For Whole Foods Market, Vertical Integration May Become Its Whole Point Of Sale

Sep. 01, 2015 4:09 AM ETAmazon.com, Inc. (AMZN)21 Comments
Jay Wei profile picture
Jay Wei
368 Followers

Summary

  • Competition in organic foods retail sales has really picked up for Whole Foods, and the company is losing market share to newcomers.
  • Pricing pressure is all on Whole Foods, and the company is trying to find ways to be more competitive with pricing, for example, by offering less-costly, private-label products.
  • The ultimate solution to lowering costs and maintaining quality is through vertical integration whereby Whole Foods engages in both producing and marketing organic foods.
  • The new venture in organic foods producing may require a lot of capital investments. But Whole Foods has the financial resources to carry it out.

Time has definitely changed for Whole Foods Market (WFM), as its pioneering heydays are a thing of the past when the company was the only marketer for natural, organic foods. Competition has caught up and is now plenty, from other specialty stores such as Sprouts Farmers Market (SFM) to mainstream grocers and general discounters like Kroger (KR) and Wal-Mart (WMT). It seems that competitors have all tried to make their products more affordable than those at Whole Foods, reinforcing the company's image of Whole Paycheck with customers.

Whole Foods earned that nickname because of its pricey tags on a lot of products. The lack of competitive pricing has contributed to the declines of its quarterly revenue in all last five quarters but one. Meanwhile, sales of organic foods by its rivals have gone up. Without a strategy to counter such changes in competition, Whole Foods has suddenly found itself losing market share. Not surprisingly, investors have also lowered their valuation of the stock over the past two years or so. Absent a convincing turnaround strategy, Whole Foods risks losing its standard-bearer status in the organic foods movement that it helped pioneer.

There have been some price reductions by Whole Foods to better match with lower prices from competitors. But with its operating margins at a thin 4 to 6 percent in recent years, the company has little room to cut prices further. On the other hand, companies including Kroger and Wal-Mart can even afford to be a loss leader with their organic-foods offerings, if doing so attracts customers to come in and then buy more of their other merchandises, something not in Whole Foods' playing cards. Whole Foods believes that healthy, natural foods should be offered at premium but reasonable prices, and racing to the bottom is not a solution for the company.

The key is to manage costs in a way that allows Whole Foods to have competitive pricing, but also earn a decent profit. For any retailer of organic foods, the most expensive item in its operating cost structure is the input costs of the food products themselves. Organic foods cost more to produce and organic farmers certainly don't sell them cheaply. Whole Foods does use its private labels, similar to store brands found in supermarkets, to get input costs down by partnering up with some suppliers. But the company should go one step further to invest selectively in the organic foods producing business. Such a vertical integration not only further cuts down on input costs, but also better ensures the quality of the organic foods that it sells.

Vertical integration of producing and marketing organic foods under a single entity could be a new, leading position for Whole Foods to take, as it tries to better respond to today's more competitive market. Without leveraging production, focusing on marketing alone may achieve only so much. However, Whole Foods is actually launching another chain of stores, called 365 by Whole Foods Market. It's designed to be value oriented and sells only the company's private-label products. The move takes on the issue of pricing, but it's limited to only the new chain and considers less about product quality. As such, this new marketing strategy doesn't solve anything that concerns the company's existing, flagship stores, which will remain premium priced and thus less competitive even as the company plans to expand its store count.

Whole Foods seems to realize that reducing sales prices to further constrict margins or by using private labels that cost less but don't boast premium quality is not a solution for its flagship stores. While its "365" may catch on with price-conscious customers, it could have a cannibalizing effect on Whole Foods' other higher-priced stores. Any "365" success may in the end contribute little or no net growth for the company. Therefore, vertical integration could be a new venture in the organic foods field for Whole Foods to discover this time around. Controlling organic foods production would give Whole Foods a distinctive, competitive advantage over the rest of the market. It would give the company's flagship stores a secure source of both affordable and quality organic foods supplies.

The new venture may require a lot of capital investments, but Whole Foods has the financial resources to carry it out. The company has plenty of operating cash flow and its debt-to-equity ratio is very low. These two favorable financial conditions should give Whole Foods enough leeway when planning capital investments. The success of such a venture could have positive effects on everything from competitive pricing, premium quality and increased sales to expanded margins, earnings growth and higher return on equity. After all, it's the company's pioneering spirit that has given us the Whole Foods, and it should be the same venturing mentality that will keep it growing.

This article was written by

Jay Wei profile picture
368 Followers
An impassioned investment research analyst and writer, Jay Wei holds an MBA in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco. He writes syndicated investment commentaries with various investment content providers, including The Motley Fool. Wei takes pride in providing unique and original investment and business analysis on a consistent basis. Find more research reports by him on https://investorsbusinessinsights.com/
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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