Despite inhibitions of the legendary investor Warren Buffett (Trades, Portfolio), it is impossible to dispute that Whole Foods Market Inc. (WFM, Financial) is a good company that offers niche products to a captive consumer base that is certain to grow in time. Selling food and food ingredients will stay around unless we all turn farmers, and that is certainly not about to happen. The increasing concerns around what goes into our food and also into the ingredients in our food is good news for specialised supermarket chains like Whole Foods and Sprouts Farmers Market Inc. (SFM, Financial) that specialise in selling fresh produce that is natural and organic. Not restricted to supermarkets alone, but also spreading to fast-food and fast-casual restaurants, this consumer behaviour has led other regular supermarkets like Wal-Mart Stores Inc. (WMT, Financial) and The Kroger Co (KR, Financial) to start stocking such products as well. With the entry of traditional heavyweights, is Whole Foods the best bet in its category?
The positives
Whole Foods is a strong brand with a huge a customer base over the years that has made it the largest retailer of natural and organic food in the U.S. Taking advantage of the brand value, the company can and does charge a high premium for its products (earning it a not-so-healthy moniker of ‘Whole Pay check’), which allows the grocery giant to post very high gross margins and sales per square foot.
The management knows its target audience well, and is making the right moves to appeal to them. For two years now, the company is making attempts to label all products in its stores to specify whether they contain GMO products or not, and the exercise is expected to be completed by 2018. The company is also committed to sourcing organic food to sell in its stores. The company is also planning to open smaller-format stores under a separate brand name to appeal to younger generation millennials, a segment Whole Foods identifies as a significant market.
Further, the company has solid financials. Revenues last quarter grew by 10.2% compared to the same period last year, while EPS grew by 9.5% in the same duration. The operating cash flow has also increased to $387 million and its debt-to-equity ratio is a meagre 0.02.
The negatives
Having no specific entry barriers, the market for organic and natural foods is open to severe competition. Companies like Sprouts Farmers Market have taken a similar route as Whole Foods and offer similar products at cheaper prices. With the likes of Wal-Mart and Kroger entering the arena, Whole Foods may not be able to charge its hefty premiums forever, and that will affect the company’s top and bottom lines. Gross margins are already declining, since the company has been forced to lower prices due to increasing competition. According to some estimates, Kroger will overtake Whole Foods as the largest retailer of natural and organic food in the U.S. in two years from now.
The move to open new, smaller format stores targeted at millennials is a potentially risky move. There is no certainty that these stores will work, and even if they do, the lower prices in these stores could, theoretically, affect the ‘exclusive’ brand image Whole Foods has built for itself.
Conclusion
The positives somewhat outweigh the negatives, but the negatives are still not to be ignored or taken lightly. Already trading at about 20% discount from its price a month ago, the stock is definitely not a sell. Investors could pick up the stock if it falls another 5% or so, and for those who are already invested in it we suggest a HOLD.
