Whole Foods Market Inc. Thinks Smaller to Drive Future Growth

Whole Foods (WFM) investors are on edge. The original organic grocer is under attack from major competitors like Wal-Mart, Costco, and Kroger as they expand their own organic offerings to cash in on growing consumer preference for natural, healthy foods. Same-store sales growth has slowed significantly, and the company is focused on shedding its "Whole Paycheck" reputation of high prices. The solution -- a new, smaller store format targeting younger and more budget-strained shoppers.

Elsewhere in the land of retail, Barnes & Noble (BKS) is focused on books and Nooks, as the company prepares to restructure its entire business. Tasked with leading these efforts is the new chief executive, Ronald Boire, who currently serves as CEO of Sears Canada.

Will Whole Foods succeed as it moves into uncharted territory? And will Boire be able to leverage his retail experience to save a sinking ship? 

A full transcript follows the video.

 

Sean O'Reilly: We've got Twinkies in our lunchbox on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from in beautiful Alexandria, Virginia just south of the nation's capital in Washington D.C. I am at Fool headquarters joined by the one and only, the incomparable, the incredibly handsome Vincent Shen.

Vincent Shen: Thanks, Sean. I'm flattered.

O'Reilly: Yeah. You're a nice guy. We've actually got a lot to talk about today here, folks. We've got Whole Foods' new, smaller store format for urban areas, we've got Barnes & Noble's new leadership; but first -- oh man! Big news this morning; Twinkies are coming back to the grocery store shelves!

Shen: Oh, yeah? Is that the case?

O'Reilly: Yeah. Hostess brands went bankrupt late last year, in November. They had tons of debt, the cost structure wasn't working because 80% to 90% of their workforce was unionized and they brought in a reorganization expert who's the new CEO. He sat down with all these unions -- I'm not bashing anybody, but it wasn't working for anybody. They were losing money just operating day to day.

They couldn't work anything out so they entered chapter 11 and when they didn't get good offers for the company, they just liquidated and sold a bunch of the brands. Actually, it was kind of split up. I'm going to butcher this, but Metropoulos & Co. and Apollo bought the Twinkies and other Hostess cakes for about $410 million, the Wonder Bread brand went to McKee Foods -- later edit: Flowers Foods -- I might be wrong here.

Don't quote me, anybody. They have turned it around and operations are actually going smoothly, everybody's happy, and they're thinking about selling the Twinkies and Hostess brands. They're like "No. We'll just have an IPO." So we'll talk about this more when they have the S1 IPO filing at the SEC in a few weeks, but I'm sure you've noticed that Twinkies have not been on the grocery store shelves. I know you love those, Vince.

Shen: It's big news.

O'Reilly: Yeah. They will be returning, here. All the Twinkies boxes will also have the tag line "The sweetest comeback in the history of ever." They're branding the comeback.

Shen: That's an interesting idea, actually.

O'Reilly: Very smart. So Vince, what's going on with Whole Foods?

Shen: This is somewhere you won't find Twinkies to be honest.

O'Reilly: Why not? Is that because Twinkies are so full of preservatives that it will survive the nuclear holocaust?

Shen: Exactly. In May, Whole Foods they announced that they were going to be experimenting and launching these new, smaller format stores. Last month they announced the name: 365. That's tied to their private label brand at the Whole Foods Market now -- 365 by Whole Foods. I think a big reason for that is that this private label is going to be a major anchor product and offering line for these new format stores.

It's going to be headed up by Jeff Turnas who's a 20 year veteran at Whole Foods. He used to run their North Atlantic and UK regions. They're going to start opening the stores in 2016. They'll start out small with about 5 to 10 stores next year, but their ultimate growth plan is big. If the potential is there, if it's doing well; they ultimately want this to have a similar footprint.

O'Reilly: This was an interesting move for me because arguably -- and I don't think anyone would dispute this -- Whole Foods is already an urban store. They're really only found in certain types of areas, and they're usually quite urban.

Shen: Well, I think the reason they're moving in this direction is to hit two new "markets". As you mentioned the urban store, to an extent, but I think having these smaller locations will let them have more than one store in one area.

O'Reilly: That's what I was going to say because the way their demographics work, the demographics of their customers are: they're upper income, they're college educated, etc. These people are usually found in big cities. We have one right down the street here in Alexandria, Virginia. I think there's two in the district, there's one in Cleveland Heights which is five miles from my college in Case Western, and you don't find them in small suburbs.

It doesn't work. They just don't get the traffic that's there. A full sized Whole Foods store requires a certain square footage and it's hard to find those in a lot of cities.

Shen: Yeah. In general, the new stores -- like we said with the private label goods -- are going to try to lower prices. With these new 365 locations, we already know the stores themselves are going to be cheaper -- the buildouts are. They're going to integrate a lot of technology. They're obviously going to be smaller and they're going to have a much more carefully curated selection of products.

They've mentioned specifically that this is all going to target the millennial consumers. The reason for that is, a lot of the younger generation is now picky, they want high quality, natural, organic food; but they're still on a strict food budget.

O'Reilly: My wife sent me to the Whole Foods down the street the other day because we were out of peanut butter. They have every organic peanut butter and jelly options. They have every preserve you can think of and I was like "Whoa! This is too much. It's too expensive." So I just got their 365 brand.

Shen: There you go.

O'Reilly: Boom.

Shen: If you look at a competitor like Trader Joe's, who has done a really good job of targeting this market -- the younger shoppers who want those natural foods on a budget. Trader Joe's has done extremely well with that.

O'Reilly: We need to do a show about the Two Buck Chuck; Trader Joe's line.

Shen: Oh, yeah. We can definitely cover that at some point. The thing is, Whole Foods' main stores are also on the defensive from major, organic offerings from big competitors, too. We're talking about Kroger, Wal-Mart, Costco. There was a report recently that Costco may dethrone Whole Foods this year as the largest seller of organic goods, at $4 billion of sales. That's more than double in just the past three years.

O'Reilly: They have the store footprint, all they had to do was pivot.

Shen: Exactly. A lot of these competitors are attacking them on price. So Whole Foods sees an opportunity here to expand their locations, hit some new markets -- especially younger consumers -- with these lower prices, without watering down their core, Whole Foods brand.

O'Reilly: I have to wonder though if this will be -- it might be better. What kind of returns are we looking at? Internal rates of return and everything.

Shen: The thing is, recently Whole Foods' same store sales have slowed significantly. I think they logged just over 3%.

O'Reilly: Yeah, this compares to 7%, 8% a year or two ago.

Shen: Yeah. They were doing double digits not long ago. They missed on revenue and the stock has taken a beating. It's been very volatile. It's 20% down year-to-date and since 2013, it's jumped as high as $65 to come back down to $40. Then it's gone as high as $57 again and now it's back in the $40 range, trading at 23x current year earnings.

That growth is stalling out and I'm sure they're seeing of the success that Wal-Mart is having with the smaller format store. The Neighborhood Markets has been a huge, shining star in their recent earnings reports.

O'Reilly: Have you ever been to one of those?

Shen: I have not.

O'Reilly: They're nice.

Shen: I haven't seen one in person. You've got to keep in mind, while Wal-Mart's overall business is seeing 1% growth for the last quarter, the smaller format, Neighborhood Market Express stores saw 8% same store sales growth.

O'Reilly: Wow.

Shen: That kind of strength is probably something that Whole Foods would love to target with their 365 concept. This year alone, Wal-Mart is opening 200 new Neighborhood Markets.

O'Reilly: That's pretty much all Wal-Mart can do at this point, in my opinion.

Shen: They have thousands of Supercenters, but Whole Foods is pursuing this. I think it's a great idea, honestly. Targeting both new locations, being able to have multiple locations in some of these urban areas, targeting the younger shoppers. In general, organic foods is one of the fastest growing categories.

O'Reilly: Very good. Before we move on and talk about Barnes & Noble, I want to make our listeners aware of a very special offer for all of our Industry Focus listeners. If you found this discussion informative, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We're offering the lowest price out there for all of our Industry Focus listeners. It is $129 for a two year subscription to Stock Advisor.

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Vince, I was surprised to find out that Barnes & Noble got Sears Canada's former head to come in as CEO. First and foremost, let's talk about what's been going on with Barnes & Noble. They're the last survivor in the book industry, let's first say that.

Shen: Yeah. Exactly. They're business is going through a lot of changes, and we're going to see them try to pivot again into being a pure play book seller. Right now you only have three major segments. They have their retail, they have their Nook segment, and then they have their College Education segment. They initially made plans to spinoff the Nook along with the College business. Now they're going to hold onto the Nook business, because I think they really want...

O'Reilly: The future of digital, or whatever.

Shen: Exactly. They want exposure to the digital market. They're going to spinoff their college business. They valued it around $775 million.

O'Reilly: The College business?

Shen: Yes. It's currently a little over 700 locations.

O'Reilly: If I had to pick a segment to own I would pick that one.

Shen: The thing is, it's the only one in the recent fiscal year to post any sales growth. The segment makes up about 30% of revenue, about 30% of EBITDA.

O'Reilly: I really wanted to highlight this because I feel very strongly about it. I went back to my alma mater -- Case Western in Cleveland -- and they just did a big redesign of the campus. The cornerstone is this giant Case Western/Barnes & Noble store. I'm sure this is the case in all 700 of these locations; it's basically a monopoly. It is a mini-monopoly on all of these college campuses.

Shen: I think they're adding these college stores at the rate of 25 locations per year. That business is going to be spun off. Each current shareholder is going to get a share of the new entity that they're calling Barnes & Noble Education, around August. That essentially leaves the original Barnes & Noble entity able to focus on the retail and Nook business. That is a big part of the reason this new CEO has come in. He has only had the job at Sears Canada for less than a year -- about 10 or 11 months.

O'Reilly: Okay. So he's not an alum by any chance.

Shen: So, a short stint. Before that he spent time at places like Best Buy, Brookstone, Toys "R" Us. He generally entered those senior positions when those businesses were struggling. He's had a pretty good track record of being able to stabilize revenue, attack new initiatives like mobile, and some of the businesses went under regardless. Brookstone declared bankruptcy a year or two after he left, but he's still shown the ability to turn things around while he's there.

So I think Barnes & Noble is really going to need his help, because they announced a partnership last summer with Samsung to release a new version of the Nook. They've completely gotten rid of internal hardware. They want to get out of the hardware business -- which I think is a great idea -- now they're going to focus on making the Nook more attractive against competition like the Kindle, expanding digital offerings, focusing on their main Barnes & Noble stores.

I think they want to reduce from their current store count, which is around 600, down to 400 or 500. Ultimately, they think that's sustainable for their business.

O'Reilly: It seems to me at a 20,000 foot in the air view that the college -- I'm highly interested in that spinoff. I'm not a shareholder of Barnes & Noble, but that spinoff of the college business is basically a monopoly. Think about it. You go in there, they sell the apparel, they sell the books -- you don't have to get the books there, but they're there -- there's usually a Starbucks inside; it's pretty slick.

Shen: They've expanded to textbook rentals, they've recently released a whole new platform for...

O'Reilly: Come to think of it, my wife had one of these at her college, too. I have seen it. Students hang out there and buy snacks.

Shen: The thing is, there's still a lot of untapped stores in the market. I think over half of colleges still manage their own stores.

O'Reilly: Yeah, I actually just pulled that up here. You said there were 600?

Shen: A little over 700 of these college stores.

O'Reilly: In the United States right now, in public four year institutions, there are about 629 of those. There are 1,845 private four year institutions -- so we're up to about 2,400, 2,500 give or take. For public two year institutions: 1,070; and private two year institutions: 579. They're, what? Half of these things could hold a Barnes & Noble. They're 40% there.

Shen: They're the second biggest player as it is now. One of their competitors has closer to 800 or 900 of these college locations.

O'Reilly: Yeah. And it sounds crazy that Barnes & Noble is basically a showroom for Amazon.com's books; but they do have the brand name of Barnes & Noble. "Come here to buy books and hang out."

Shen: Exactly.

O'Reilly: That Nook; I'm really surprised at how it's not performing.

Shen: That business has been a disaster the past few years. They're basically seeing sales drop. The most recent holiday season being as important as it is -- and keep in mind this was after they released their new tablet with their partnership with Samsung -- and it didn't lift sales at all. Year-over-year, the holiday season saw a 50% drop in Nook's revenue segment. It was hemorrhaging money for a long time.

They've stemmed losses by up to 60%. So it's still losing money, but not losing quite as much, but that's going to be a tough business turnaround. You've got to think about how competitive the tablet market is. Not only that, you're not competing against small players. You're talking about Apple and Amazon.

O'Reilly: Right.

Shen: These guys are not going to be giving up market share very easily.

O'Reilly: For sure. When does that spinoff happen?

Shen: The current shareholders will receive their shares of the new entity in August.

O'Reilly: Got it. Very good. Well thanks for your insight and thoughts, Vince.

Shen: Thank you, Sean.

O'Reilly: Have a good one. If you are a loyal listener and you have questions or comments we'd love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!