Whole Foods Market (WFMI)

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Morgan Alcalay

Andrei Popovici

Lawrence Gu

Whole Foods Market Inc.(NASDAQ: WFMI) is the world’s leading retailer of natural and organic foods, with $8.0 billion in 2009 sales. Sales of natural products nationwide grew by 10% to $68 billion in 2009.^[1] WFMI has ridden the health & wellness trend, thanks to consumers' perception that organic foods are healthier than their non-organic counterparts. As a result, Whole Foods can charge a substantial premium for the products it carries.

To date, the organic movement has been confined to wealthier and more educated demographics. WFMI has been the segment’s pioneer and has made good use of the lead time by opening stores in affluent neighborhoods. However, as these areas reach saturation, Whole Foods is beginning to expand to less wealthy neighborhoods. This is bringing it face to face with retail behemoth Wal-Mart, which is expanding its organic food section in light of organic food's growth and healthy margins. Wal-Mart has a history of undercutting its competitors on price, and as Wal-Mart and other traditional grocery stores such as Safeway (SWY) enter the organic foods market it may be difficult for Whole Foods to maintain its attractive margins and premium prices.

In August 2007, Whole Foods agreed to acquire competitor Wild Oats Markets for $565 million. Although an antitrust suit against the deal was initially dismissed by a trial judge, a federal appeals court ruled the suit valid. Before going to trial, however, the company settled the suit with the FTC in March 2009. Under terms of the settlement, Whole Foods will divest of 12 acquired Wild Oats and one Whole Foods outlet. Additionally, the company will sell the leases and associated assets for 19 acquired Wild Oats outlets.^[2] In order to cover fees associated with the deal and gain additional cash reserves, Whole Foods received a $425 million investment from a private equity firm in November 2008 in return for a 17% stake in the company.^[3]

History

Whole Foods Market, which was incorporated in 1980, is considered a pioneer in organic foods retailing and enjoys a significant first mover advantage. The company is the industry leader in this segment, accounting for approximately 37 percent of total natural and organic foods sales in 2005, and enjoys strong brand awareness. The large size of the company gives it the ability to realize economies of scale in its supply chain, which in turn has enabled it to post strong growth in profitability as well as revenues.

Business Overview

Whole Foods, and its subsidiaries, is the largest chain of natural and organic foods supermarkets in the United States.^[4] At the end of fiscal 2009, WMFI operated 284 stores: 273 stores in 38 U.S. states and DC, six stores in Canada, and five stores in the UK. US sales represented 97.2% of revenues in fiscal 2009. Whole Foods operates one main business segment: supermarkets that emphasize natural and organic foods.^[4] In August of 2007, Whole Foods acquired Wild Oats Market for $565 million plus approximately $148 million in debt.^[4] Current business operations are focused on transitioning the Wild Oats brand over to the Whole Foods brand, as well as increasing the number of stores throughout the US, Canada, and the UK. With 289 stores in Q1 2010, Whole Foods plans to open 51 new stores through 2013, with an average square footage of 44,500 – 20% larger than its current average of 37,000.

Whole Foods’ product portfolio includes produce, seafood, grocery, meat and poultry, dietary and nutritional supplements, vitamins, specialty (beer, wine and cheese) body care products, floral and household products and pet products. The company also undertakes catering of prepared foods.

The products are marketed under private labels, such as 365 Everyday Value, Whole Kids Organic, 365 Organic Everyday Value, the Whole Brands family, and Authentic Food Artisan (AFA). Store-made and regionally-made fresh items are sold under the Whole Foods Market label. Allegro Coffee Company, a subsidiary of Whole Foods Market, offers specialty and organic coffees and teas.

The products under the 365 label are positioned as value for money products as this brand provides all the benefits of organic food at lower prices. Expansion of this program to other departments, such as organic fresh vegetables, is expected to pay off in the future.

Business Financials

Whole Foods Market generated $8.0 billion in sales in fiscal 2009 (ended September 27, 2009), an increase of 1.0% over the previous year. Yet in fiscal 2009 same-store sales were down 4.3% over the previous year’s, and Q4 and the previous four quarters all brought year-over-year declines. Operating income for Whole Foods was $284.3 million in fiscal 2009, up 20.4% over the previous year. This improvement was largely due to stringent cost-containment measures that Whole Foods put into place in the face of the recession economy. In fiscal 2009, Whole Foods opened 15 new stores, for a total of 286 stores.^[5]

FY2010 Q1 Earnings Summary

In the first quarter of fiscal 2010 (ended January 17, 2010), Whole Foods generated $2.6 billion in sales, a 7.0% increase over the same period last year. Comparable store sales were up 3.5% and identical store sales were up 2.5%, reversing a trend of negative growth for all four quarters of fiscal 2009. However, on a two-year basis identical store sales were down 2.4% while comparable store sales were down 0.5%. In Q1 2010 Whole Foods opened 6 new stores and closed one Wild Oats, bringing its store count to 289. ^[6]

FY2010 Q2 Earnings Summary

Second quarter earnings of fiscal 2010 (ended May 12, 2010) generated total sales of $2.11 billion compared to $1.86 billion in same reporting quarter of FY2009, with earnings per share coming out to $0.39 compared to $0.19 EPS 2nd in quarter FY2009.^[7] Whole Foods attributes its increase in sales due to a faster emergence from the recession compared to its peers.

As Whole Foods generally caters toward premium foods of perceived higher quality, Whole Foods products have greater price elasticity due to its nature. For example, while Whole Foods stores suffer during the recession as consumer flock to discount locations, the company stated that it had benefited from shoppers who chose to "selectively trade up" as consumer confidence increases.^[8] In addition to this increase of sales which has led to a 8.7% increase in same-store sales, previous cost-control measures, inventory management, and store-level performance has allowed Whole Foods to sustain during the recession.^[9] This is shown through its stable gross margins of between 34% to 35% in the past four quarters.^[10]

Business Drivers

Comparable store sales, new store productivity and growth in square footage are the main drivers of revenue in the food and retail industry.

Comparable store (comp sales) or same store sales reflect the ability of the existing stores (stores greater than one year old) to generate revenue. If the comparable sales growth rises, it implies that there has been a higher turnover of goods for every square foot of existing store space owned by the company. New store productivity is measured as the ability of new stores to generate revenue (per square foot) as compared to existing stores. New stores include stores, which are newly acquired or newly opened in a year. New store performance cannot be compared with existing store sales as the former usually take more time to generate sufficient sales to catch up with existing stores’ performance. An increase in square footage growth implies that each unit would be able to store more goods and thus generate more revenue. Comparable store sales growth rate can decline over the years as stores mature. Revenue per square foot can decrease if there is high rate of new store additions. Mergers and acquisitions in particular can lower revenue per square foot if the acquired entity has lower operating metric values.

The comp sales of Whole Foods Market slowed down from 15 percent in 2004 to 7 percent in 2007 as the stores matured over the years. On the other hand, the square footage growth also increased by 18 percent in 2007. Including the acquisition of Wild Oats which closed in late 2007, Whole Foods now operates 289 stores.

Further, due to the conservative advertising policy of Whole Foods Market, new stores take a longer time to break even compared to those of the company’s competitors. The company relies on word-of-mouth publicity, in contrast to the print, television, and online media favored by its competitors. Whole Foods Market may have to change its strategy and increase its total spending on advertising (which was a meager 0.4 percent of the total revenues in 2005) to create more consumer awareness about organic products.

The table below tracks the historical performance of Whole Foods Market.

Higher average sales per square foot

Because it caters to a higher-end market, Whole Foods has one of the highest gross sales per foot figures in the industry. In fiscal 2007, average weekly sales for all stores increased 7% to $632,000, translating to sales per square foot of $923. With an average square footage of 37,000 in 2009, Whole Foods is building larger stores as it expands, with new stores planned for 2010-2013 averaging 44,500 sqft. ^[11]

Customer Demand

Whole Foods Market stores have chosen the most desirable locations for their premium priced products by choosing regions (especially the coastal areas) where the demographic profile of the customers, in terms of income, house value and population density is much higher than the U.S national average. However, once these markets get saturated, the company will have to relax demographic standards and expand into lower income areas. This could lead to a slow down in revenue growth of the company in the future, especially as it enters into direct competition with retailers, such as Wal-Mart.

Further, Whole Foods Market is exposed to the risk of consumer demand for natural and organic foods. There is an ongoing debate on health benefits from consuming organic foods as compared to conventional foods. If it is proven that organic foods do not provide the benefits as expected, the stocks of organic food retailers are likely to be impacted. In addition to this, decisions taken by Whole Foods Market in the past (such as to sell live lobsters) have drawn flak from animal welfare organizations and could damage the company’s image.

The expected slowdown in the U.S. consumer spending can also affect specialty retail chains, such as Whole Foods Market, as consumers may turn to lower-cost non-organic produce.

Operating Costs

The major component of the total operating cost of Whole Foods Market is 'Direct Store Cost', which as a percentage of sales has varied from 25-26 percent since 2004. An increase in share-based compensation to employees (USD 10.1 m in 2006) and natural disaster costs (USD 13.4 m in 2006) contribute to the high direct store cost.

Also, the organic foods market is subject to several laws and regulations relating to health, sanitation and food labeling. Federal regulatory agencies such as the Food and Drug Administration (FDA), the Federal Trade Commission (FTC), the Consumer Product Safety Commission (CPSC), the United States Department of Agriculture (USDA) and the Environmental Protection Agency (EPA) have set stringent standards for the manufacture, packaging, and advertising of organic products. Failure to meet these standards could result in the confiscation of marketing and sales licenses. The compliance costs arising from these regulations would reduce the margins of Whole Foods Market.

Comparison to Competitors

Whole Foods Market, until recently, faced competition primarily from direct competitors in the organic foods segment, such as Trader Joe’s and recently acquired Wild Oats Markets (OATS). However, a growing industry and attractive margins have brought new players into the organics food market.

With traditional grocers (Safeway, Kroger, and SuperValu (SVU)) as well as global and national retailers (Wal-Mart, Sam’s Club, BJ's Wholesale Club (BJ), and Costco) beginning to offer organic foods in their retail baskets, competition for Whole Foods Market is intensifying. In May 2006, Wal-Mart announced its plans to launch products in the organic segment. Wal-Mart now has an organic range, that includes fresh produce, dairy and dry food items as well as clothing. The entry of Wal-Mart can erode the market share of Whole Foods Market.

However, with the acquisition of Wild Oats, which was a direct competitor, Whole Foods Market has attempted to consolidate its position in the market. This acquisition is viewed as a strategic initiative to provide the company long term returns through synergies, reduction in costs and increase in comparable store sales. The comparable store sales growth at Wild Oats is expected to improve within 12 to 18 months, driven by Whole Foods Market retailing experience as well as its ability to make capital investments (Whole Foods Market operates at twice the store productivity in Wild Oats).

The table provided below compares the operational metrics, margins, and capital expenditure (as a % of sales) of Whole Foods Market vis-a-vis its competitors in 2006.

Source: Company Data

As evident from the table, Whole Foods Market is the market leader with higher comp sales growth, gross margin, operating margin as well as net profit margin as compared to its competitors.

References

1. ↑ [1]
2. ↑ Whole Foods Market(R) and FTC Reach Settlement.
3. ↑ Whole Foods 4Q Net Falls 96% Amid Charges, Gets $425 Million Invest.
4. ↑ ^{4.0 4.1 4.2}
5. ↑ Whole Foods Market Reports Fourth Quarter Results, 2009
6. ↑ [2]
7. ↑ [3]
8. ↑ On the money: Whole Foods emerging from recession “faster” than peers
9. ↑ Whole Foods Market, Inc. Raises FY 2010 Guidance
10. ↑ Whole Foods Market Q2 income increases
11. ↑ [ http://www.wholefoodsmarket.com/company/pdfs/Q110financial.pdf]