Wal-Mart Makes Organic Cheaper, but at What Cost?

Wal-Mart is challenging the logic that organic food has to be expensive, but that sets it at odds with other businesses and may put consumers off the brand.

Aug 16, 2014 at 10:05AM

The contrast could hardly be more stark. On one side of the road stands Wal-Mart (NYSE:WMT), home of the deep-discount and "price is king" mentality, pledging to "[remove] the premium associated with organic groceries." On the other side, Whole Foods Market (NASDAQ:WFM), often referred to as Whole Paycheck, says it expects long-term gross margin to hang out in the 34% to 35% range.

Consumers are likely to applaud Wal-Mart's efforts to bring organic to the masses, while Whole Foods remains stuck with the "expensive" label. Truth be told, though, Whole Foods has been taking a hit on prices as organic food costs rise and the company holds back large price increases in an effort to increase its consumer appeal. Last quarter was the 10th in a row, according to Whole Foods, that the company's costs increased more than its prices. 

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Wal-Mart has partnered with the Wild Oats organic brand.

Wal-Mart isn't alone in this incursion into the organic space, either. Costco (NASDAQ:COST) is also increasing its sales of organic items, though the wholesale retailer has said that supply has been holding it back from making a huge push. It's not the first time that the organic segment has run into supply issues, and overcoming those issues is going to be key to the future success of organic.

Supply and demand in the organic segment
Whole Foods and Chobani had a public split in 2013, when Whole Foods stopped carrying Chobani's products. Among the issues raised during the divide was the sheer amount of milk that Chobani would require in order to make all of its yogurt with organic milk, which was something that Whole Foods wanted from its yogurts. Chobani argued that it was making the best product it could given that most of the milk in America -- 99%, according to Chobani -- is non-organic.

'Doing your best' might not be enough for consumers who want all organic all the time, and Wal-Mart and Costco may need to find additional sources for their organic goods in order to keep costs low for consumers. Milk is just one of the constraints in the organic market, and many organic items are not currently produced on a scale that would fit the needs of a business like Wal-Mart. In order to make supply fit demand, it's possible that Wal-Mart and Costco could get involved in production and distribution of organic food.

The CEO of Wild Oats, which has partnered with Wal-Mart, has suggested that Wal-Mart could unify organic producers through its "wold-class distribution system." The smaller nature of organic growers means they don't have the same distribution and production capabilities as their bigger, non-organic counterparts. That can clog the production line, meaning farmers are limited in what they can grow not by arable land or time, but by the harvesting, packaging, and shipping of the final product. By inserting its incredible distribution model into the system, Wal-Mart might be able to massively increase production.

Why we buy organic food
The flip side to that is that such a move might put off some shoppers who buy organic to be closer to the farmers who supply their food. If those ties are severed through the introduction of larger scale operations, shoppers may hesitate to fork over additional cash for their groceries.

Part of the reason that different retailers are taking different approaches is that the organic label means different things to different people. It can mean eco-friendly, healthy, farmer-focused, humanely raised, locally focused, or any number of other things to different consumers. Wal-Mart is hoping that it can drive down costs on organic food and bring in a big swath of those shoppers. 

Whole Foods is banking on a scenario in which consumers are more concerned with the local focus, humanely raised, and farmer-centric aspects of organic food. For instance, Whole Foods has made supporting farmers and suppliers a part of its brand, with annual awards and dedicated marketing for producers.

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Whole Foods is feeling the pricing pressure of increased competition. Source: Whole Foods.

One step beyond that is the lower volume that Costco has implemented. It's clear from its supply and demand concerns that Costco is worried that oversaturation of organic foods could lead to a drop in their perceived value. The company would have little trouble implementing a Wal-Mart-style distribution system, but it's holding off, for now.

On the opposite end of the spectrum from Whole Foods is Wal-Mart, which is banking on the value of the organic label as a catch-all for healthy and green shoppers regardless of any specific connection with producers. That may be a fine approach, as organic food is implicitly -- or sometimes explicitly -- valued for its production methods. Even if Wal-Mart doesn't develop a relationship with its producers, even the farm-concerned shoppers might buy more organic simply because the label implies better treatment for farmers.

The future of organic food is divided
The worry for many shoppers, though, is that the expansion of organic foods and the price pressure that retailers like Wal-Mart put on the segment will mean less pay and worse conditions for producers. Wal-Mart's program is still too young to judge in full, but regardless of the impact on farmers, traditional organic retailers such as Whole Foods are likely to feel the pinch in the near future.

It's clear that a line is being drawn, with Whole Foods on one side and Wal-Mart on the other. Costco has yet to pick a side, but it will have to eventually. If organic food continues to grow and if Wal-Mart can produce it at scale, then it seems like the retailer will have the most to gain over the next few years. Whole Foods could be in a difficult spot if Wal-Mart takes over, as it may have to fight with the giant for supply. That's a fight that would be very difficult for Whole Foods to win.

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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 Costco Wholesale and 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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