Whole Foods Storefront

Image Source: Whole Foods Market

Earlier this month, I wrote about how I believed the market was too pessimistic on Whole Foods Market (NASDAQ:WFM). However, every investment comes with risks, and Whole Foods is no exception. Let's take a look at a few risks facing this organic grocer.

Brand erosion
Whole Foods is in a highly fragmented and competitive retail industry. Sustainable competitive advantages are difficult to build as consumer preferences can change quickly. Furthermore, retail is an industry with aggressive advertising and promotional activity, which leads to price competition that shrinks profit margins. The best defense against this intense competition is building a strong brand.

In 2015, the Reputation Institute ranked Whole Foods No. 3 on its list of America's most reputable retail companies.  Whole Foods ranked as the 23rd most valuable retail brand in the United States in Interbrand's 2014 list. The 2015 retail brand rankings likely will not be released until August. After a year of bad press, I expect both of these rankings to fall.   

In July, Whole Foods admitted to overcharging customers on pre-packaged foods, a blow to the trust the company has built with customers over the past two decades. A month later, customers and the media mocked it for selling water that had asparagus stock in it for $6, substantiating the company's reputation as "Whole Paycheck" -- a moniker the company has struggled to shake. In September, Whole Foods announced that it was laying off 1,500 employees, which was a hit to its reputation as one of the nation's top employers.

Whole Foods Market took a hit this past year, but the company has built such a strong brand that, given time, it should be able to recover. However, if further missteps are made, it might not be so lucky. Whole Foods' values as a company -- it emphasizes that it cares for its customers, employees, suppliers, and the environment -- are a large part of why the company has been so successful. When those values are compromised, it effects the company more than it would the competition. The media also has a field day. In a Fortune magazine interview in August 2015, co-CEO John Mackey had this to say about Whole Foods' recent missteps:  

This stuff goes viral, because people are eager to believe bad things about Whole Foods so it doesn't disrupt their mental model [of business as selfish and greedy]. ... They want to prove I'm a hypocrite. I think that's true for Whole Foods as a whole. 

Fair or not, perception is reality when it comes to a brand. The biggest risk to Whole Foods' business would be if its strong brand is compromised.

Failing to grow location base
Given slowing growth at current locations, Whole Foods' growth prospects are more dependent than ever on new store growth. The company has given guidance of growing to 1,200 locations over the long run. If it begins to appear that Whole Foods won't be able to grow to that many locations, it may be time to take your investment dollars elsewhere.

One of the challenges to getting to 1,200 locations is that the competition for real estate is heating up. With 415 U.S. locations, Whole Foods has a large lead over natural and organic grocers such as Sprouts Farmers Market (NASDAQ:SFM) and Natural Grocers Vitamin Cottage (NYSE:NGVC). However, both companies have also announced plans of growing to over 1,000 locations. Trader Joe's currently has over 420 locations and is also growing rapidly. Conventional grocery giants are not only increasing floor and shelf space dedicated to organics but are also introducing new store concepts that will compete directly with Whole Foods. For example, Kroger (NYSE:KR)  recently introduced Main and Vine, a test concept focused on prepared foods and fresh, affordable local produce and meat. 

Despite the increased competition, getting to 1,200 locations is not an unreasonable goal. As a barometer, Kroger currently has 2,625 locations and Safeway has over 1,300 locations despite very little exposure to the Midwest and East Coast. Furthermore, the market for organic food is increasing rapidly. According to the Organic Trade Association, consumer demand for organic products has increased by double digits every year since the 1990s, growing from $3.6 billion in sales in 1997 to over $39 billion in 2014. I don't expect this upward trend to slow down as more people are becoming conscious of their health. 

Cannibalization

Images

Image Source: Whole Foods Market

A significant development from Whole Foods in 2015 was its announcement of 365 by Whole Foods, a new store concept with a smaller footprint and a focus on value and technology. In 2016, management expects to open three of these stores, along with two to three relocations of existing Whole Foods stores. Management believes the 365 stores will expand the growth opportunity beyond 1,200 locations, but it doesn't come without risk to existing locations.

On its third-quarter conference call, management made the following statement: "With opportunities in new and existing, as well as urban and suburban markets, most of our first stores are expected to be in the existing markets to better leverage our existing team member base and infrastructure."  To lessen the learning curve, it makes sense to have the initial locations in existing markets. However, it's reasonable to believe that the more affordable 365 stores will take business away from highly profitable Whole Foods Market locations. Going forward, management will be walking a fine line between entering new locations and not cannibalizing current stores.

Co-CEO Walter Robb noted that the first five locations under lease are in "A+ real estate sites," which is essentially the markets it currently serves. There is a limited amount of quality sites in the United States, and Whole Foods is already competing for those locations. It may now find itself competing against itself when it comes to its 365 locations. 

Trading near its 52-week low, Whole Foods is an intriguing value. However, investors need to pay close attention to the organic grocer's brand perception and growth prospects. A few more missteps, and Whole Foods stock may become a value trap.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Palbir Nijjar owns shares of Whole Foods Market. 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.