Whole Foods' Internet Story (Fool on the Hill) October 19, 1999

An Investment Opinion

Whole Foods' Internet Story

By Warren Gump (TMF Gump)
October 19, 1999

Management at Whole Foods Market (Nasdaq: WFMI) must be disappointed with the stock market's reception to its plans to expand its e-commerce initiative well beyond the current offerings of its site. Since releasing plans to broaden its assortment to cover the "whole living" category, the stock has fallen from $36 9/16 to its closing price today of $30 15/16. While the market (and I myself) have disparaged many "real-world" retailers moves into the online space as being halfhearted, too aggressive, and/or haphazard, Whole Foods seems to be taking a rational and intelligent approach to its online efforts. This type of strategy shouldn't be too surprising from an innovative company that created the nation's largest natural foods chain.

Before talking about the company's Internet efforts, it is very important to realize that Whole Foods is not transforming itself to become solely an Internet firm. It is continuing to pursue its planned expansion of its successful traditional stores, which has been a key ingredient to its prior success. Off of its current base of 100 stores, the company plans to open an additional 15-20 new stores over the next year. In addition, it is already at work trying to find sites for stores that will open in 2001 and 2002 to ensure that it will have solid locations for future sites. The real-world stores have been and will continue to be the primary driver of the company's profitability.

Over the past five years, the company's stores have posted positive comparable store sales of 5%-11%. These strong increases were fueled by the maturation of newer stores and increased consumer acceptance and willingness to pay for natural and gourmet food items. Benchmarking these increases off of traditional grocery stores, most of those chains have struggled to post sales increases of 2%-3% over the same period. From an EBITDA perspective -- that's earnings before interest, taxes, depreciation, and amortization, a measure of profitability -- Whole Foods boasts an 8.6% margin, a number that is far higher than the 6.6% margin earned by the average traditional supermarkets.

While the real-world stores are the primary reason for investors to consider an investment in Whole Foods, this article is going to be focused on the company's evolutionary strategy to expand into e-commerce. Last spring, the company opened the e-commerce site as its first foray into the new retailing medium. The site was experimental in many ways, offering a limited selection that has gradually been expanded to cover more offerings. To enhance the shopping experience beyond just point, click, and purchase, the company incorporated a wide range of consumer information and suggestions into the site.

Whole Foods took a mellow approach to promoting its site. Instead of going hog wild with a multimillion dollar advertising and brand awareness campaign that would have turned profits into losses, the company used its retail stores as the primary driver of traffic to the site. Signs were posted in all of the stores, and store associates were given bonuses based on the number of people they referred to the site. The company did do some selective advertising, but it was mostly in-store and word of mouth. While sales to this point have not really been meaningful to the overall company, management was given a chance to learn about consumer preferences and site usability.

Having gathered information and observed performance of the online store for half a year, Whole Foods decided to use the Internet to pursue greater opportunities. Although many retailers have used the Internet simply as another distribution mechanism for the same products offered in their stores, Whole Foods will dramatically broaden its offerings beyond items like groceries and vitamins that are the staples of its stores. The company will create a new subsidiary called that will target consumers focused on healthy lifestyles and the environment. Whole Foods will combine its and Amrion subsidiaries to form (Amrion is the company's nutritional supplement and direct marketing unit.) is not intended to be a reincarnation of The company has explicitly stated that within a short period after the launch of, it expects only "a small percentage" of online sales will be from products carried in bricks and mortar stores. Instead, most of the sales will come from new product categories including ecologically friendly items, cooking and gardening accessories, and accessories for outdoor and wilderness activities. While such a broad range of product offerings may sound disparate to some people, it would be hard to argue that they are not items purchased by well educated, affluent customers who tend to care about their health and the environment. This is the same customer base that tends to be online and comfortable using e-commerce and, conveniently enough, the same group of people that tend to be Whole Foods' best customers.

Whole Foods announced investments with two partners who will help beef up's offerings. The company plowed $20 million into American WholeHealth, a provider of integrative medicine that combines conventional and alternative medicine. This partnership provides with an exclusive e-commerce application for, which will develop personalized plans for the self-management of chronic illnesses. The company also purchased a 16.4% stake in Real Goods Trading Corp. (Nasdaq: RGTC) and announced a strategic alliance that will allow to sell Real Good's environmental and renewable energy products online. Both of these partnerships will help expand Whole People's offerings beyond what Whole Foods stores currently offer.

Pursuing this ambitious Internet strategy does have its pitfalls. In the press release announcing these moves, Whole Foods estimated that next year's earnings will be knocked down by $0.18-$0.26 per share to cover's site development and marketing costs. Even with those costs, however, the company is expected to earn $1.93 per share next year. Shareholders looking only at next year's earnings projections will obviously be disappointed at such an announcement, but investors with a longer-term horizon should be enthusiastic that the company is looking at new opportunities that could provide attractive returns on capital.

In an encouraging sign for investors who don't want to see Whole Foods ignore its retail stores, the company announced that it had signed non-binding letters of intent with outside investors to purchase a 13.5% stake in for $35 million. This capital infusion means that Whole Foods will not have to divert capital from its retail store expansion to fund the development of Instead, this outside investment will provide the capital needed for a substantial part of the new venture. Capital for expansion beyond the next year is expected to be provided by a potential initial public offering.

In my view, Whole Foods is taking a measured risk in further expanding its e-commerce efforts. The company appears to have determined that its brand strength is one of its prime assets, and it will try to leverage that across a broader array of items that will be of interest to its core customer base. While making a significant investment in, the company isn't investing enough to break the bank. A failure would be disappointing, but it wouldn't prevent Whole Foods from continuing to grow its core retail operations. This limited investment by Whole Foods doesn't, however, mean that the company won't aggressively pursue the space -- the capital infusion from venture capitalists and a potential IPO will ensure that is well funded.

On paper, the company's strategy seems quite smart to me. Of course, the market has concluded otherwise and taken the stock out to the woodshed for a beating. I'll grant that my perspective may be skewed since I'm looking at the venture from the optimistic perspective of a Whole Foods shareholder. We'll just have to wait and see who's right.