Whole

Logo: Whole Foods

Whole Foods Market (NASDAQ:WFM) shares are up over 30% in the last six months. One reason shares have surged is the company's success in changing its pricing strategy to drive more sales in the last two quarters.

While the company has been successful in starting to shed the "whole paycheck" perception, moving forward, investors have to watch the company's gross margins that helped in making the company so profitable. Increasing competition and rising food costs could put downward pressure on Whole Food's gaudy gross margins -- which nearly hit 40% in past years.  

Why Whole Foods has needed to lower its prices
With Whole Foods' success in marketing more healthy, quality, and sustainable food and products, many other companies have joined in offering consumers foods with natural ingredients, traceable sources, and more sustainable production practices. 

Sprouts Farmer Markets is an example of a company directly competing with Whole Foods in the natural food market, but even major companies like Wal-Mart Stores and Kroger are offering their own versions of health food brands and dedicated locations to directly compete with Whole Foods and gain from more health-conscious consumers. And most of these competitors have been able to offer their version of health-conscious food at much lower prices than Whole Foods. A 2014 study by Bloomberg Industries of 148 name brand items found 13% higher prices on average at Whole Foods than at Sprouts, and 22% higher prices on average for similar natural produce.      

Whole Foods has started to try to change this perception by lowering prices on many of its products, and to share those price cuts with the public by being more transparent on its pricing strategy as well. In the most recent earnings call, Whole Foods co-CEO Walter Robb said that:

"We know where we stand relative to the others. And, yes, of course, on the items that are ubiquitous, we're going to be in and we're going to have to price them right."

These prices will drop for perishables and brand names that can be found at competing stores, more so than for meat and produce that Whole Foods still believes it can increase value by being transparent on its sustainable sourcing of the products. During the call Robb and co-CEO John Mackey noted that this is a multi-year strategy, not an immediate one time change. 

Higher COGS + lower prices = _____
Whole Foods' gross profit margin has gone down consistently from 35.8% at the end of 2013, to 35.5% at the end of 2014, and most recently to 34.8% in the first quarter of 2015, which is its lowest point since 2011. 

WFM Gross Profit Margin (TTM) Chart

WFM Gross Profit Margin (TTM) data by YCharts.

A risk that could lower margins further
Whole Foods made headlines recently when one of its major beef suppliers was negatively affected by a drought in the region. Because of the lack of water, the supplier's own costs were much higher -- to the point that its own operations were strained. Whole Foods stepped in and offered to split the cost increase with the supplier.

This is a good example of Whole Foods' sustainability and total shareholder values that have helped the company grow to where it is now. But it is an example of a major risk facing Whole Foods: Rising food prices could push Whole Foods' gross margins even lower, further straining earnings and making continued earnings growth a challenge. 

Even though Whole Foods sources its products from many different local and regional sources, the company's single largest third-party supplier United Natural Foods, (NASDAQ: UNFI) supplies 32% of Whole Foods' total purchases. With such a high percentage of purchases from a single partner, rising costs from UNFI alone would substantially affect Whole Foods' margins. The two companies have a distribution agreement that extends until 2020, but issues at UNFI could seriously affect Whole Foods' own business in the short term, and there is always the possibility of less favorable terms for the next contract.

Mackey has spoken about the UNFI relationship in the past, and it's generally viewed as a partnership rather than a buyer-supplier dynamic. With the "five-year notice" agreement they have, any margin impacts would likely be able to be anticipated rather than an absolute shock to the system, but Whole Foods reliance on UNFI shouldn't be ignored, especially with other deep-pocketed competitors like Kroger growing their organic offerings. 

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Bradley Seth McNew has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market and 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.