Eleven months ago, I wrote an article titled “Whole Foods (WFM): A Lost Decade” (here). I discussed the optimistic valuation assigned to the stock by Mr. Market in the early to mid-2000s and the impact it had on returns over the ensuing decade. I concluded with the following:
The valuation clearly doesn’t look as absurd as it did a decade ago; at the same time, it’s hard to find many people who are pounding the table on WFM as they’ve done consistently in the past. Those two things happening simultaneously is not a coincidence.
I felt like Mr. Market's pessimism may have been overdone. After a bit more work on the name, I decided to purchase a few shares of Whole Foods. Since that time, the stock has largely been rangebound between $30 and $35 per share. The most recent turn on the roller coaster was a steep decline after reporting weak third-quarter results.
For the quarter ended July 3, comparable store sales declined by 2.6%. Through the first nine months of the year, sales increased 2% (due to new unit growth).
Gross margins fell ~90 basis points in the third quarter to 34.7%; this is comparable to the year-over-year decline in gross margin rate that the company reported over the first nine months of the fiscal year.
Selling, General and Administrative (SG&A) expenses through the first nine months of the year improved marginally (measured as a percentage of sales). The net impact has been a ~80 basis point reduction in EBIT margins to 5.7% – driving a 9% reduction in operating income (EPS has declined by a smaller percentage due to a sizable increase in share repurchases).
Some of this was expected; management has guided to the gross margin declines in an attempt to become more competitive on pricing in key categories. Unfortunately, this has not had the beneficial impact on customer traffic and spending that management expected (at least not yet). Management initially expected results to improve through 2016 (relative to the first quarter’s 1.8% decline in comps). Instead, comps were down more than 2% in each of the past two quarters. Management cut guidance after the second quarter, calling for comps to finish the year at "up to -2%"; now that we’ve seen the third-quarter results, it looks like it might miss that mark as well.
Co-CEO John Mackey summed up the main source of Whole Foods' troubles on the third-quarter call:
“There's a lot more competitors in the marketplace, and there's a lot of new formats in the marketplace, from home meal replacement to meal kits, fast casual restaurant growth, more entrants in the natural and organic food space and the mainstreaming of natural organic. These are all factors. There's a bit of a regression to the mean as we lose customers from a convenience standpoint. People don't drive as far as they used to because there's good enough alternatives in many cases close by to them. They can stop by a Kroger (KR) or an HEB or a Wegman’s to get products that they used to only be able to get at Whole Foods. Now there's some overlap in our product base and other competitors. I think there's no sense in denying it.”
When I analyzed Whole Foods, I thought a lot about Sprout’s Farmers Market (SFM), Fresh Market (TFM, Financial), Trader Joe’s and other niche / specialty competitors. What I failed to sufficiently appreciate was the willingness of a fair percentage of customers to settle for “good enough” offerings from conventional grocers like Publix (PUSH, Financial), Costco (COST), Kroger and others (the majority of Whole Foods’ locations are within five miles of either a Costco, Kroger or both). Competitors have stepped up their games; looking forward, it probably won't get any easier.
We can see from the financials why this is a difficult situation for Whole Foods. As noted earlier, the company has gross margins in the mid-30s and SG&A expenses in the high 20s (percentage of sales). Contrast that with Kroger, which consistently reports gross margins in the low 20s (again, percentage of sales). If we assume its fuel sales are at cost, the remainder of Kroger’s business has ~25% gross margins. Whole Foods' gross margins are roughly 1,000 basis points higher than Kroger’s. Kroger makes up for this huge gap by controlling operating expenses; the company’s SG&A spend has been ~16% of sales over the past three years.
For every dollar of sales, Whole Foods pockets 35 cents in gross profits. Kroger and many of Whole Foods’ competitors bring in 20 or 25 cents or so per dollar of sales. Despite this, Whole Foods' profitability is essentially in line with its peers. The math is not encouraging.
For customers, this means higher prices for comparable products. This is anecdotal but consider an example I saw this past week; at Whole Foods, a dozen organic eggs (sold under the company’s own “365” private label brand) cost $4.29, or 36 cents per egg. At Costco, on the other hand, I’ve seen five dozen organic eggs (private label again) on sale for less than $10 – a unit cost of less than 20 cents per egg. I’d be willing to bet that this example is directionally correct for the vast majority of overlapping products at the two retailers.
Customers have figured this out. Costco had more than $4 billion in natural and organic food sales in fiscal year 2015 and is expecting ~20% growth in this business in fiscal year 2016. Kroger, which has grown this business by more than 10% annually over the past six years, reported more than $12 billion in natural and organic food sales in 2015. The appealing high single digit / low double digit growth in the segment (compared to lackluster growth in the center of the store) has attracted competition from conventional players; Whole Foods is currently losing market share.
I’m skeptical that consumers will consistently pay higher prices for comparable products – even if shopping at Whole Foods is a better experience (this may be difficult to maintain if declining gross margins are offset by cutting SG&A). As noted on the second quarter conference call, the issue hasn’t been with the core Whole Foods customer; it has been with the occasional shopper. I’m betting this customer base is much more price sensitive – and recognizes the large price discrepancy between Whole Foods and its competitors. To me, the math simply doesn't work; even with the investments in price completed to date, Whole Foods has a long way to go if it hopes to get anywhere near parity with competitors (this comes at the cost of less profitable sales to the core customer who was content with paying a premium). I’m not so sure it will succeed.
In addition, as with any retailer, the long-term threats from Amazon (AMZN) cannot be overlooked; as the ecommerce giant moves into online grocery, price-insensitive, high-end consumers (those willing to pay for the convenience of quick delivery) are likely targets.
Conclusion
Whole Foods has the benefit of competing in a category with a structural tailwind. However, as is often the case, opportunity has attracted competitors. I’m concerned that lower gross margins are not a short-term development; it’s a structural change in the business. Unless Whole Foods dramatically changes its cost structure, this will likely mean lower EBIT / net margins, too.
There’s a real risk that the unit economics of the business will continue to trend in the wrong direction. The company’s moat is shrinking. I originally thought this would take five or more years to play out, with EPS continuing to grow at an attractive pace in the interim; I think I was wrong.
As such, I’ve decided to sell my position.
Disclosure: Long WFM (for now).
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