Regional grocer Roundy's (NYSE:RNDY) has had a rough start to 2014 after poorer-than-expected profitability in its latest financial update sent its shares down sharply in early May. The company was primarily hurt by a relatively bad sales performance during the period, due to weather-related issues and the growing aspirations of major competitors in its geographies, including Whole Foods Market (NASDAQ:WFM) and Wal-Mart Stores (NYSE:WMT).
Undaunted, Roundy's appears steadfast in its conviction that it can be a major player in the premium segment of the grocery business, with plans to roughly double the store base of its Mariano's banner in 2014. So, after a price haircut, is Roundy's a good bet for investors?
What's the value?
Roundy's is a relatively small player in the grocery business, operating a network of approximately 170 stores in the Midwest region of the U.S. under a diverse group of banners, including Pick 'n Save, Rainbow, and Copps. A generally lackluster sales performance for its overall business over the past few years, though, led management to reverse course, abandoning its diversified strategy and putting most of its firepower behind its premium banner, Mariano's.
Management is also in the process of reducing its geographic presence, recently deciding to sell most of its Rainbow branded stores and exit the Minnesota market, a move that will allow it to focus resources on its two key urban markets, Milwaukee and Chicago.
Unfortunately, Roundy's strategy has yet to produce the desired results, as evidenced by a decline in comparable-store sales in its latest fiscal year, continuing an unfavorable, multiyear trend. More important, the company's operating profitability took a nosedive during the period, hurt by the higher operating costs of locating stores in major urban markets, which led to a double-digit decline in its operating income. The net result for Roundy's was a lack of cash flow growth, negatively impacting its ability to both fund its ambitious growth plans and improve its leveraged financial profile.
Fighting for crumbs at the table
Of course, part of the company's problem is that it is going after growth in the premium customer segment at a time when everyone seems to be angling for greater market share in the space, potentially lowering the profitability of the segment. Whole Foods Market, for one, continues to open stores at a feverish pace as it tries to build toward its long-term goal of 1,200 domestic stores.
Despite poorer-than-expected profitability in its latest fiscal quarter, a data point that weighed heavily on its stock price, Whole Foods Market has still posted an operating margin above 6% in fiscal year 2014, more than twice the level achieved by Roundy's. The superior profitability has led to a continuation of strong cash flow generation, allowing it to internally fund its fast growth, with plans to add another 10% more stores to its footprint in 2014, including a greater presence in the metro Chicago market, Roundy's backyard.
Wal-Mart Stores, the nation's largest grocer, also has its eyes set on the premium customer cohort, recently partnering with the Wild Oats brand to bring a greater selection of fresh foods and natural/organic items to its network of more than 4,800 domestic stores. At the same time, the company is upping its investment in its smaller-format Neighborhood Market brand, with plans to end the current fiscal year with more than 200 locations around the country.
As alluded to by management, Wal-Mart's goal is to lower product prices in the premium grocery segment by taking advantage of its massive purchasing scale, which it likely hopes will allow it to pick off customers from smaller competitors such as Roundy's.
The bottom line
With its stock price down by more than 45% in 2014, Roundy's is certainly cheaper than it was at the start of the year. That said, the company is attempting to compete in relatively high-cost markets against a growing roster of competitors, including some large players that enjoy greater scale efficiencies and have better financial profiles. As such, the path to higher profitability seems like it is going to be a tough, uphill climb for Roundy's, and investors are probably better off finding another horse to bet on.
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 and 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.