The once strong bullish case to own organic food stocks has now been discredited.
The organic food industry has been growing steadily over the past few years and investors have been looking to catch in on the craze by buying shares of organic grocers, including Whole Foods Market, Inc. (WFM)
Investors were justified in buying stock of organic food sellers because they were niche players in a fast growing market. However, organic food retailers have yet again disappointed investors in the second quarter through a sequential deceleration in comps as traditional grocers continue flexing their muscles and gaining market share.
Organic grocers are now left with little choice but to fight back and become more price competitive … at the expense of their own margins. That is, if they can continue to attract traffic in the first place.
Comps & Competition In Focus
Whole Foods reported in its second quarter that comparable sales fell 2.3%. During the quarter, the average price per organic food item it sells rose just 80 basis points — the lowest increase in five years. Meanwhile, the average basket size during the quarter also fell 0.9% and the total number of transactions fell 2.1%
This should make it clear that Whole Foods’ price investments are not being offset by any notable gains in volume. The trend of eating organic food is as hot as it has ever been, but consumers are simply shopping for their organic food elsewhere.
After all, several studies have concluded that the organic food market is expected to grow at a compounded annual growth rate of over 16% through 2020.
Traditional grocers are sensing a weakness in niche organic food sellers and can’t seem to hide their excitement over the prospects of gaining market share at the expense of companies like Whole Foods.
Costco Vs. Whole Foods?
Companies that organic food investors wouldn’t associate with the space, such as Costco Wholesale Corporation (COST), are issuing commentary that should frighten Whole Foods investors.
When asked to comment on Costco’s outlook in the organic space during its second-quarter conference call back in March, Richard Galanti, the company’s Executive Vice President and Chief Financial Officer answered:
“We’re about $4 billion, which was I think in the last two years, it was up 30%-ish. And we’re on task, I think our goal this year to have a double-digit number that has a two in front of it, and we feel good about it.”
Here is Galanti brushing off Whole Foods new “365” store format during its third-quarter conference call on May 26:
“Now there’s other players coming into the market. I think just this week you’ve got a 365 opening and you’ve got other people coming to town with different health-related organic-related types of retail formats.
We are pretty good at that stuff too and again, you’ve got to like bigger sizes, but we are pretty awesome in the fresh area and I think that will continue to — should be for us an increased sales penetration area and something that’ll keep driving our members.”
What about The Kroger Co (KR)? Their management is just as positive on the organic space as Costco is.
W. Rodney McMullen, Chairman and CEO of Kroger, had the following to say during its fourth-quarter conference call in March:
“As you know, we’ve had phenomenal success in natural and organic over the last several years and we really see customers continuing to see that as important.”
It should be clear as day that traditional grocers are flexing their much larger muscles and looking to dominate the organic space.
Investors are now scrambling to find the answer to the all important question of how Whole Foods can respond.
Given its small size relative to giants like Costco and Kroger, one of the major options at its disposal is simply continue investing in price and hope that traffic follows accordingly.
Needless to say this will harm its margins for years to come.
Ignore The Latest From Wall Street
Edward Kelly of Credit Suisse came out with a timely upgrade of Whole Foods’ stock on Wednesday and boosted his recommendation to “Outperform” from “Neutral” with a new $40 price target — $10 higher than his prior target.
Kelly’s bullish thesis surrounds the company’s investments in price, acceleration of private brand penetration, improved marketing and its new store format called “365,” which is essentially a “mini-Whole Foods” store designed to reach markets where constraints make its core-store impossible or undesirable.
The problem is most of these initiatives have already been in place for quite some time. The Wall Street Journal reported in late September 2015 that Whole Foods is slashing 1,500 jobs to lower prices and upgrade its technology. The publication also noted that the company “has been working for more than two years to cut prices and repair its reputation for high prices.”
Why should investors believe this time is different? Why is Whole Foods investments in price and technology to help boost organic food sales going to succeed today when it hasn’t over the past few years?
As for Whole Foods’ new 365 store, the concept has been open and operating since May 25, 2016 and it is way too early to call it a success story.
Bottom Line: Avoid WFM Stock
Investors should pay close attention to Whole Foods’ own commentary, which solidifies the thesis against owning Whole Foods’ stock.
When Whole Foods management guided its fiscal year 2016 results to be “at or below the low end” or prior guidance, it cited “recent sales trends and additional investments in marketing and technology in the second half of the year.”
Organic food investors should avoid Whole Foods stock as its comps trends have not only worsened, but are showing no sustainable pathway toward acceleration and growth. The same can also be said for its gross margins that face risks in the short- and medium-term and it is uncertain at this point if management’s initiatives face similar threats over the longer term.
Costco and Kroger aren’t direct competitors with Whole Foods in the traditional sense. Costco is merely looking to gain market share in the organic space and can do so given its massive scale and balance sheet.
Bottom line, Whole Foods sells organic food at a higher cost than grocers (which is why its nickname “whole paycheck” has stuck over the years), leading consumers to choose low-cost grocers over WFM. Costco and Kroger’s push into the organic space isn’t necessarily a reason to buy their respective stock, but it certainly is a reason to avoid Whole Foods’ stock.
As of this writing, Jayson Derrick did not hold a position in any of the aforementioned securities.
