Why Whole Foods Market Inc. Investors Shouldn't Lose Sleep Over These 2 Essential Metrics… Yet

Selling food is a brutal business. Nowhere is this more obvious than in a company's gross and net margins.

In essence, you buy something from a middleman for $1 and try to sell it for $1.25. With that extra quarter (your gross margin), you have to subtract out everything from rent to employee wages to utilities. If you're left with $0.02 profit (net margin) on your sale, you're considered a success.

That helps explain why Whole Foods Market (WFM) has been such a huge success for over two decades. Unlike standard grocery chains, Whole Foods has been able to sell its products for, say, $1.36, and pocket a little over $0.04 in profit from every purchase.

That might sound like a small difference, but applied to millions of individual purchases every day, those two pennies move the needle in a very important way.

Margins are important in any industry, but with grocers, small changes make an outsize difference.

Whole Foods is an important part of my family's retirement plan, accounting for more than 5% of our retirement investments. And yet I won't be sweating Whole Foods' margins too much in the company's earnings release this week.

A Whole Foods Market in Canada. Source: ChadPerez49, via Wikimedia Commons. 

Whole Foods has made a lot of noise the last six months by stating over and over that it is "investing in price." To us normal shoppers, that means, "offering food for cheaper." In Whole Foods' case, that specifically means perishable goods like fruits and vegetables.

Not surprisingly, choosing this path has caused some serious pain for the company's stock. But there's little else it can do in the face of pricing pressure from a host of upstarts, as well as an entrance by some of the nation's largest grocers into the organic field.

Over the long run, I believe Whole Foods can weather the storm with this approach. Whole Foods' clientele are unlikely to run to a discount grocer for organics. Anyone who has been to a Whole Foods store knows that being a patron of the company is as much about the enjoyable/educational shopping experience as it is the actual food.

And where the host of natural/organic upstarts are concerned, they won't be able to compete with Whole Foods' prices, and none offer anywhere near the same volume of products.

But that day of reckoning is likely far off, and investors need to be patient. That's why I won't be focusing too much on margins or comparable-store sales (comps) when the company publishes its quarterly report on Wednesday after market close.

A long delay in the feedback cycle
One of my favorite diagrams for understanding how organizations work is a feedback loop. In its most basic form, it looks like this:

Source: Author illustration.

The part that almost everyone ignores is the delay, and when it comes to understanding an investment in Whole Foods, its margins, and its comps, that delay is crucial.

The company is lowering prices on goods. Naturally, that is going to lower margins. But Whole Foods knows that the organic/natural food movement is only picking up steam. It believes that the total number of purchases will raise enough to more than offset the decline in prices.

But it will take time.

Whole Foods won't lose the "Whole Paycheck" moniker overnight. Some of it will come from advertising, some of it will come from word of mouth, and some of it will come from the company's plans to drastically accelerate its expansion plans.

Over time, people will see that they can't get the same price and selection of organic goods anywhere but Whole Foods. But that time may well be years down the road, and it certainly won't be by the end of 2014. That's why I'm fully prepared for margins to shrink.

It's also why I won't be too concerned if comps come in below the 5% mark, as they have been lately. That's because the metric is the product of two factors: total volume and average ticket price. If I go in and purchase the same things now -- at lower prices -- that I did last month, my volume stays the same, and the ticket price shrinks.

That's why, barring disastrous results, if there was one thing I would focus on, it would be total volume growth. Whole Foods refers to this as "Change in Transactions" (as opposed to "Change in Basket Size"). Over the past three quarters, this metrics has nudged up an average of 3%.

Other than that, I think most long-term investors of Whole Foods might be better off focusing on... well... the long term, and not worrying too much about margins or comps this quarter.