Whole Foods Market (NASDAQ:WFM) must be glad to see the month of June. The company's shares lost a full fifth of their value in a brutal May, after a solid earnings report was followed by revised guidance. A realization like a slow-burning fuse seems to have hit analysts, investors, and Whole Foods management simultaneously: The company's niche of the last two decades is dissolving into the mainstream, and a host of competitive pressures are suddenly compressing its prospects.
On the surface, investors are focused on one of Whole Foods' traditional yardsticks: comparable-store sales growth. In May of last year, WFM told investors it was gunning for fiscal 2013 comparable store sales growth of between 6.7% and 7.5%. Since then, the company has revised near-term comparable store numbers downward nearly every quarter. Including the revision issued this month, current fiscal 2014 growth prospects stand at 5%-5.5%. The near-term revisions cast frigid water over the proposition that the natural foods grocer can return to its four year average of 7.8% comparable store sales growth any time soon.
Yet May's sell-off and continued doldrums are more than a reaction to disappointing guidance. The selling reflects investors' conscious fear of increased competition from the likes of newly public Sprouts Farmers Market, traditional grocer Kroger, and the nimble Trader Joe's chain. On a deeper level, the selling also reflects an unconscious dread of Wal-Mart's (NYSE:WMT) plan to expand its organic food offerings nationwide via a slate of new Wild Oats Markets organic products, at an anticipated average of 25% below current market prices.
Wal-Mart's gambit: forceful, but not fatal
The Wild Oats tie-up is interesting in that Wal-Mart won't be buying Wild Oats inventory directly. Rather, Wild Oats is negotiating with organic suppliers on Wal-Mart's behalf, using long-term agreements as a lever to win pricing. This ensures that the economics work for both Wal-Mart and Wild Oats.
Such agreements will likely work best for "pantry" items, such as cereals, canned goods, olive oil, and other staples, which tend to have a lower unit cost versus meat, fish, and some produce categories. Since Wal-Mart isn't planning initially to create any new shelf space for additional organic items -- it will substitute Wild Oats items for current Wal-Mart products) -- the new agreement isn't likely to upend Whole Foods' business anytime soon. The pricing is a threat nonetheless, as it has the ability to peel away some of Whole Foods' least loyal customers.
Some analysts and investors are concerned that Wal-Mart's more forceful push into natural and organic foods will cause the category to become commoditized. If Wal-Mart purchases on a huge scale from organic suppliers, the reasoning goes, the prices for these products could be driven down to a point not much higher than conventional food items. This would be a tremendous boon for health-conscious consumers, while potentially wrecking Whole Foods' margins.
One problem with this scenario is that demand in the organic industry currently exceeds supply by 25%, as discussed in a recent International Business Times article. There's not enough supply for Wal-Mart to drive commoditization with a fistful of dollars -- yet. In fact, it's still to be proven what influence Wal-Mart will ultimately wield in an industry dominated by small farms. Will local farmers prefer to continue to do business with Whole Foods and its peers for a handsome reward for their efforts? Or will they accept lower margins for the promise of larger scale purchases and years-long, contractualized commitments?
Wild Oats has rather defensively posted to its blog that "organic isn't about scale; it's about adhering to the principles of producing food without synthetic chemicals, and with a respect for sustaining the land and water used to produce that food." While one has to laud Wild Oats for its efforts to put organic food onto more consumers' tables, such a statement may be disingenuous. Wal-Mart books Whole Foods' entire annual $13 billion revenue every 10 days, and for organic foods to make a further meaningful impact on its finances, it will likely have to introduce massive economies of scale, just as it's done with conventional food items and indeed virtually all other merchandise sold in its diversified businesses.
In sum, Wal-Mart's competitive threat, while formidable, will take some time to affect Whole Foods' business significantly, and there are many caveats along the way.
A buried strategic vision
While investors fret over increased competition and declining comparable store sales, Whole Foods is shifting its focus to accelerating new store openings, a centerpiece of its "Strategic Vision" included within its quarterly filing last month. While the information presented boils down to a table of operational goals, the ambition of the numbers is eye-opening.
Here are some targets I've extrapolated from the numbers presented, which show how aggressive the company intends to be in capturing growth during the next five years:
- Whole Foods will grow total revenues by 84% in the next five years.
- The company will increase EBITDA by 84% in the next five years.
- The company will nearly double the rate of total square footage growth, from 6.2% to 11.3% annually.
- The company will increase its total store base by 54% in the next five years.
Building new stores may seem like a questionable strategy, given the pricing challenges that Whole Foods is facing. Yet the company is finding that it has revenue potential outside of the major metropolitan areas in which it has based its stores for years. New locations in smaller markets such as Jackson, Mississippi, which have surprised management in their success, provide a partial offset to same store cannibalization in cities such as Boston.
Expansion in non-major markets may be a hidden strategic lever for Whole Foods, as it can tap pent-up suburban demand, where the cachet of its stores provides some insulation against a simple onslaught of pricing. By the same principle of new customer demand, these markets lend themselves to optimizing prepared foods and bakery items, which account for a massive one-fifth of Whole Foods' total revenue, and represent a growing category that's beyond Wal-Mart's reach.
Overall, the shift to stretching square footage will keep Whole Foods' growth trajectory intact. If you'd like some deeper analysis on the rationale for this change, please read this anticipatory article I wrote earlier this year.
Welcome to the mainstream
Both pessimists and realists would be right to assume that the natural foods landscape will never quite be the same. As CEO John Mackey put it on the company's recent earnings call:
Our tremendous success has created more competition. And that's the way capitalism works, so we have, what we thought was a niche and we still think it's a niche. But it's just gotten to be a very big niche and in some ways it's gone mainstream. So there's a lot more competition, a lot more entrants into the marketplace as well as conventional supermarkets copying and imitating a lot of what we're doing.
In the next few years, Whole Foods will get a sense of what it's like to step out of a safe and profitable niche. Expect the company to weather Wal-Mart's challenge and push new stores as it cascades into the mainstream it helped create.
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