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The Most Revealing Comment in Whole Foods' Q2 Earnings Call

By Asit Sharma - May 12, 2016 at 6:30PM

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The natural-foods grocer's fiscal second-quarter 2016 earnings call provided a clue about the possible strength of a sales recovery over the next few quarters.

As Whole Foods Market (WFM) struggles to regain its sales momentum, many shareholders are keeping tabs on, and indeed some are obsessing over, comparable-store sales, or "comps." Rising comps indicate healthy sales potential to investors, and they're critical to Whole Foods' long-term rejuvenation.

Thus, a comment made by co-CEO John Mackey during the company's May 4 earnings conference call stands out, as it implies that a strategy to jump-start comps is initially having the opposite effect.

Let's delve into Mackey's curious comment to see if investors should begin to worry over the direction of sales in 2016. Brace yourself for a bit of corporate speak (which we'll proceed to break down), in what was nonetheless the most illuminating comment of the entire call:

Beginning in week 11 of Q3, we will anniversary the sharp drop in our comps last year after a weights and measures audit generated negative national media attention. We expect the offsetting impact from our value strategy to continue, however, as we ramp up our price investments and promotions over the remainder of the year. 

First, Mackey refers to the event which was the catalyst, but not the entire cause, of Whole Foods' comparable-sales decline from mid-2015 to date. You may remember that a weights and measures audit by New York City's Department of Consumer Affairs, publicized in June of last year, found systemic problems in the company's weighing and labeling of packaged foods, resulting in the overcharging of some customers.

While Whole Foods moved to put this mini-scandal behind them with a quick apology and a generous refund offer to customers encountering any pricing errors, comparable sales never really recovered. This has more to do with a long-term trend of comps compression, however, than the harsh publicity Whole Foods endured from its labeling stumble:

Data source: Whole Foods Market SEC 8-K quarterly earnings filings, 2013-2016.

As Whole Foods' executives readily admit, competitors have consistently tried to copy the most successful aspects of the grocer's business model in recent years, and the resulting customer shift is the preeminent reason behind steadily shrinking comps in the bar chart above. 

It's true that beginning in Q3 2016, Whole Foods will lap last year's curbed sales which tanked after national fallout from the NYC audit. But the trend line suggests additional pressure on comparable sales. If the weighing setback was the only force at play, one could logically expect some moderation in prior-year comparisons as the quarters rolled on. That's clearly not the case yet.

So, while the Q3 2015 anniversary may lower the comparison bar going forward, this doesn't automatically guarantee a resilient comps rebound.

The challenge of pricing

The second part of the quote above isolates at least one reason why those comps might still be under pressure. Mackey stated the company's belief that its value strategy will offset some of the Q3 lapping benefit, as it continues to make price investments this year.

To translate, Whole Foods' investment in gross margin (i.e., selectively lowering prices to keep customers from departing for competitors) will produce a drag on comparable sales.

But wait just an organic moment: Aren't price investments, the backbone of Whole Foods' value strategy, supposed to increase comparable sales?

In the best of scenarios, this is indeed the objective. Price markdowns and promotions draw customers in, and from there, the company's task is to make up for lower margins by improving average basket size (the dollar amount of product we throw into our shopping carts before checking out).

The company can do this by enticing you to purchase its lucrative prepared foods, or perhaps through in-store signage which extols the virtues of its sustainably sourced products, a tremendous competitive advantage:

Image source: Author's photograph, Ridgewood Shopping Center Whole Foods Market, Raleigh, NC.

Profiting from traffic bolstered by promotions seems within reach. Increasingly, Whole Foods is using its produce department as a pricing lure, as it's taken to running regular national perishables promotions on popular fruits and vegetables.

Again, such is the desired outcome. Consider what happens if a company invests in pricing, but basket composition (what people put in their shopping carts) doesn't change much, and the size of that basket remains the same, or declines.

In this case, even with a traffic boost, the pricing changes have the effect of decreasing, not increasing comps, as customers buy the same amounts of food as before, but at lower prices, resulting in lower revenue per comparable store.

This is the reality Whole Foods is wading through presently. As the chart presented above suggests, Whole Foods' first task isn't actually to jump-start comps. If that were possible, management would have done so at any time over the last 14 quarters.

Rather, the first item of business is to stabilize comps, which would indicate that the customer base is secured. Lapping the third quarter of 2015 will improve comparability. And the recent launch of digital coupons, an integral part of the company's growing loyalty platform, may prove an effective tool to build basket size in the long run.

Mackey's comment on comps reveals that the necessary tactical price reductions are as much a contributing factor to near-term comp declines as they are to long-term comps rehabilitation. In stabilization mode, this isn't too out of the ordinary, and perhaps should even be expected. But it also signals that while a comps lift may be reported next quarter, a significant upside surprise isn't likely.

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