Is Whole Foods' Use of Exclusive Brands a Competitive Advantage?

By Markets Fool.com

Continue Reading Below

Whole Foods 365 Everyday brand. Photo: Whole Foods.

Whole Foods Market (NASDAQ: WFM) prides itself on its exclusive brands, such as the365 Everyday Valueand other products that made up 13% of store sales (18% of nonperishable item sales) during 2014.In the company's 2014 10-K, management said that selling exclusive brands "is a key component of our value platform and essential to our product innovation and differentiation strategy."

But are Whole Foods' exclusive brands really a competitive advantage? The Kroger Co.(NYSE: KR), Safeway(which is now privately owned by investment firm Cerberus Capital Management LP), and even Wal-Mart Stores (NYSE: WMT) all have their own exclusive brands. Here's why Whole Foods "differentiation strategy" might not be the competitive advantage it's piped up to be.

Whole Foods' 4,400 exclusive SKUs
Whole Foods' exclusive brands come from various private labels and exclusive contracts with small companies, which together total about 4,400 stock-keeping units, or SKUs, the way stores measure unique items, at Whole Foods across the country. During fiscal 2014, those products accounted for $1.8 billion in sales. Whole Foods says about half of those sales come from its main 365 Everyday Value brand, and about one-third are certified organic.

One way Whole Foods promotes exclusive brands is in partnering with smaller companies that are just getting started. Whole Foods stores are a sought-after market for start-up natural food companies that are vying for national shelf space but whose products are too niche or don't have the production levels to be picked up by many bigger retailers. Many small brands such as Feridiesnatural peanut productsgot their start by signing contracts with Whole Foods; many, but not all, of them are exclusive deals.

Continue Reading Below

Kroger's Simple Truth brand: Photo: Kroger

When everyone is exclusive, is anyone?
The threat to Whole Foods is not so much that many other brands have private labels (something national grocers have been doing for decades) but that these companies are developing and growing private labels uniquely for natural and organic foods.

Safeway introduced its Open Nature brand of all-natural items over three years ago, complementing theO organic brand released in 2005.

These large companies are also elbowing their way into Whole Foods' niche of doing business with local, small-scale brands. For example, Wal-Mart partnered to sell Wild Oatsitems in the big-box retailer's stores for an average 25% lower price than similar national brand organic products.

Whole Foods' biggest threat from an exclusive brand might be Kroger's Simple Truth brand. This line already has over 35,000 products, and sales reached $1.2 billion last year. According toJ.P. Morgan, Kroger should pass Whole Foods as the single-largest seller of organic food in the U.S. in two years.

Whole Foods comps have taken a nose dive
As these other grocers are each increasing their own exclusive brands push, especially regarding natural and organic items, increased consumer options is likely a major reason Whole Foods same store sales growth has been declining. Here's what same store sales look like for these three grocers over the last 4 years (by each companies' fiscal year end):


Source: Companies' 10-k filings

Putting Pressure on Margins
According to Safeway's CEO,exclusive products gross marginis around35% vs. 25% for name brand items. Whole Foods success with exclusive brands (and high prices)has led to agross margin around 35% compared to the industry average over around 25%. To counter act this decline in same store sales growth, Whole Foods would probably need to continue lowering prices, driving down its gross margin. If that happens, profit growth will also likely slow.

Investors' takeaway
Whole Foods' gross margins have fallen to their lowest point since 2011 at just below 35%. This is still well above the industry average of around 25%, but the trend toward lower margins and less competitive advantages with regards to these brands is not a good sign for much more earnings growth in the long term unlessthe grocer can offset this margin decline through increased sales and store openings.

With comparable-store sales growthdown to just 3.6% in the most recent quarter, the lowest in recent history and below the 8% rate realized just a few years ago the company will be challenged to produce that growth from new stores alone. And with Whole Foods' price-to-earnings ratio well above the industry at over 27 times over the trailing 12 months, declining earnings growth from lowered margins and weak sales growth might not bode well for the stock price going forward.

The article Is Whole Foods' Use of Exclusive Brands a Competitive Advantage? originally appeared on Fool.com.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Bradley Seth McNew owns shares of Apple. The Motley Fool recommends Apple and Whole Foods Market. The Motley Fool owns shares of Apple 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.