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Whole Foods' Business Model Makes It a Solid Investment

June 19, 2014 | About:
Vinay Singh

Vinay Singh

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Whole Foods Market (WFM) is a growing company in an industry that's been struggling for years. It's made its mark by charging more for better quality and service. It's a winning combination.

The grocery isle

From a distance, Whole Foods looks like a grocery store. That's been a pretty horrible industry to be in for the last decade or so. Not only does the industry suffer from low margins, but big box retailers like Wal-Mart have been using groceries as a loss leader to get customers through its doors.

Wal-Mart can do this because it sells so many other items. If enough people come for groceries and leave with a few non-grocery items, it evens out. Companies that sell nothing but groceries have to maintain lower prices to compete, which just squeezes their margins even more.

Different but equal

Whole Foods sells groceries, but it has taken a different approach. It sells organic and “healthy” fare. That's allowed the company to ride a growing trend toward healthier lifestyles. The interesting thing about that is that people are willing to pay more for this type of food, so Whole Foods' profit margins tend to be in the mid-single digits. Grocery industry leader Kroger boasts a profit margin that tops out at around 3% or so.

With such thin margins, two percentage points makes a big difference. For example, Kroger's sales in its just ended fiscal year reached nearly $97 billion, its net income was about $1.5 billion. In its most recent fiscal year, Whole Foods posted sales of about $11.5 billion with net income of just under $500 million. Kroger had nearly nine times the revenue, but only a little over three times the net income.

Kroger is a good company in the grocery space, it just isn't as good as Whole Foods.

Service

The type of products that Whole Foods sells aren't the only differentiating factor. It focuses on the store experience just as much as product selection. That's increasingly important, particularly at the higher-end price points where the grocer operates. While you can get cheap groceries at a Wal-Mart, the experience of shopping is going to feel just as cut rate.

Although Macy's operates in a different industry, a change the company made after the 2007 to 2009 recession shows just how important Whole Foods' customer centric model is. After the recession, Macy's initiated what it calls “magic selling.” It trained its floor staff to be more responsive to customers and “celebrate” their purchases.

While department stores like Sears Holdings and J.C. Penney have struggled to recoup lost ground, Macy's has managed to grow its top line in each of the past four years and doubled its profit margins along the way.

An increasing focus on customer service has helped support that, and should continue to help the company grow its top and bottom lines over the next few years. A nice price advance, however, makes the shares most appropriate for growth and momentum investors. That said, Whole Foods will continue to benefit from its customer focus for years to come, too.

Room to grow

Kroger has more than 2,400 stores. Whole Foods has only around 330. While Kroger caters to a wider audience than Whole Foods, which means it can support more stores, Whole Foods clearly has room to continue growing its store count. Even if you assume that Whole Foods can only support half the stores that Kroger has, that means Whole Foods can grow its store count to nearly four times of what it is today.

The company opened 25 stores last year, the highest level in the last five years. If you assume 900 additional store openings, the company has more than a decade of store growth ahead. Although the shares are reaching all time highs again, there's plenty of growth potential to support a premium valuation. Like Macy's, growth and momentum investors should like what they see here.

Its own drummer

Whole Foods dances to the beat of a different drum in the grocery space. That's allowed the company to succeed on a relative and absolute basis in an industry that has been suffering from increased competition and low margins. Kroger, an industry big wig, is also seeing its shares reach new highs, but it doesn't have the strong fundamentals or growth prospects of Whole Foods.


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