Oh, how quickly things can change!
Coming out of the Great Recession, there were few grocery stores that performed as well as Whole Foods (WFM). While many traditional players abandoned expensive organic fare consumers couldn't afford, Whole Foods solidly established itself as the entrenched player in the niche. When family budgets loosened, that benefited the company and shareholders, as Whole Foods stock quintupled in just five years time.
But the last two years have not been kind for those holding Whole Foods' stock. Shares have lost over half of their value since late 2013.
And while a series of smaller organic players have taken their toll on Whole Foods' bottom line, no company has been more of a thorn in the side than Kroger (KR 0.95%). The nation's second-largest grocer -- behind Wal-Mart -- has now become one of the leading purveyors of organic food, and it seems to be taking more and more business from Whole Foods. Last week's earnings release by Kroger shows that trend is continuing.
Whole Foods stock won't recover until this changes
Call them strangers passing in the night, heading in very different directions.
There is no metric more important to grocery stores than comparable-store sales (comps). While any store can increase its revenue via store buildout, it takes a company that's truly executing on its vision to consistently increase its comps -- showing the ability to both drive more traffic and pass on incremental price increases to the consumer.
As you can see above, Whole Foods' comps were out of this world coming out of the recession, but compared to Kroger, they have cooled considerably in the last two years.
While some decline in comps from Whole Foods was unavoidable -- with comparisons getting tougher every year -- movement over the past 18 months shows a stark contrast with Kroger's.
Kroger's stock was simply situated to benefit from increased competition for organic food, while Whole Foods was fragile to such competition. Coming out of the Great Recession, Whole Foods was able to enjoy market-bashing gross margins, as the company was the only player in a very lucrative niche. The lack of competition allowed the company to price its wares far higher than the traditional grocer.
As competition has entered, management has "invested in value," industry speak for lowering prices. At the same time, Kroger is expanding its margins by entering the field, even if the organic food that it sells doesn't enjoy the type of profitability that Whole Foods did during its heyday.
Kroger isn't going away
In last week's earnings release, Kroger management raised its estimates for earnings per share and comps, an ominous sign for Whole Foods investors. Company CFO Michael Schlotman pointed directly at the company's natural and organic offerings for the impressive performance: "We continue to see outstanding double-digit [comps] growth in our natural foods department."
When you consider that Kroger has over 2,600 locations and a presence in most geographies where Whole Foods is established, it's not hard to connect the dots: Kroger is taking serious business away from Whole Foods.
For the rest of 2015, Kroger's management sees comps coming in between 4% and 5%. Whole Foods, on the other hand, sees low-single-digit comp growth.
Is there hope for Whole Foods stock?
The underlying story is simple: With increased competition, shoppers are simply going to Kroger. And why not? They can get the organic goods they want and equal or lower prices while having access to all the non-organic goods they want to buy that Whole Foods doesn't carry. Throw in the fact that going to Kroger is more convenient -- because of its footprint, that's over six times the size of Whole Foods' -- and you have a recipe for continued disappointing results.
But Whole Foods isn't going down without a fight. Its newest initiative is its smaller-footprint, 365 mini-stores that are aiming to target smaller pockets of communities that the banner stores are too big and expensive to serve.
The first of those stores has yet to open, so investors need to keep a close eye on results from that segment in the year to come. Perhaps the greatest fear is that if 365 stores are successful, they will cannibalize sales from the traditional Whole Foods stores and simply lead to needless infrastructure spending. Only time will tell if that's the case.
But there is one other boon for Whole Foods investors: The stock is cheap. Unlike many other companies, Whole Foods breaks out its capital expenditures into regular costs associated with running the business and those used to build out new stores. Though Whole Foods won't reach saturation for at least a decade, this type of breakout lets us know what the company's free cash flow would look like if it stopped building new stores today.
Currently, Whole Foods trades for just 13 times the $891 million in (modified) free cash flow that it has generated over the past 12 months. While not pound-the-table cheap, it's a more-than-fair price for such a prominent and growing grocer.
Kroger, on the other hand -- which is very near its saturation point in the United States -- trades for 30 times its free cash flow. Over time, we'll see if that premium is deserved. Backing up a bit, however, Kroger hasn't been this expensive -- nor Whole Foods this cheap -- in quite some time.