clear point of view" on how to improve value in its stores. Shares closed on May 7 at $38.93, down 18.8%, and have rebounded since then to about $39 per share. The current share price is near the low end of the stock's 52-week range of $37.31 to $65.59.

Competitors with similar offerings adopt different approaches to growth
As Whole Foods turns its focus to its pricing strategy, increasing value, and expanding its store base, the competition is also focused on growth but has different approaches to achieving it. The Fresh Market announced during its fourth quarter/fiscal full year 2013 it will be closing four stores in 2014. Operating losses and other expenses in fiscal 2013 related to these four stores totaled $6.9 million, or $0.09 per diluted share. Up to $20 million, or $0.23 to $0.26 per diluted share, in additional charges related to the store closures will be booked in fiscal 2014.

The Fresh Market has plans to focus more on expanding in existing markets and plans to open between 23 and 24 new stores in 2014. Expansion in new markets is being scaled back. With consumers exhibiting "cautious" spending habits at year-end 2013, a slower pace of expansion is a smart strategy to maintain the company's historical returns.

Meanwhile, Sprouts Farmers Market reported a 26% rise in net sales during the first quarter of 2014 to $722.6 million. Sprouts is known for catering to a more middle-income consumer, while Whole Foods is a favorite among the high-end consumer and less popular among the cost conscious. Sprouts has placed more importance on offering healthy food choices at affordable prices, especially in the produce aisle.

Comp-store sales increased 12.8% in the first quarter. Favorable pricing in produce contributed to gross profit margin improvement of 70 basis points to 31% of sales. In comparison, Whole Foods historically has a gross margin that ranges between 34% and 35%. Also focused on expansion, Sprouts opened 19 stores in 2013 and plans to open 23 or 24 stores in 2014 .

My Foolish conclusion
With the drop in Whole Foods shares after the earnings announcement, shares of The Fresh Market and Sprouts Farmers Market also fell. The market reaction to the earnings report shows investor uncertainty on the direction Whole Foods will take to improve its operating and profit margins, so it's possible the stock could drop further. Smaller grocers Sprouts and The Fresh Market could also see more downward pressure on their share prices as they also navigate the realities of increased competition from supermarkets and other retailers.

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