Whole Foods: Fundamentally Flawed?

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Summary

Whole Foods shook off another bad quarter that included missing key comp sales estimates.

Some opportunity exists to expand the destination appeal of existing and relocated stores without focusing on more locations.

The company appears fundamentally flawed, but the stock action suggests otherwise.

Despite the market not expecting much, Whole Foods Market (WFM) still disappointed when reporting FQ1 results. The stock though managed to stay above the mythical $28 level where Whole Foods has held for more then a year.

The organic grocer announced a shift in the growth strategy along with the quarterly results. Should investors buy the stock at $30 or is the concept fundamentally flawed?

Even with a trend of negative comp sales, Whole Foods reported a FQ1 decline of 2.4% in comparison to analyst expectations of 1.7%. The pressure on food prices was only slightly offset by an increase in the basket size. Even worse, the comp sales trend was worst to end quarter instead of improving.

Possibly most disturbing about the quarterly results was the elimination of the previous goal to reach 1,200 stores. Whole Foods plans to close nine stores during the quarter with an ultimate goal of opening 30 net stores in FY17. The company will end the year only approaching 500 stores.

The biggest issue is that Whole Foods focuses on premium products and has already mostly cornered the high-end organic market. Customers routinely made extended trips to visit a retail location, therefore making expansion a process in cannibalizing existing stores.

These numbers are supported by the constant declines in transactions in the midst of food deflation. Customers should make more trips if food prices are lower so this issue points out the problems with not only competition but new stores stealing traffic from established locations.

The amazing part is that the stock bounced before even reaching the previously established $28 support. The stock valuation isn't cheap at nearly $10 billion and fundamentally difficult issues in the space.

The shifts to focus back on premium customers at existing stores is one of the reasons for the stock holding at levels suggestive of a growth stock. Whole Foods now trades at 21x forward EPS estimates.

The organic grocer has a pipeline of 15 relocations to bigger and better stores in addition to the recent moves in Philadelphia and Winter Park. The Philly location has a food hall with room for 140 customers to eat from several dining venues that makes the location a destination. These store sizes are nearly double the original ones.

In short, the company has the ability to use an approach targeted at the existing customer base to drive more frequency and higher spending levels. Instead of trying to compete with Kroger (NYSE:K) or Sprouts Farmers Market (NASDAQ:SFM) for the low-end organic and natural food segment, Whole Foods can utilize the dominance in the premium segment and highlight some concerns about the questionable quality of the organic offerings at the other grocers.

Ronnie Cummins of the Organic Consumers Association (via Sacramento Bee) discussed how most mainstream organic products don't truly meet the strict definition for organic. Such loose definitions have allowed the supermarkets to grab over 53% of organic food sales in 2015 and in the process reduce the value of the products at Whole Foods.

The key investor takeaway is that despite horrible quarterly results, Whole Foods continues to trade above $28. The reasoning isn't clear, but the organic grocer appears to have an opportunity to expand the retail locations into destinations to attract more consumers versus competing with main-stream grocers on low-quality organic food items.

Whole Foods still appears too expensive up at $30, but one is always wise to watch a stock that doesn't trade as expected.

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.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.