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Summary

  • Whole Foods reported Q2 results below consensus estimates.
  • Whole Foods hasn't differentiated itself from the competition.
  • Increased competition presents future challenges.

Introduction:

Whole Foods (NASDAQ:WFM) recently reported Q2 earnings of $0.38/share which came in below the consensus estimates of $0.41/share. Revenue came in at $3.3 billion, once again below consensus estimates of $3.34 billion. Whole Foods also lowered full year 2014 EPS to $1.52-$1.56 down from the projected earnings of $1.61. Whole Foods is currently trading at $37.78, down 41.5% from its 52-week high of $65.59, but the stock is still not cheap with a P/E of 25.19. This decline in Whole Foods' stock price has occurred for numerous reasons, but the first and foremost cause is heightened competition.

Whole Foods was the first major grocery chain to exclusively sell healthy, all-natural, and organic products. They were the leader in the space and had very little competition. After they demonstrated that the natural and organic food market was extremely profitable, other entrepreneurs and large corporations jumped in on the market. To enter the organic foods space is not that difficult; there are practically no barriers to entry except the necessity of capital. There is nothing exclusive about the business. There are no patents or anything proprietary about it.

This increased competition has come from all angles; it has not only come from "copycat" Whole Foods like Sprouts Farmers Market (NASDAQ:SFM) and The Fresh Market (NASDAQ:TFM), but also from national superstores like Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST) and mainstream grocers. The direct competitors Sprouts Farmers Market and The Fresh Market continue to take away market share from Whole Foods. The indirect competitors Costco, Wal-Mart, and mainstream grocers continue to implement more and more all-natural, organic, and gluten free foods into their product lines also reducing Whole Foods' market share.

A Lack of Differentiation:

There is nothing that differentiates Whole Foods from its competitors and this is the major reason why the company is in decline. What provides Whole Foods with a competitive advantage? Certainly, they have some loyal customers that will always shop there no matter what, creating customer lifetime value, but other than that what gives Whole Foods a competitive advantage? They can't differentiate by the uniqueness of their products because the products sold by their competitors are very similar. They can't differentiate on convenience like a Wal-Mart or Costco because they are not a one-stop shop (unless you're wealthy). Whole Foods' value proposition is the same as all their direct competitors - there is nothing distinctive; that is to offer the consumer high-quality, premium organic and natural foods to provide health and wellness. The only difference is that Whole Foods is more expensive. This is why Whole Foods cannot win. There is nothing special about Whole Foods and nothing compelling about it to make consumers choose it over the same product, same quality, lower priced competitors.

A Deeper Look into the Direct Competitors:

Sprouts Farmers Market currently trades at $27.12. The company reported Q1 earnings of $0.23/share beating estimates by $0.04. Q1 revenue was $722.6 million, which beat estimates by $15.87 million and was a 26% increase from the same quarter last year. The company also saw 12.8% rise in same store sales growth. Sprouts Farmers Market expects to open 23 to 24 new stores this year.

The Fresh Market currently trades at $29.15. The company just reported Q1 results after the market close on Thursday. The Fresh Market beat consensus estimates on revenue and was in line with estimates on earnings per share. EPS was $0.43. Revenue was $431 million versus $419.85 million. This is a 17.6% increase in revenue from the same prior year period. The Fresh Market's gross profit increased by $18.8 million to $148.2 million, which is a 14.6% increase from the same prior-year period. Additionally, the company has already opened seven new stores in 2014 and expects to open up 21 more stores this year. Currently, The Fresh Market has 154 stores in 26 states.

All of Whole Foods direct competitors beat on earnings and revenue, while Whole Foods missed badly. Furthermore, they all increased their full year 2014 EPS guidance, whereas Whole Foods significantly cut its full year EPS outlook. The statistics show that Whole Foods' direct competitors are cutting into its market share, therefore decreasing revenue and earnings. I expect this trend to continue as I view this whole situation as a quasi-arbitrage effect. Whole Foods was the first major player in the organic and natural foods space, so their profits were quite large, but now that similar companies have arrived in the space, consumers are leaving Whole Foods for other companies, therefore dispersing Whole Foods business across its competitors, creating an evening-out effect among the companies.

A look into the Indirect Competitors:

The organic retail field that used to be dominated by Whole Foods and small co-ops is now being integrated in large supermarkets. Costco and Wal-Mart are both increasing their product lines of natural, organic, and gluten free products. Although Costco's and Wal-Mart's target market is the average consumer, their expansion of their natural, organic, and gluten free products does take away market share from Whole Foods because those average consumers that previously would have had to go to Whole Foods to purchase their specialty items can now buy them at lower costs and greater convenience at these superstores. In a survey conducted by Wal-Mart, 91% of their customers would buy organic products over non-organic products if they were priced closer to conventional foods. Even though only Wal-Mart customers were surveyed, Wal-Mart customers are indicative of the average consumer in America today. The results of this survey show that as demand for organic foods continues to increase in America (projected to increase 14% a year through 2018) that Wal-Mart, Costco, and mainstream grocers are better positioned to capitalize on it, since consumers prefer the lower cost providers instead of the upscale Whole Foods. Wal-Mart recently struck a deal with Wild Oats to supply its stores with organic food at immensely lower prices than Whole Foods. In fact, Wal-Mart claims that customers will save 25% against comparable organic products. Furthermore, Wal-Mart announced last month that it plans to add over 100 organic and natural products to its stores. In Costco's Q1 earnings report, the company stated that it plans to add organic beef and giant packs of kale to its stores. Also, Costco recently added gluten free pizza to its stores. As the popularity for organic foods continues to increase, Costco, Wal-Mart, and mainstream grocers will continue to add to their organic, natural, and gluten-free offerings, which will only escalate the competition that Whole Foods already faces.

The Final Word:

Whole Foods is a solid company, but the management has not figured out how to deal with the heightened competition yet. As Whole Foods' CEO John Mackey stated on the Q2 conference call, "Competition is more intense right now than we've ever possibly experienced before." Whole Foods has nothing, other than premium prices, that differentiates it from the competition. And because of that I do not see any catalyst that will drive up revenue and earnings in the future. I expect the demise of Whole Foods to continue and believe the stock will fall to the low 30s. As for its direct competitors, The Fresh Market is the most compelling buy right now.

Source: Will The Demise Of Whole Foods Continue?