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Summary

  • Organic food demand is expected to grow at a CAGR of 14% through 2018. This high growth rate is attracting new businesses into the organic food market.
  • Walmart has announced it will disrupt the organic food market with its business model. It is unlikely that WFM would replicate its great past performance with such stiff competition.
  • WFM's stock entails very high growth estimates, and on the basis of fundamentals, there should be a downward correction in the stock price.

Demand for Organic Food

Whole Foods Market (NASDAQ:WFM), the market leader in organic food grocery, did a great job in capturing the growth in the organic food market in the past years, but there are some eventualities that it has to face. With the growing awareness and increase in domestic production of organic food, organic food demand is expected to grow at a CAGR of 14% through 2018. The organic food market was a small market in 2010 and accounted for 4% of the total food market in US, but this market is growing at a high rate. About 81% of families in the US bought organic food in 2012.

With this increase in demand, production of organic food has also grown at a high rate. From 2002 to 2011, domestic food production has increased by 240%, while inorganic food production increased at a much lower rate of 3%.

This is a huge opportunity for the grocery businesses to capitalize on this growth trend. Inorganic grocers that have been experiencing meager growth in demand for years are not satisfied with the situation and are looking for ways to enter the organic food market. The world's largest grocer, Wal-Mart (NYSE:WMT), is now aiming to capitalize on this growing demand in organic food with its proven business model.

Economic Moats vs. Price Performance

Over the past five years, WFM's share has posted a tremendous growth of 387%. This is a fantastic price return, and the company posting such a huge return should have high economic moats. WFM did very well to capture the growth in demand for organic food in the past years, but WFM's success has attracted more investment to this segment, and competition is stepping up. WFM's market leadership in the organic grocery market does not give it a high economic moat that justifies such a rapid increase in its stock price. After all, WFM is not doing something that other businesses can't replicate over time. Investors that invested in WFM five years ago are very happily realizing their profits by selling the shares, since the competitive landscape is going to experience a big change with WMT's announcement of entering the market. WFM is going to see growth in the coming years, but it wouldn't be of the same level of growth that was priced in its stock price. So the correction is justified on the basis of fundamentals.

Wal-Mart's Lethal Business Model

Wal-Mart is making an entry with the aim of disrupting the market. WMT believes that there are inefficiencies in the organic food market that it intends to remove. WMT is expected to pass the cost savings to customers through lower prices, and is planning to remove the intermediaries in the supply chain for cost reduction.

Wild Oats has been a big player in the organic food market, and the company is teaming up with WMT to offer nearly 100 organic food items exclusively at 2,000 WMT stores in the US. In the next stage, WMT plans to introduce the products to 4,000 stores.

WFM doesn't consider WMT's entry as a potential threat, since it believes that its customers don't overlap with that of WMT's. As we know, Wal-Mart has ability to impact the grocery market in a major way, and WFM will be immune to this for very long. WFM has its premium brand that is expected to grow in the future, but this growth will not be the same as it would have been without the competition from WMT.

Overvalued

With an earnings estimate of $1.62 for 2014, Whole Foods Market's EPS is expected to be 10.2% higher than last year. Currently, WFM is trading at a forward P/E of 29.71, and this is higher than the industry and sector averages and the S&P 500 index. With its relatively high P/E ratio, WFM is overvalued at its present stock price. Such a high valuation is suited for a very rapidly-growing company, and can't be suitable for a WFM with an expected EPS growth of 10.2%. With Wal-Mart's entry into the organic market, Whole Foods Market's growth is likely to be adversely affected.

(click to enlarge)

Source: Yahoo Finance

Analysts' estimates for 2015 include an 18% growth forecast. I expect this average estimate would be adjusted and made smaller to incorporate the change in the competitive landscape of WFM. Organic food demand is expected to stay strong, and this fact will attract more competition to the organic food industry in the coming years. Whole Foods Market's high growth rate is not expected to be sustainable in the long run.

Conclusion

The business environment is very dynamic, and a company that has posted a high growth for years can easily be disrupted. WFM performed very well in capturing the growth in the organic food market, but Wal-Mart is expected to bring intense price competition. WFM needs to rethink its business model in some way to adapt to the evolving competitive landscape before it's too late. WFM is overvalued on the basis of fundamentals, and investors should avoid investing in WFM.

Source: Whole Foods Market - A Price Correction Is Needed