The 2 Big Reasons Whole Foods Market Inc. Is Getting Hammered

By Markets Fool.com

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Photo: Whole Foods Market.

You'd think when a company releases its quarterly report in which earnings came in ahead of expectations, revenue fell an eyelash below, and guidance remained the same, it wouldn't make too many waves on Wall Street. But as shareholders of Whole Foods Market could tell you today, theory and reality don't always mesh.

Indeed, Whole Foods' results were largely in line with expectations, but the stock slumped as much as 12% when the market opened this morning. That is largely based on two factors that have introduced significant uncertainty -- at least in the short term -- about the grocery chain's situation. And if there's one thing Wall Street hates, it's uncertainty.

Comparable-store sales growth
There is, perhaps, nothing more important for grocery investors than comparable-store sales, or comps. That's especially true with operations that are growing their footprint, as Whole Foods is. While just about any retailer can increase revenue by building new stores, it takes an exceptional organization to consistently grow sales within existing locations.

Historically, Whole Foods has been a master at this.

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Comp Growth at Whole Foods | Create infographics

While most grocery chains were happy to eke out gains that kept pace with inflation, Whole Foods' comps boomed after the Great Recession. Starting last year, though, cracks started to appear, and the stock fell accordingly.

In February, the company reported first-quarter comp growth of 4.5%, and said second-quarter comps were accelerating further, to 4.9%. The stock jumped 5% on the news.

But something happened between then and the end of the quarter: the number of transactions dropped off precipitously. While the average basket size (the amount of stuff the shoppers buy, on average) grew between February and the end of the quarter, the number of actual transactions dropped from a growth rate of 2.9% to just 0.8%. That's a huge change.

Management said weather and competition played a role. But I suspect the real culprit -- which management also acknowledged -- was cannibalization, specifically in Chicago and Florida. Consider that the greater Chicago area is home to 23 Whole Foods locations. Three of those opened within the last few months.

Consumers who might have traveled longer distances to get Whole Foods' fare suddenly had closer options. That meant existing stores --which is all that counts for comps -- lost lots of business. While that problem will smooth itself out when these new stores join the comp base, it raises the question of whether Whole Foods is reaching market saturation in some of its more mature cities.

Half Foods?
The second takeaway from the company's release was the announcement of a new store geared toward millennials -- which will be an entirely separate chain -- that the company plans to open in 2016. Here's how co-founder and co-CEO John Mackey described it during the quarterly conference call:

Offering our industry-leading standards at value prices, this new format will feature a modern, streamlined design, innovative technology and a curated selection. It will offer convenient, transparent, and values-oriented experience geared toward millennial shoppers, while appealing to anyone looking for high quality, fresh food at great prices.

Some took to the Internet to mockingly call this new concept "Half Foods." While I don't think the initiative invites quite so much snark, I do think it raises fair questions about the company's approach. The most important:

  • Will this lead to further cannibalization of existing stores?
  • How big can this concept become if the flagship Whole Foods brand still plans for 1,200 locations?
  • Isn't a focus on lower prices and technology what Whole Foods has already been working so hard on in its existing locations? Is this an admission of failure in that regard?

Management responded by saying that while cannibalization may occur, this is still the right long-term move. The stores will likely have much lower costs given their small footprint, and focus on technology -- which could reduce the number of employees needed at each location. And because the same distribution network would be used to provide a smaller base of products, there would be no requisite start-up costs to consider.

As a Whole Foods shareholder myself, I have faith that management knows what it's doing. That being said, with the stock still trading at a relatively expensive 26 times earnings, I'll wait to see how this new concept pans out before adding more shares. If, however, you want to initiate a starter position, now might be the right time.

The article The 2 Big Reasons Whole Foods Market Inc. Is Getting Hammered originally appeared on Fool.com.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Whole Foods Market. The Motley Fool recommends American Express and Whole Foods Market. The Motley Fool owns shares of Capital One Financial., JPMorgan Chase, and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.