With demand for natural, organic, and high-quality food growing at a rapid pace, Whole Foods Market (NASDAQ: WFM) finds itself the market leader. But as the market has grown, so has the desire of traditional grocers to get in on the action. No longer operating in a strictly niche market, Whole Foods is facing heavier competition than ever before.
When Whole Foods reported earnings earlier this month, results were right around what analysts expected. But a combination of slowing growth and a weak forecast caused the stock to plunge by as much as 10%.
While revenue grew by 10.8% year over year, the trend is not encouraging. In Q3, sales grew by 11.7%, down from 13.3% in Q2 and 13.7% in Q1. Comparable-store sales growth followed a similar trend, with 5.9% growth -- well below the 7.2% growth from Q1.
These are still strong numbers, but compared to the valuation the market was assigning to Whole Foods' stock prior to earnings, they leave a lot to be desired. At around 44 times full-year earnings before the decline, the stock was priced at a level that assumed incredible growth going forward.
Whole Foods operates in a low-margin industry, and to achieve fast enough growth to justify the valuation would have not only required comparable-store sales growth to accelerate but for margins to expand as well. Earnings grew by 16% in the quarter, a solid result, but not even close to justifying a P/E ratio of 40-plus.
Whole Foods has been expanding into more urban markets, and after seeing initial success in Detroit, the company is growing that effort. There are two important takeaways from this. First, expanding into these new markets means that the company is likely running out of the kind of locations that it has focused on up until now. Second, the margins at these new locations will be much lower than traditional stores, which cater to the upscale shopper.
Going forward, this means that while revenue will continue to grow, margins will decline. By expanding beyond its core consumer, Whole Foods is becoming more like a traditional grocer. And traditional grocery is not a very attractive industry.
Target gets in the game
When the market for organic and natural food was small, it made little sense for big grocery chains to make any real effort in the area. But now that the category has become more mainstream, companies like Target (NYSE:TGT) are getting serious about natural foods. Target uses grocery to drive people into its stores, and grocery now makes up about one-fifth of the company's annual sales.
Earlier this year, Target launched the Simply Balanced line of groceries. The products include wholesome ingredients, and more than 40% of the line is organic. The entire line excludes partially hydrogenated oils, high-fructose corn syrup, synthetic colors, and artificial flavors and sweeteners.
Target has always been a bit more upscale than competitor Wal-Mart, so the move to natural foods makes sense. Not only will this steal some business away from Whole Foods and similar stores, it could also raise Target's grocery margins.
With traditional grocer Kroger taking a similar initiative with its own line of natural foods, Whole Foods is facing a slew of new competition from the behemoths of the industry.
Along with big grocers stepping up their respective games, smaller companies are starting to expand into Whole Foods' turf. Sprouts Farmers Markets (NASDAQ:SFM), a small but fast-growing chain, is one example. Sprouts' management has stated that there's potential for 1,200 stores across the country, and that a sustainable 12% store growth rate is possible. Sprouts caters to the same market as Whole Foods, with a focus on fresh produce and prices that are often lower than at its larger competitor.
It's hard to say if Sprouts will see the same success as Whole Foods, but more competition will lead to Whole Foods lowering its prices in order to compete. This is bad news for the company's margins, and I suspect that profitability will decline going forward.
The bottom line
Whole Foods is facing slowing growth as competition in the organic- and natural-foods business is heating up. Investors let their expectations get out of sync with reality, and those expectations must be dialed back down. Even after the post-earnings decline, Whole Foods is an expensive stock given its growth prospects, and even the best company at too high of a price is a terrible investment.
Fool contributor Timothy Green has no position in any stocks mentioned. 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.