Whole Foods Not A Wholesome Stock

By Kristin Graham | August 10, 2009 AAA

Welcome back, Whole Foods (Nasdaq:WFMI). Since peaking at the end of 2005, the premium organic food retailer was shunned by investors as it struggled to integrate its Wild Oats acquisition and lure in cash-strapped consumers. But the company is in the midst of revolutionizing its brand and growth strategy and for the first time in years, it's showing signs of life.

That said, Whole Foods still has a tremendous amount of work ahead. Consumers are still trending toward purchasing cheaper goods at traditional grocers, making it hard for Whole Foods to compete with Kroger (NYSE:KR) and SuperValue (NYSE:SVU), which offer healthy, organic food selections for smaller premiums.

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The Good
We'll start with the positives at Whole Foods. I like that management is finally addressing inefficiencies in its operations and admitting to straying from its core mission. CEO John Mackey was recently quoted by the Wall Street Journal as saying "We sell a bunch of junk", referring to the growing number of prepared foods, cakes and candies the company has come to stock. Mackey has plans to revitalize stores to help the company return to its roots.

The third quarter revealed that some of the company's efforts are already beginning to pay off. Margins expanded, operating earnings rose 23% and $93 million was generated in free cash flow. It was a solid start by management to rejuvenate the business.

Investors are obviously impressed. The stock opened 15% higher on the release of third-quarter 2009 results last week. Year to date, the stock has soared over 200%. However, investors who have sent this stock flying up to a ridiculous valuation have undoubtedly overlooked some of the challenges Whole Foods still faces.

The Bad
Sales increased just 2% and comparable sales fell 2.5%. Mackey may have sounded upbeat in the conference call about emerging traffic patterns, but I have my doubts. With unemployment at 9.4% and consumers still reluctant to spend, I have trouble understanding just how Whole Foods can justify a slight uptick in traffic as a sign of momentum.

Through these tough times, the company's core customers will likely stick to their healthy eating habits and remain loyal to Whole Foods. But like the phenomenon we witnessed at luxury retailers such as Coach (NYSE:COH) and Nordstrom (NYSE:JWN), the average Joe who once used credit to "peek" over the upscale barrier has had to abandon its faux upper-class lifestyle. It will be years before these consumers can even think of dipping into luxury goods again - if ever. At this point, I see store expansion as the only means of growth for Whole Foods. The company will have to tap wealthier shoppers in new markets.

Me vs. John Mackey
CEO John Mackey certainly disagrees with me. He insists that his company's sales do not rely on consumer income, but rather education. His philosophy is that people who are committed to eating healthy will purchase organic and natural foods regardless of the economy. In fact, he doesn't even categorize his company as an upscale grocer.

I've shopped in Whole Foods many times and I'd have to readjust my overall budget if I wanted to establish a "Whole Foods" lifestyle. I commend the company for stocking generic brands and offering promotions to help reduce the cost of shopping there, but when it's all said and done, Whole Foods is downright expensive. Regardless of a desire to eat organic, the prices at Whole Foods block certain income levels from shopping there. And this is what worries me about the company's future the most; I don't think Mackey or his management team have correctly defined their target audience.

Regardless of what Mackey thinks, Whole Foods has been labeled a luxury place to shop for groceries, much like Tiffany's (NYSE:TIF) has been dubbed a luxury jeweler. Mackey can dream that his products can be sold to all income levels, given that consumers are correctly informed about healthy eating. But in reality, not everyone can afford to shop at Whole Foods. This fact alone could put a damper on the company's long-term growth.

Bottom Line
I think Whole Foods is a great concept; the store shopping experience is quite enjoyable and the stores stock high-quality food. Further, I like the fact that management has finally taken a step back to reassess its growth strategy and cost structure. But I'm leery about how the company will be able to successfully complete its much-needed restructuring during a severe recession.

It's possible that Whole Foods will be able to impress Wall Street with margin expansion and earnings growth over the next few quarters as it revitalizes its operations. But these improvements can only buoy the bottom line for so long, as sales at existing stores will have to pick up at some point to drive growth. Unfortunately, I'm not too optimistic about that happening.

Despite its status as a premium grocer, Whole Foods most certainly doesn't deserve its premium trailing P/E multiple of 44. This is one stock no investor should have in the shopping cart. (See Evaluating Grocery Store Stocks to learn more about analyzing stocks in this industry)

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