On May 5, after BMO Capital Markets set a $54 price target for Whole Foods Market (NASDAQ:WFM), I argued that Whole Foods stock was overpriced because of increasing pressure from competitors such as Kroger and that a more fair valuation was probably around $41.
In the next five weeks, shares dropped nearly 20%, to around $40 as of June 11, when Whole Foods released more information about its new concept stores. Now that shares are much cheaper and the company has reported more about what these new stores will be, here's why Whole Foods stock just got interesting again.
The new "365" stores
Whole Foods management finally released a little more information about the new store concept it first hinted at in early May. The new concept store will be called "365 by Whole Foods Market" and cater to a younger and more technology-focused consumer.
The new concept is meant to be "fun and convenient," with what Whole Foods management says will be "a modern, streamlined design with innovative technology." The stores will sell a product mix more geared toward this younger audience (which may mean lower prices) and that offers an "efficient and rewarding way to grocery shop."
"It's a new convenient and affordable way to get the good stuff you crave, all with the same quality standards you find today in our Whole Foods Market stores," the company says in regard to the new 365 stores.
The first of these stores is likely to open next year and will focus on selling the Whole Foods exclusive brand called 365 Everyday Value. Here are two ways this new concept store could help Whole Foods regain lost ground.
Cheaper food means higher margins ...
One of the main reasons Whole Foods' future looked uncertain not too long ago was that the company may not be able to sustain its industry-high gross margin.
Being the premier seller of natural and organic food, and one of the first with significant scale, Whole Foods Market historically could charge relatively high prices and reap a gaudy 35% margin on its products. With new competition from many lower-priced chains, Whole Foods' ability to maintain that stellar gross margin has come under pressure.
Exclusive brands have the advantage of being cheaper to source, as Whole Foods can cut out the middleman and make the products itself. This approach will help its profit margin. Whole Foods will probably be able to keep some price advantage with the quality of its 365 Everyday Value brand, which is cheaper than most in-store brand-name items but more expensive than competitors' exclusive brands, such as Kroger's Simple Truth.
... and it might even reignite comparable same-store-sales growth
The growth of other quality options seems to be the main reason why Whole Foods' year-over-year same-store sales growth has declined to 3.6% in the most recent quarter, from its high of about 8% in years past.
However, the lower cost of producing private label items will help Whole Foods offer lower prices to customers. This could help revitalize comparable-store sales growth once the new 365 by Whole Foods Market stores are up and running.
More properties, faster
Whole Foods currently has a little more than 400 stores. The company has said it would like to grow to around 1,200 stores in the future, with an unspecified date. In 2014, the company added 38 new stores, so at this rate it would take Whole Foods about 20 years to reach its 1,200-store count goal.
Fortunately for investors, it looks as if these new 365 stores might also be easier to roll out quickly. In their appeal to millennials and convenience, the stores will probably be smaller, and Whole Foods' management has said they'll be "streamlined."
That may also mean they'll be easier to replicate and build out in urban areas. It wouldn't be surprising if in 2016 and 2017 Whole Foods is able to speed up its store expansion to more than its current pace of around 40 per year.
Is Whole Foods a buy?
Whole Foods still faces the risk that the natural and organic food industry is getting more and more competitive. This could continue to put pressure on Whole Foods' gross margin and same-store sales growth. However, Whole Foods' current P/E of around 24 after its recent five-week share price drop makes it look much more fairly valued.
Now that Whole Foods has given us more insight into what the new concept stores will look like, there's reason to believe that by using its 365 house brand and perhaps being able to roll out new stores more quickly, the stock could have some room to increase over the next few years.