All high-growth stocks reach a point at which they start seeing the pace of their sales and profit gains slow, and it's always a challenging time for a company. Natural-foods grocer Whole Foods Market (NASDAQ:WFM) has definitely hit that point, and investors have had a lot of trouble adjusting to the falling growth rates that the company has seen in recent quarters.
Coming into Wednesday afternoon's fiscal third-quarter financial report, Whole Foods shareholders wanted signs that the grocery chain's efforts to reinvigorate itself and adapt to changing conditions in the industry had started to pay off. The company's results gave investors almost none of what they wanted to see, raising questions about Whole Foods' strategic vision, and how it can turn itself around in the long run.
Let's take a closer look at Whole Foods, and why its latest results spooked investors so strongly.
Why Whole Foods' results were unappetizing
For those hoping for a turnaround, Whole Foods' fiscal third-quarter numbers simply didn't deliver the goods. Sales climbed just 8%, to $3.63 billion, which was a slight sequential decline from last quarter, and well short of the nearly $3.7 billion in sales that investors wanted to see. Net income inched upward by 2%, to $154 million, but the resulting earnings of $0.43 per share missed the consensus forecast by $0.02. Even adjusting for a one-time charge from the implementation of sick leave laws in California, Whole Foods failed to live up to investor expectations.
As we've seen several times recently, Whole Foods continued to see pressure in comparable-store sales. Comps for the quarter rose just 2.2%, and on a constant-currency basis, the growth was even weaker, at just 1.3%. That growth rate was down substantially from fiscal second-quarter levels.
Even worse, trends toward the end of the quarter weakened further, with comps for the last two weeks of the quarter rising just 0.4%, and the first few weeks of the fiscal fourth-quarter posting just a 0.6% gain. The company suggested that the weights-and-measures audit in New York City that found pricing disparities was to blame for the shortfall, with the incident drawing negative media attention throughout the country. Growth in both customer traffic and average basket size slowed compared to last quarter.
Moreover, Whole Foods suffered continued erosion of its margins. Gross margins fell two-thirds of a percentage point, to 35.6%, and overhead expenses rose at a faster rate than sales, cutting operating margins by a quarter of a percentage point.
Co-CEO Walter Robb tried to emphasize the positives. "In this rapidly changing marketplace," Robb said, "we believe we are taking the necessary steps to position ourselves for the longer term." With rising store counts, the promise of online-ordered home delivery, and other initiatives, Robb thinks that Whole Foods can keep improving.
Will Whole Foods ever be the same?
Whole Foods also provided some details about its 365 by Whole Foods Market concept, with unit president Jeff Tumas revealing that the first 365 store will open in the Los Angeles area. As Tumas said, "With a fresh format and unique product assortment, we think 365 will offer convenience and value while providing the quality standards and transparency that consumers love and expect."
Yet Whole Foods' guidance for the immediate future remains muted, at best. Based on current trends, the grocer said that sales growth for the fiscal fourth quarter would be around 7%, with earnings of $0.34 to $0.35 per share. Both figures are far below expectations, with investors wanting to see 10% sales growth and per-share earnings at $0.38. For the full year, Whole Foods downgraded its comparable-store sales guidance to eliminate the possibility of mid-single digit gains, narrowing its expectations to low single digits.
The 365 rollout will likely take longer than impatient investors want. The company signed four leases for 365 stores, and renegotiated one other lease to convert it to a 365 location. In addition to Los Angeles, the targeted areas include Santa Monica and Houston, as well as the Seattle suburb of Bellevue, and Portland, Oregon. Yet even though the company hopes to open up to five stores in the second half of 2016 , and double openings in 2017, it will take a long time to see how the proposed solution to Whole Foods' problems pan out.
Shareholders were clearly skeptical about Whole Foods' strategy, sending shares plunging more than 10% in the first half-hour of after-market trading following the announcement. What's becoming clear to many investors is that, even if the company's long-term strategy pans out, Whole Foods will have to endure a longer turnaround period than they had hoped.
John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Dan Caplinger owns shares of Whole Foods Market. 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.