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Whole Foods Market, Inc. (NASDAQ:WFM)

Q2 2014 Results Earnings Conference Call

May 6, 2014 5:00 PM ET

Executives

Cindy McCann - Vice President, Investor Relations

John Mackey - Co-Chief Executive Officer

Walter Robb - Co-Chief Executive Officer

A.C. Gallo - President

Glenda Flanagan - Executive Vice President and CFO

Jim Sud - Executive Vice President, Growth & Development

David Lannon - Executive Vice Presidents, Operations

Ken Meyer - Executive Vice Presidents, Operations

Analysts

Karen Short - Deutsche Bank

Ken Goldman - J.P. Morgan

Rakesh Parekh - Oppenheimer

Kelly Bania - BMO Capital Markets

Jason DeRise - UBS

Stephen Grambling - Goldman Sachs

Kate Wendt - Wells Fargo

Chris Mandeville - Jefferies

Charles Grom - Sterne Agee

Bob Somers - Susquehanna

Operator

Good day, everyone. And welcome to today’s Whole Foods Second Quarter Earnings. At this time, all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the Q&A session. I will be standing by, should you need any assistance.

And it is now my pleasure to turn the conference over to Cindy McCann, Vice President of Investor Relations. Please go ahead.

Cindy McCann

Good afternoon and thank you for joining us. On today’s call are John Mackey and Walter Robb, Co-Chief Executive Officers; A.C. Gallo, President; Glenda Flanagan, Executive Vice President and Chief Financial Officer; Jim Sud, Executive Vice President of Growth & Development; and David Lannon and Ken Meyer, Executive Vice Presidents of Operations.

As a reminder, all forward-looking statements on this call are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions discussed today. This maybe due to variety of factors, including the risks outlined in our company’s most recently filed Form 10-K. Please note, our press release and scripted remarks are available on our website.

I will now turn the call over to John Mackey.

John Mackey

Thank you, Cindy. Good afternoon, everyone. First I will share highlights from the quarter and then turn to our updated outlook for 2014 and strategic vision for the next few years.

In Q2, our sales grew approximately $300 million to a record $3.3 billion. Our comparable store sales, excluding the Easter shift increased 5%, reflecting healthy market share gains.

We increased our operating square footage 8% to $14.2 million, expanding our reach to 374 stores across 41 states in three countries. We are particularly proud to have produced average weekly sales per store of $743,000 translating to record sales per gross square foot of $1,000.

As we have called out since the fourth quarter, we believe our comps have been impacted by many factors, including our own strategies around value and growth, as well as increased competition, the macro-environment and weather.

Since Q3 last year, our average price per item growth has moderated to 160 basis points from 3.3% to a three-year low of 1.7% this quarter. We attribute this primarily to our proactive value strategy and believe this is the biggest contributor to the change in our comp trends over the last several quarters.

A dynamically changing competitive market is certainly a factor as well. The growing demand for fresh healthy foods, the offering of natural and organic products is expanding everywhere and new stores, existing stores and online.

Looking at the big picture, that’s a positive for us, as it affirms our mission for the last 36 years and speaks to the increasing growth opportunity. However, we believe it is currently impacting our transaction count growth. In addition, severe weather in several of our larger regions impacted shopping patterns again this quarter, customers making fewer trips and buying more items each trip.

And looking at the sequential change in costs from Q1 to Q2, we estimate the Easter shift was approximately 50 basis points. The moderation in average price per item growth was 26 basis points and an increase in the impact from cannibalization was 5 basis points.

Our comps have always included some impact from cannibalization, with our accelerated growth over the last few years we’re seeing a slightly greater impact today. However, at the same time we’re gaining market share, Austin and Boston, two of our oldest markets are great examples where we have received recently increased our square footage significantly in a short period of the time, temporarily negatively impacting our cost that resulting in 20% higher annualized run rate sales in the last year.

Turning to the income statement, our gross margin was 51 basis points lower than our record 36.4% result last year, due primarily to an increase in cost of goods sold as a percentage of sales. This increase reflects our value efforts and the cycling over of significant improvements in shrink we produced last year.

Our value strategy while impacting our sales growth and gross margin year-to-date has driven significant improvements in our relative pricing position, improvements of over 400 basis points in some cases. Based on our prior experience, we believe these investments will translate into higher sales growth over time.

We have mentioned value several times today which is certainly important as we seek to you appeal to a broader customer base. Even more important, however, are our ongoing efforts to further differentiate our product offering and advance our leadership in areas that matter most to our loyal customers.

Customers look to us to create and curate new and existing products. We offer thousands of items that can only be found at Whole Foods Market. We continue to develop exclusive partnerships in parts through efforts like our local producer loan program through which we have provided over $12 million in loans building relationships with 176 unique suppliers.

As we raise the bar of differentiation, our customers have responded with sales of mission and attribute based products such as organic, non-GMO, whole trade guarantee, responsibly farmed seafood and grass fed beef, along with sales of our exclusion brand products continuing to grow faster than the store average.

Strong store level operating disciplines drove our sixth consecutive year of improvement in direct store expenses to a record 25.3% of sales and our third consecutive year of double-digit store contribution margin.

While we were not able to improve upon last year’s record 7.6% operating margin, our business model still generated a healthy 15.6% return on invested capital and produced $282 million of operating cash flow.

We invested $143 million in new and existing stores, returned $45 million in dividends to our shareholders, repurchased $55 million of stock and ended the quarter with $1.5 billion in cash and investments.

Since Q1, we have added eight stores in six new markets, including the acquisition of four new frontiers, natural marketplace stores. Our EVA-based approach to site selection allows us to succeed in markets as diverse as Jackson, Mississippi, San Luis Obispo, California.

For the last eight quarters our new store class has average sales of $503,000 per week, translating to sales per gross square foot of $729. New store productivity levels of 86% and contribution margin of 4%. Most importantly, our comp sales less than two years old have averaged 15% return on invested capital.

Returning now to our updated outlook for fiscal year 2014 and our longer term strategic view of the vision of the business, we were overly optimistic in our ability to compare against the record breaking results we have produced for the last few years, particularly in light of the rapidly changing competitive landscape and our ongoing strategy around value.

We’re resetting expectations for this year and for the first time, laying out our strategic vision for the next several years. This is not guidance, but rather a framework around how we intend to manage our business over the intermediate term.

We are very confident in our future growth potential. We are having our game, evolving, differentiating, innovating and improving our value while cutting our cost. With an average of over 21,000 items per store, we are uniquely positioned as the leading creator and curator of the highest quality and widest selection of natural and organic products.

We are also more than just a grocery store. We are a restaurant and premier brand with sales of $2.5 billion in prepared foods and bakery, and $1.7 billion in exclusive brands in the last year.

And a digital technology transforms our lives and the retail landscape, we are investing in technology to meet and connect with our customers where they are whether physically, digitally or both.

We have several pilot projects in process including click and collect, direct delivery, payment at food venues using square, a mobile app, affinity program and expanded access to our e-store from just the holidays to year round. We aim to create seamless and unique experiences that add choices, convenience and flexibility to support our customer’s busy lifestyles.

As we continue our value strategy to broaden our appeal and drive sales growth over the longer term, we expect our gross margin to return to our historical range of 34% to 35% over the next several years. We have successfully reduced operating expenses by 175 basis points over the last five years and will be working to further improve our cost structure to offset the impact of these value and tech investments.

We expect to produce year-over-year improvement in operating margin in 2015 and beyond. We believe we will continue gaining share as the demand for fresh, healthy foods outpaces rising competition, creating millions and millions of new customers for us.

To put it into perspective, we expect to increase our sales by $11 billion, approaching $25 billion over the next five years. It took us 34 years to cross the $11 billion mark. We are moving aggressively to take advantage of the tremendous growth opportunity. And with 56 new leases signed over the next -- over the last 12 months, we now have a record 114 stores in our development pipeline.

We expect to end the year approaching 400 stores and cross the 500-store mark in 2017. Over the longer term, we see demand for 1,200 Whole Foods Market stores in the United States alone.

We will now take questions. Our call will end at 4:45 Central time today to allow more time for questions. Please limit yourself to one question at a time so that everyone has an opportunity to participate. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Karen Short with Deutsche Bank. Please go ahead.

Karen Short - Deutsche Bank

Hi. Hi. Just looking at your guidance overall, I mean, obviously the perception here is you’ve lowered your guidance and yet at the same time you’re accelerating your unit growth. And I know you have obviously very long-term, a very long-term vision in terms of where you can be in a couple years but can you help us reconcile that a little bit because obviously those two don’t really go hand in hand?

Glenda Flanagan

Well, we -- hi, Karen. It’s Glenda. We definitely wanted to look at where we were year-to-date. And we have a clearer picture of what the rest of 2014 looks like. And so it’s one thing to translate that into what we see happening for the next six months.

But on the other hand, we are very optimistic about the future and our ability to continue to manage the investments that we are making in our value strategy. And at the same time put additional measures in place to lower our cost structure so that with fiscal year 2015 and beyond, we can deliver the unit growth. And at the same time deliver the slight improvement in operating margin growth that we have put forth in our strategic vision.

Karen Short - Deutsche Bank

So is the slight operating margin expansion growth coming from just slight benefit from that 100 to 150 basis points direct store expense savings that you identified or is that not something that’s tangible that immediately at this stage?

Glenda Flanagan

The slight increase in operating margin improvement comes even while we are continuing to make further investments in gross margin. So yes, it’s coming from the expenses, both direct store expenses and G&A.

Karen Short - Deutsche Bank

Okay. Thanks for taking my questions.

Operator

Thank you. We’ll go next to Ken Goldman with J.P. Morgan. Please go ahead.

Ken Goldman - J.P. Morgan

Thanks. I have to admit, I’m surprised by what I perceive to be a constructive tone on this call. You’re telling us that our estimates for the next couple years are significantly too high. Your stock’s down around 14% after hours. One of the questions I’ve been getting lately is does Whole Foods management appreciate that the world has changed and there’s a lot more competition out there?

I’ve got to be honest. I’m not really hearing anything that’s suggesting management is taking this situation as seriously as some investors want you to. There’s a lot of talk about what’s going, not a lot to talk about what it takes to win the change market. I’m really just curious what are you doing differently versus a year ago other than taking your cost down which I think the market’s telling you may not be enough anymore?

John Mackey

Well, we’re lowering prices. We’re making investments on price. We’re cutting expenses. And we’re…

Ken Goldman - J.P. Morgan

You’ve been doing that for years. You’ve been taking price down for years. I mean, it’s hard to understand.

John Mackey

No, we haven’t. I mean, if you look at we had rising gross margins for the last five years. So we haven’t been investing in price as aggressively as we probably needed to do. So we’re going to be investing more aggressively in price going forward while continuing to take our expenses down and continuing to innovate and differentiate. That’s our t strategy. We’ve laid it out. So there you have it.

Ken Goldman - J.P. Morgan

All right. Thank you.

Operator

We will go next to Rakesh Parekh with Oppenheimer. Please go ahead.

Rakesh Parekh - Oppenheimer

Thanks for taking my question. So my question has to do with competition. So as you guys look out there right now as competition intensified lately from what you’ve seen maybe the past few quarters, whether from competitor openings or maybe just from some of your competitors being more promotional?

John Mackey

Could you repeat the question? We didn’t quite hear it.

Rakesh Parekh - Oppenheimer

Yeah. Just from a competitive standpoint, we’re clearly seeing a number of -- a greater number of specialty unit openings. You’re seeing more competition from discount channel and even conventional chains. So are you guys seeing -- has competition intensified from your perspective this quarter, maybe compared to what you saw some of the previous quarters?

Walter Robb

I think -- this is Walter. I think we’ve acknowledged that the marketplace has become more competitive. And we’ve -- we’re also telling you that we are stepping up our value and our price investments to respond to that. We’ve laid out kind of the pathway over the next five years how we intend to compete with that, not just through the price investments but also through our investments in technology, our continued innovation in the store experience and our continued innovation in a number of different areas of the customer experience.

So pick a point this quarter versus last quarter, I think we all see the world evolving pretty quickly with the different choices customers have and our kind of thought about that is to continue to make these price investments. We have a point of view that they’re going to continue -- they’re going to work and they are going to continue to build the long-term growth for the company.

We’re increasing our square footage growth as quicker than any time we have in the history of the company. And we are pushing hard on the digital side and the innovative side to continue to differentiate ourselves from the competitors.

Rakesh Parekh - Oppenheimer

And just one quick question. Just in terms of competition, are you seeing any differences maybe in some of your suburban versus urban locations right now for competition versus some of the prior quarters?

Walter Robb

I think it’s important to understand that competition has accelerated. There’s no question about it. We’ve seen the conventional supermarket companies like Kroger and Wegmans and HEB, they certainly have upped their game in natural and organic foods. We’ve seen new entrants get public money such as Sprouts, Fresh Market, Natural Grocer, they’re expanding more rapidly. Trader Joe’s continues to expand.

So I’d say competition is more intense right now than possibly we’ve ever experienced before. But it’s also important to understand the Whole Foods Market is still gaining share. I mean, we’re still growing our comps at a much faster rate than the rate of inflation.

So we’re just not gaining it as fast as we have gained it in previous years. So we still remain the leader in this category by I think a pretty significant margin. And we think the markets continue to expand as well which is why all these guys are jumping into it. They see there’s a seed change, that natural and organic foods are continuing to penetrate to a larger marketplace and everybody wants in on it. So I think for a long time Whole Foods had the field to ourselves, pretty much. That was nice.

But we don’t any longer. So we’re adapting to the reality of the marketplace which is increased competition and important that we continue to innovate, differentiate, while paying more attention to value. That’s why we’ve outlined sort of how we see ourselves moving forward over the next five years. We’re obviously radically increasing our store growth. We have never opened stores at this type of pace before.

And we think that shows you -- what we think is the potential market for our business long term. The second time we are -- the second point, we are making investments in price on a continued basis. Our gross margins do sort of trend down gradually every year. The third time we’re very focused on more discipline on the cost side of our business. So we think that’s the right strategy. We want to be as transparent as possible to our investors as well as to the leadership throughout Whole Foods markets so they can see exactly where we’re heading.

Walter Robb

This is Walter. It is evolving quickly. But to respond to, kind of, the previous question there, is this team taking it seriously? Absolutely. Is this a competitive team? Do I think we have the -- whoever on this team, the competitive chops to meet this challenge and make our way forward? Absolutely. Yeah, there is some headwinds here and there are some quick changes in the marketplace.

But this company has 36 years of a track record of being the leader in the nat food industry and continuing to make these investments strategically in price and in technology and differentiation and evolution. And I think are going to -- over the long term, this is the right path for us and we are absolutely 110% focused on this competitive battle. We will do what it takes to be competitive. We’ve laid out our pathway to be able to do that and make no mistake about it we will be there in the end.

Rakesh Parekh - Oppenheimer

Thank you.

Operator

Thank you. We’ll go next to Kelly Bania with BMO Capital Markets. Please go ahead.

Kelly Bania - BMO Capital Markets

Hi. Good evening. Thanks for taking my question. Just want to talk about expenses. I think you’re looking for about a 30 to 40 basis point in annual reduction in operating expenses over the next several years. And just curious if you can give some more details on where in the stores those are expected to come from and are you at all concerned that a multi-year reduction in in-store expenses could in anyway impact the company’s ability to continue innovating that in-store experience?

Ken Meyer

Hi. This is Ken. One of the things that if you look over the last five years, we’ve showed our ability to leverage our expenses as our sales have grown. We anticipate being able to continue to do that. Coupled with that, we anticipate looking at structurally how we run the business and make some adjustments there within the operations, both at the store level, at the regional level and at the global level and that combination together will provide us with the platform to reach that reduction in our direct store expenses and operating expenses overall.

Operator

Thank you. We’ll go next to Jason DeRise with UBS. Please go ahead.

Jason DeRise - UBS

Hey. I wanted to ask about the inflation in the basket. So, I guess it was up 1.7%. Can you talk about, one, I guess, what was the actual cost input inflation that you felt just so we can understand how much you’re investing in price, or to sensitize that maybe even just a comment about what the life inflation you actually charged. And then secondly, to comment about that 1.7 relative to overall food inflation, which I think the last data point for all food types was up about 90 basis points, so reconciling if you’re doing enough relative to conventional baskets to drive that trade-in to your store?

A.C. Gallo

Hi, this is AC. Inflation was fairly flat for us in the quarter. We’re seeing a little bit of -- just starting to pick up now going forward. We see that there’s certainly certain areas as we get further into this year that are -- there’s quite a bit of inflation and we see some drought effects in California for produce this year. Things like shrimp are up 8% going forward. Beef futures are up 14% going into the summer. And pork is also up as everybody knows.

But there’s other areas that are down like corn is down this year and whereas -- we know there’s going to be a 25% short wheat crop. So we see that wheat’s definitely -- hard red winter wheat is going to go up and that’s going to affect a lot of baked goods. We have a lot of contracts in place for the rest of this year. We think we can mitigate a lot of what’s going to happen here. But a lot of what we do is really dependent on what the market does.

I mean, we are -- as we’ve talked on the call so far, we’re really focused on being really competitive with our prices and on some of these areas like we know that California cherry crop’s really short this year but we don’t know what we’re going to charge. It’s really going to depend on how the market breaks. If retail prices stay fairly low then we’re going to stay there. We’re going to be really competitive. So, it’s not really clear in a lot of these different areas where the inflation and cost is really -- what’s going to kind of pass through into the retail. It’s really going to be how the overall market, competitive market responds to it.

Jason DeRise - UBS

Can I follow up on that? I mean, in the prepared remarks, it was the average price for item growth moderated to a three year low of 1.7%. So if inflation was flat, though, for the quarter, I mean, what is driving the up 1.7%? Is that all mix? I guess I’m just having a hard time reconciling that number with the comments you just made about it being flat, or that’s just your input cost being flat and then it looks like you’re still getting pricing above inflation which doesn’t look like a price investment. So again, I just hope we can clarify that a bit.

Glenda Flanagan

That would mostly be mix, yes.

A.C. Gallo

Throughout the year, our mix changes and what we’re selling. Different departments, you sell more or less. So sometimes that change can really have to do more with mix than inflation.

Glenda Flanagan

And it’s also customers trading up, so it can be a variety of factors. The point that we’re trying to make is that it’s significantly lower in this quarter than what it has been in our history.

Jason DeRise - UBS

Okay. Would you quantify by what percent you’ve, on average reduced your prices relative to how inflation is happening for you? I just want to understand.

John Mackey

We don’t think about it that way. We don’t have that kind of top-down approach. We respond to each market based on our competition, based on the feedback received from our customers. So we’re hopefully a more decentralized company and we compete on a regional, local basis. So there’s really no answer to that. So thank you very much. We’ll go to the next question.

Jason DeRise - UBS

Okay. Thank you.

Operator

Thank you. We’ll go next to Stephen Grambling with Goldman Sachs. Please go ahead.

Stephen Grambling - Goldman Sachs

Good afternoon. Thanks for taking the questions. Maybe as a follow-up to Ken’s line of questioning, management has consistently indicated that Whole Foods pricing gap has converged with peers. So it seems like price investments may not be as relevant of a comp driver. So can you maybe give us a little more detail on how you will more effectively convey a value image aside from price and also maybe give some details on what other levers you have to reaccelerate the comp?

John Mackey

Well, we still have work to do in certain perishable areas on price. We’ve done a much better job on central -- center store. But we still have some gaps on perishables and that’s where we’re going to be focusing going forward on pricing. And in terms of accelerating comps, probably the biggest driver of accelerating comps is going to be the age of the stores because we’re accelerating the number of new stores opening up. Younger stores have higher comps than older stores. So as we do that, that’s going to help.

Also, we’re going to start going against easier comparisons. We’ve had some tough comparisons and as we anniversary those and start getting into easier comparisons that’s going to help as well. We had a lot of bad weather. I mean, I don’t every like it when retailers make weather excuses but there was a lot of bad weather. It was a tough winter. And that continued on through our second quarter and so we’re looking forward to that stuff going away. And we think our price investments are going to gain traction as over time -- it doesn’t happen like immediately when you begin to lower prices. It takes a while for customers to see it and respond to it so you get lift later on. There’s a lag in other words between price investment and cost picking up. So we think all those things together will help reaccelerate our comps in new stores.

David Lannon

This is David. Just picking upon what John said about new stores, this year’s crop, we’ve got some blockbusters that have opened, Domain in Austin, well over 60,000 square feet, Brooklyn Rooftop Garden, landmark store, we’ve got a store in Houston that’s going to be opening up close to 60,000 square foot (indiscernible) now just finishing up the designs in all the stores that will be opening next year, working with the regions.

All the Dominick’s which are 50,000 square feet will all be opening, will be starting opening next year. So we’re really -- we’re excited about this year’s crop and how they’re going to grow and they’ve got a room to grow because they’re bigger and next year’s crop the same way.

Stephen Grambling - Goldman Sachs

Thanks. I’ve got some follow-ups, but I’ll follow up after. Thank you.

John Mackey

Thank you.

Operator

Thank you. We’ll go next to Kate Wendt with Wells Fargo. Please go ahead.

Kate Wendt - Wells Fargo

Yeah, thanks. So in terms of the investments in price, obviously we understand it takes time. But in terms of your second half and especially your long-term guidance, is it fair to say that the price investments that you’ve been seeing aren’t really getting the lift that you expected and are maybe now necessary to get to the comps that you project versus accelerating comp growth? And then, as a follow-up to that, does your guidance include any spend for more advertising or marketing around what you are doing on price because it seems to us like that’s part of the problem, people have no idea what you are doing?

Walter Robb

So this is Walter. I would say it’s fair to say that some -- I think what we expect from them we’re learning about the price investments and we are learning about some work, some don’t work, some need to be evolved and place in different areas. And so it’s a mix across all the learnings from those investments. But directionally, this idea of continuing to make investments and continue to improve and figure out where they work, where you see the lift, where you see last lift and how we need to continue to invest, that is the correct direction for us as a company.

And with respect to marketing, it’s fair to say that we are reinvigorating that function so to speak in the different regions. There are some things that we are learning about how to communicate these investments and these improvements and we’re looking to spread those practices around the company. Plus, we’re also looking at different things on a global level of how we could do that better, too early to talk about those. But clearly we recognize the need to make sure in the changing world that we’re communicating more clearly the investments that we’re making and the value that we’re offering our customers.

With respect to other things, I just want to mention one other thing about the differentiation. We haven’t talked about which is a catalyst to the comps is the continuing evolution of the standards for our products. We’re working now on our new produce standards, which will begin to roll out this fall on conventional produce giving customers greater transparency, visibility into the quality of the product and the standard of the product. And again, our ability to communicate that clearly I think represents the type of differentiation effort that’s going to continue to set Whole Foods Market apart from other retailers in the marketplace.

Kate Wendt - Wells Fargo

Okay, thanks. Just sneak in a quick housekeeping one. You gave Easter adjusted comps for Q2, what would be the Easter adjusted comp for Q3 to-date since overall for the quarter it’s 50 bps. I imagine that’s even bigger in the period that actually included Easter.

Cindy McCann

Well, the number we showed for the current quarter was actually a six-week number, including Easter in both years. So that would be in effect Easter adjusted. The impact on the entire third quarter will also probably be about 50 basis points.

John Mackey

Thank you. Next question.

Operator

Thank you. We’ll go next to Mark Wiltamuth with Jefferies. Please go ahead.

Chris Mandeville - Jefferies

Thanks for taking my call. This is actually Chris Mandeville on for Mark. You touched upon the Dominick’s stores a little bit earlier. I was just hoping to get some greater color as it relates to when we should start to see those begin to cannibalize the comp base a little bit. And then, if you could provide any color as it relates to that impact versus what we had seen in Boston.

John Mackey

Yes, those stores are all in process. The first one will open up in January, so next January and they’ll open up throughout over the next year.

David Lannon

This is David. In addition, we have many other openings in the Midwest as well. It’s one of our fastest growing parts of the company. So just like we’ve seen in other markets like Boston and like, say, Minneapolis, we’re expanding the market, we’re growing the market. So they start to roll out in January and go forward from there.

John Mackey

So of course we don’t know exactly the cannibalization impact it will have. We’ve made some internal estimates of it. The good news there is of course Boston will be anniversaried, Austin will be anniversaried, though more than offset the Chicago impact.

Chris Mandeville - Jefferies

Chicago’s big enough to…

David Lannon

Chicago’s a really huge city. And some of those are new market areas for us where we haven’t yet entered. So this should be -- some of the stores will have very little cannibalization impact.

Chris Mandeville - Jefferies

Okay, great. And if I could just follow up with one other question. In terms of the price investments which you’ve made or accelerated over the last several quarters, have you seen any kind of response from your competitors in particular, the one whom you had cited being your main competitor in Q4?

John Mackey

They haven’t changed their pricing in response to customer, if that’s what you’re asking. So, I mean, one thing people don’t quite understand is that when you lower a price, the first impact on it is it lowers your comps as you’re selling the same amount of product for the most part at a lower price. So your sales are slightly lower. Over time, though, as people come to see that, you’ll hopefully get lift on that item as people purchase more of it and the overall perception of your basic price value ratio is improved and it helps your overall sale. That’s what we experienced in the past we made investments in price. But there tends to be a lag period. So unfortunately initially it’s not good in terms of comps, but then it does have a lift over time and so we’re hoping it will lift sooner rather than later, but the investments are being made now.

Chris Mandeville - Jefferies

Okay, great. Just wanted to ensure you’re not chasing a moving target. Thank you.

John Mackey

Thank you.

Walter Robb

It is a moving target always and we are chasing it, but sometimes you catch the moving target.

Operator

Thank you. We’ll go next to Charles Grom with Sterne Agee. Please go ahead.

Charles Grom - Sterne Agee

Thanks. Good afternoon. Good evening. Just the follow-up here on the topic (indiscernible) just the price investments, Walter. Just wondering how you guys are planning to evaluate the success of those price investments? My understanding is there has been a couple 100 SKUs you’ve adjusted prices on. What are you doing to evaluate it and how should we think about future price investments in light of the gross margin view that you guys have shared. Should we expect multiple quarters and multiple years here of continued price investments? And then if you also could just shed some light on where you made those price adjustments so far? Thanks.

A.C. Gallo

Hi, this is A.C. What we’re doing is we made quite a few price investments this past year and we’re now -- we now have about seven months of experience under our belts with them and we’re in a process of evaluating -- some have shown tremendous lift, others moderate, some have shown no lift at all. So we’re evaluating that and coming up with new list of items that we might want to pull some of them back a little bit and use that investment in other items. We’re in a process also of working on the next phase of price investments and we’ll have -- of course before we do any of it, we’ll have real clear criteria in place as to what we consider success.

Because you know it’s really different. You may have some items which are kind of known value items where you lower a price on it and people don’t necessarily buy that much more of it. But you know you need to do it in order to be competitive in the marketplace because people really know the price of an item. And other items you lower the price and you really expect to get a large increase from it. And so we have different criteria for each item.

You asked the question about how long will this go. I think we showed in our long-term vision here is that we’re looking to do further investment in price every year. We show up for the next five years because we think it’s important in this environment to continually be -- to be -- to do a better job all the time and we’re going to work both on price investment side and also on the differentiation side as well as Walter was speaking earlier.

Walter Robb

We will return to our historical, we think, we’ll return in the next five years to our historical gross margin percentage of 34% to 35% range. While we will have lowered significantly our operating expenses, so that we think our operating profits will be actually at record levels in the five years. So that’s the strategic vision that we’ve laid out.

So we’re going to continue to invest in price, we are going to and -- but we will see our gross margins slowly shrink down to what they have been for much of our history, but our expenses at the end of the period are going to be much lower and the overall profitability much higher. That’s our strategy.

Charles Grom - Sterne Agee

Okay. Is it fair to say that so far in the seven months that you’ve started this journey that you really haven’t embarked on getting the message out there to somebody’s question earlier, which was a good one that you’re lowering prices, but you haven’t been really advertising them within the stores or doing it in some of the promotions that you do to get the message out there? Is it safe to say that that’s still to come or it’s not part of the strategy at all, you’re just going to lower the prices and hope that the customer starts to recognize that overtime?

David Lannon

Yeah. This is David. Just -- we’ve had some very encouraging results. We’ve been doing this experiment in half regions in the company with salmon and their farmer send at $10.99. And in California specifically, we’ve run additional marketing spend in California and additionally, we have the most savvy of our social marketing teams out there and we’re doing some extensive marketing in social media for this particular salmon price which is a great value and also a great differentiator for us.

So we’re encouraged by those results. The other regions are studying it. We also are regional, so we do have experiments going on all the time. So we’re kind of experimenting, trying a variety of different approaches, of which marketing is one of them, so.

Charles Grom - Sterne Agee

All right. Thanks.

Operator

Thank you. We’ll go next to Bob Somers with Susquehanna. Please go ahead.

Bob Somers - Susquehanna

Hey. Good afternoon. I guess, sorry, to do this, to stay on topic, but just, regarding the competitive architecture which appears to have materially changed from your point of view sort of two questions. One would be, on the heels of sustained multiyear price investment? Are you concerned that you’re starting to follow the path of the conventional business and that you end up with something that’s a lot more commoditized than you would like?

And then related to that, since you have this vision, not guidance of committing 130 to 140 basis points of gross margin investment over a five-year period? Why not go scorched earth put it up front, make it uncomfortable for people to participate in the business since they are close to you a you have the balance sheet to do that?

John Mackey

Well, it’s easy to say scorched earth, if you’re not actually running a company and responsible to a variety of stakeholders. That’s very risky and that could blow up. So I don’t, that’s not what we’re going to do. But we’ve outlined our strategy and you can decide, if you think it’s a good strategy or not. But we are -- we’ve considered the -- we call a binocular option and we decided that that wasn’t the best strategy for our stakeholders at this time, so we’re not going to go that direction.

We’re going to continue to make price investments, we’ll continue to lower expenses and we think five years from now we’ll be in a much different competitive situation than we are right now. We like the positioning that we’ll be in.

It’s a -- we take the long-term in Whole Foods Market. We’ve been running this company for over 35 years and we think long-term, we execute our strategies over long periods of time and we found that that’s the best way to manage this business.

Walter Robb

Let me add, this is Walter. Let me just add something that, I think, I mean, our presence, our purpose in the marketplace is around the quality of the food, the quality standards, the quality of food. You could -- I think we would all acknowledge we can do a better job communicating that to our customers, do a better job communicating the value offering to our customers. But our particular purpose or role in the market has been and continues to be to bring the highest quality food to the marketplace, that’s what we stand for.

And we’re doing, so we’re never going to be a race to the bottom, chase it only on value, only on price. That’s not who we are and that’s not what we’ve been and that’s not what we’re going to be.

And so when you think about our competitive formula, you think about the combination of quality and the role of quality in the marketplace along with the value, the value that we’re bringing to our customers and that particular combination is unique to us, because our standards are the highest in the industry and there is nobody in the marketplace that’s exactly like us.

So there’s certainly a very rich competitive system out there right now. We recognize that. No one’s going to give us any business. We’re going to have to earn it through our own hard work and certainly these results today are not our finest, we acknowledge that.

But I think why we don’t descend down that road is because we are working hard at the same time to continue to raise the bar on quality, continue to evolve the experience at our stores, our new stores in particular, if you go to Brooklyn, you go to some of the stores you can see how that customer experience continues to evolve.

And continue to have thousands of exclusives and differentiated products that represent choices in the marketplace for customers that they don’t have. And if we get our digital act together, we’ll be able to be reaching our customers where they are outside the full values in the store. And I think that is going to be a nice catalyst for growth as well. So it’s a quality story as much as it’s a value story, that’s why we’re not going down that path.

John Mackey

For a long time, put this whole thing in competitive perspective. For a long time, Whole Foods Market was this small niche. I remember many years ago, talking to venture capitalists and early as a public market, as a public company. Their belief was that this was -- they wasn’t even sure it was a viable niche, wasn’t even sure that this had any legs at all. One guy said you guys are a bunch of hippies selling to other hippies. And yet we’ve grown continuously for many, many years until one time our market capitalization in the last year was the highest of any dedicated food retailer in the United States.

Our tremendous success has created more competition. And that’s the way capitalism works, so we have, what we thought was a niche and we still think it’s a niche. But it’s just gotten to be a very big niche and in some ways it’s gone mainstream. So there’s a lot more competition, a lot more entrants into the marketplace as well as conventional supermarkets copying and imitating a lot of what we’re doing.

Whole Foods Market does not want to engage and as you say, we don’t want it to become a commodity where we’re trying to just compete on the basis of price. That’s not what we want to do. Instead, we are upping our game in terms of differentiation, innovation, service, quality and overall experience that we give to our customers. You can see this if you go into many of our new stores. And we’re opening, I mean, we have 114 stores we’ve announced and we’re finding more and we just approved a bunch more stores today before this meeting.

So, we’re rapidly increasing our growth and we’re opening tremendously good stores that we think will set us apart from our competitors and we are a very-very creative, innovative company. So at the same time, we have to recognize that we have more competition going after us, kind of, on the margins on certain well known brands and products and we can’t ignore that. We have to meet that challenge head-on and we are doing that.

At the same time though, we’re continuing to differentiate. We’re continuing to innovate. We continue to upgrade the experience that we’re giving our customers. We think it’s a good strategy and that’s why we’ve gone for the first time and laid out how we see the next five years happening because we want our shareholders, as we always want our leadership at Whole Foods to understand where we’re getting to. I can tell by some of the questions on the call that people may not agree with our strategy and of course, people are free to make their own decisions about whether this is a good strategy or not.

But we want to be as transparent and as honest and as open with our shareholders as we possibly can be. This is where we’re heading. This is what we’re going to do. And I think Whole Foods has a great track record, not maybe every single quarter in the last 35 years but if you look at the long-term trends, we deliver what we say we’re going to do. And this is what we’re going to do in the next five years. So there you have it.

Bob Somers - Susquehanna

Okay. Thank you.

Operator

Thank you. It appears we have no further time for questions. I’ll turn it back to Mr. Mackey for any final remarks.

John Mackey

Thank you so much for listening-in today. A transcript of the scripted portion of this call along with the recording of the call is available on our website as well. We look forward to speaking with you again in July for our Q3 earnings call. Everybody have a great day. Bye.

Operator

This concludes today’s program. You may disconnect your lines at anytime and have a great day.

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Source: Whole Foods' (WFM) CEO John Mackey on Q2 2014 Results - Earnings Call Transcript
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