King Arthur

A popular baking item that can be ordered through Whole Foods' partnership with Instacart. Image source: www.instacart.com.

In what's proved to be a tumultuous year for Whole Foods Market (NASDAQ: WFM), is it possible to identify the company's worst business segment in 2015? The task is more difficult than it may seem at first blush, as Whole Foods reports its results under just one operating segment.

Yet, as I wrote in the companion piece to this article, Whole Food Market's Best Business Segment in 2015, we can still replicate the various ways in which management looks at its operations internally. As an investing exercise, let's name what, in an alternate universe, has already been crowned the grocer's worst business segment in 2015: name-brand natural and organic packaged goods.

As the year wore on, Whole Foods' management faced the fact that competition from larger grocers, including Kroger Co (NYSE:KR) and Wal-Mart Stores (NYSE:WMT), was a primary factor behind the company's falling comparable-store sales versus simple self-cannibalization from new store openings. During the company's fiscal fourth-quarter earnings call in November, Co-CEO John Mackey singled out the grocer's need to communicate its differentiation more forcefully to its customer base.

The concept of brand differentiation is quite important to this organization. The brand-name natural and organic packaged goods that Whole Foods sells comprised the worst business segment in 2015 for the precise reason that prepared goods comprised the best. Aside from the fact that the typical Whole Foods store can offer a wider selection of natural and organic brands than even a Wal-Mart, these goods are non-differentiated. Any competitor can procure them from the same suppliers that Whole Foods uses, and depending upon volume discounts determined by purchasing power, proceed to carve up prices.

Name-brand packaged goods are a necessity, drawing customers regularly into Whole Foods locations. Yet they don't touch what the company currently promotes as its most-persuasive reasons to shop in store: its animal welfare, seafood, and body-product standards, the newly introduced "Responsibly Grown" standards for fresh produce and flowers, and the unrivaled quality, quantity, and creativity of its prepared foods.

Neutralizing a competitive vulnerability
Encroachment on Whole Foods' market share through discounting is a dangerous form of incursion, but it's not likely to be fatal to the company. Whole Foods' numerous peers aren't necessarily taking its customers outright.

Growing urbanization and proximity of grocery stores means that customers are increasingly buying groceries from a combination of stores, with multiple shopping stops each week. WalMart, Kroger, and much-smaller competitors, such as The Fresh Market, may not end up converting customers so much as peeling off items during each shopping week that were originally destined for a Whole Foods basket. 

Although the packaged segment creates a wide target at which competitors are taking aim, Whole Foods Market has a few distinct opportunities to neutralize the challenges. Aside from the competitive advantages mentioned above, which it can emphasize in 2016, the pioneering retailer can continue expanding its own private label, the "365" brand of natural and organic packaged goods.

Evidence exists that doubling down on in-house brands can be a profitable endeavor. In a 2015 survey conducted by the Private Label Manufacturers Association, or PMLA, nearly half of the respondents had recently opted to try a retail store (private) brand over a national brand while shopping. Of this group, when asked to compare their experience with the private label to the national brand, 62% responded "favorably," and 28% responded "very favorably."

There's some indication that Whole Foods executives are already vigorously exploring how to expand private-label revenue. The 13 new "365 By Whole Foods Market" concept stores, which Whole Foods will open in the next two years, will focus on a "curated" selection of goods. Both Mackey and Co-CEO Walter Robb have hinted that these stores, despite being aimed at value-conscious millennial shoppers, will still produce a high return on invested capital and attractive margins.

Offering a higher mix of "365" packaged goods versus national labels would be one path to achieving the types of returns management is projecting. Better yet, successful product experiments in the concept stores can be scaled up later through the existing Whole Foods-branded locations.

I'd be remiss not to point out a simple caveat to the argument above: It's easy to lose perspective on Whole Foods. Despite investor dismay over the company's flat comparable sales in Q4 2015, it's still outperforming, setting a company record for sales during that quarter of $3.4 billion, on a total revenue increase of 6%. Name-brand packaged goods are a significant part of the company's success, and will continue to have a strong presence on store shelves.

Still, grappling with the weaknesses inherent in this business segment will force management to drill further into Whole Foods' competitive strengths, and shift the grocer's resources accordingly. To quote directly from John Mackey:

In fact, competition, it is your ally, it's your ally that helps you to get better. It knocks you out of your complacency. It keeps you from being lazy, it forces you to evolve.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.