If you look at the side panel of an organic milk carton, you'll find that organic means the milk is free of fertilizers, pesticides, growth hormones, and antibiotics. Is it any wonder that organic is in high demand? The only obstacle to buying more organic food for the cost-conscious consumer is the price, which is usually much higher than it is for non-organic products. In April, however, Wal-Mart Stores (NYSE:WMT), the nation's largest grocer, announced a program that will reduce the cost of organic foods by an average of 25%, making it affordable for Wal-Mart's customer base.

Many analysts interpret this offering as Wal-Mart's attempt to take market share away from Whole Foods Market (NASDAQ:WFM), and that's not a bad guess considering the history between Whole Foods and Wild Oats. But the real target is Dollar General (NYSE:DG) and other dollar stores like it. This move towards organic food, in addition to opening small-format stores, shows that Wal-Mart is targeting Dollar General's share of the grocery market.


Source: Wal-Mart Stores

A brief history of Wild Oats and Whole Foods
Wild Oats is the name of the company that will be supplying Wal-Mart with a line of organic products. Perhaps this was the very thing Whole Foods was trying to prevent when it purchased Wild Oats back in 2007. Unfortunately the Federal Trade Commission felt the merger:

...[violated] federal antitrust laws by eliminating the substantial competition between these two uniquely close competitors in the operation of premium natural and organic supermarkets nationwide...

The FTC required Whole Foods to sell the brand as part of a settlement, which it did in 2009.

So, it's no surprise that analysts believe Wal-Mart is targeting Whole Foods with this announcement. But Whole Foods has a loyal customer base, and customers who shop at Whole Foods are not likely to switch to Wal-Mart just because of lower prices. That's not the case at Dollar General. Price is one of the main reasons people go to Dollar General, and if Wal-Mart can offer a better price in addition to an organic food selection it may be able to regain market share. 

Even without incremental customers from Whole Foods, Wal-Mart said that 91% of its current customer base would prefer organic if it were affordable. Jack Sinclair, executive vice president of grocery in Wal-Mart's U.S. segment, said: 

We know our customers are interested in purchasing organic products and, traditionally, those customers have had to pay more.

Going after the grocery market
As you can see from the table below, groceries represent 56% of Wal-Mart's total sales.


Source: Wal-Mart 10-K

Wal-Mart's sales suffered dramatically in the fourth quarter as the food stamp budget was cut for millions of Americans. According to two sources, including The Wall Street Journal, Americans spend about 18% of all food stamp dollars at Wal-Mart. The company blamed its fourth-quarter earnings miss on its failure to account for the impact of food stamp cuts on sales.

Dollar General has a similar reliance on groceries -- food and other consumables make up 75% of revenue -- but it had a much better year than Wal-Mart in 2013. While Wal-Mart's same-store sales decreased by 0.4%, Dollar General's results increased by 3.3%, marking the 24th consecutive year of same-store sales growth.

The company attributes same-store sales growth to "the expansion of the number of coolers for refrigerated and frozen foods and beverages in [more than] 1,600 existing stores." But the larger truth is that Dollar General has been beating Wal-Mart at its own game with the use of small-store formats instead of massive supercenters. The game, however, is about to change.

Game on: small-store format expansion
Make no mistake, Wal-Mart is going after Dollar General. Wal-Mart announced the acceleration of its small-store expansion efforts and plans to open 270-300 locations by the end of the fiscal year. In contrast, Dollar General opened 650 stores in 2013 and plans to open 700 this year.

My guess is that Dollar General will be forced to slow expansion efforts by year-end due to declining same-store sales growth. The one major advantage Wal-Mart has over Dollar General in its expansion efforts is its ability to use supercenters as ready-made distribution centers; this allows Wal-Mart's smaller stores to carry less inventory while providing a broader product assortment -- like Wild Oats. The net affect is higher sales and improved operational efficiencies -- Wal-Mart is the clear winner.

The conundrum for the CEOs of discount-retail stores is figuring out a way to attract customers without giving away margin. It may sound overly simplistic, but Wal-Mart does this by honing in on what customers want and then providing it for the lowest cost. This strategy works so well it is often imitated by companies like Dollar General.

Now Wal-Mart is striking back with smaller stores and organic food offerings that allow it greater access to customers in urban areas. The ability to offer convenience and organic food options at lower prices will be a strong selling point for shoppers to select Wal-Mart over Dollar General.

Wal-Mart's same-store sales expansion and organic food strategy are aimed at winning back those customers it lost to Dollar General, not Whole Foods Market. If the strategy happens to get incremental Whole Foods customers, it's just icing on the cake.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. C Bryant 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.