After a Bad Quarter, Has Whole Foods Market Lost Some of Its Allure?

Mr. Market wasn't too happy with Whole Foods Market's latest financial update, dropping the company's shares for a sharp, double-digit loss. Is it time to buy in?

Jun 14, 2014 at 10:30AM

Organic grocer Whole Foods Market (NASDAQ:WFM) took a good idea, the sale of organic food, and built a highly scalable business model around it. This is evidenced by a national network of stores that are complemented by budding operations in Canada and the U.K. The company has also anecdotally benefited from rising consumer interest in healthy eating, a trend that has allowed the natural/organic segment to capture a sizable percentage of grocery industry sales, estimated at 13% in 2012.

On the downside, though, Whole Foods Market's success has attracted a growing throng of competitors, including major grocery chains like Wal-Mart Stores (NYSE:WMT) and Kroger (NYSE:KR), which have been upping their product selections in the natural/organic area. The rising competitive pressure could partially explain Whole Foods Market's worse-than-expected profitability in its latest financial update, a data point that produced a sharp subsequent drop in its share price. So, after receiving a price haircut, is the company still a good bet?

What's the value?
Whole Foods Market is the kingpin of the natural/organic segment of the grocery business, operating a network of more than 370 stores, primarily in the U.S. The company enjoys a loyal, growing customer base, with more than 7 million weekly customers, a favorable characteristic that has led to consistently strong per-store sales growth during the past few years. More importantly, Whole Foods Market's customers don't seem to be too price-conscious, which has allowed the company to generally charge premium prices and generate better operating profitability than traditional grocers.

In its latest fiscal year, Whole Foods Market continued building on its long-term growth trajectory, reporting a 10.4% top-line gain that was a function of higher comparable-store sales, and a further expansion of its overall store base. While Whole Foods Market's comp growth slipped versus the prior year period, it still generated a healthy 6.9% increase, due to higher average prices and customer traffic volumes. The net result for the company was a pickup in operating profitability during the period, fueling a double-digit gain in operating income, as well as an uptick in cash flow.

Of course, FY2014 has been a slightly different story, as you could probably discern from Whole Food Market's recent stock price performance. While the company's top line has continued to grow at a reasonable clip, up 9.9% during the year-to-date period, its adjusted operating profit has increased at a less robust pace, up 6.8%, hurt by a lower-than-expected comparable-store sales gain and higher promotions.

Fighting for health-conscious customers
Undoubtedly, part of Whole Foods Market's profit shortfall was due to the rising ambitions of major competitors in the natural/organic area, like Wal-Mart. After a lackluster 2013 campaign that included a decrease in domestic comparable-store sales and an ongoing government investigation into its business practices, the nation's largest grocer is trying to turn things around in 2014. It recently announced an expansion of its small-format Neighborhood Markets brand, focused on fresh foods, pharmacy, and fuel categories. Wal-Mart is also going big in the natural/organic area, partnering with the Wild Oats brand to expand the selection of organic items in its domestic stores, all in an apparent bid to drive down the premium prices commonplace in the natural/organic segment.

Not to be outdone, neighborhood grocery giant Kroger has also been actively courting health-conscious consumers with dedicated natural/organic product areas in its stores, part of its bid to recapture customers who have likely been lost in recent years to grocers focused exclusively on the natural/organic segment. With a solid comparable-store sales performance in its latest fiscal year, up 3.9%, it would appear that Kroger's gambit is working. This will likely lead management to continue upgrading its natural/organic product selection in the future, ostensibly putting further downward pressure on product pricing in the segment.

The bottom line
Whole Foods Market's operating profit has continued to grow in FY2014, albeit at a lower rate than Mr. Market obviously would have liked, judging by the reaction to the company's latest financial update. That being said, with competitors gunning for Whole Foods Market and its customer market share, a rebound to a double-digit operating profit growth trajectory would seem to be a tall order, making the company expensive even at its current P/E multiple of roughly 27. As such, while Whole Foods Market is a long-term winner in the grocery business, investors might want to wait for another financial update prior to jumping into the shares.

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John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Robert Hanley owns shares of Whole Foods Market. The Motley Fool recommends 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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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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