Can Whole Foods Market Win by Being Upscale and Downmarket at the Same Time?

By Markets Fool.com

It will be trial by fire for Whole Foods Market as it opens its third 365 discount store, one that will be in close proximity to a namesake store. There are concerns it will cannibalize sales. Image source: 365 by Whole Foods.

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The importance of Whole Foods Market (NASDAQ: WFM) opening its third365 by Whole Foods can't be overstated, because this one will be the chain's closest discount store yet to one of its existing sites. The chain hasn't seen much cannibalization of sales from its first two stores, but the proximity of this outlet to its Bellevue, Washington, location will give it the chance to confirm its belief that it has created a concept that will attract a whole new set of customers to the chain.

A cornucopia of choice

Whole Foods has run into a competitive logjam. Customers who once were only able to find fresh organic produce and other organic options at the high-end grocer can now buy the same kinds of goods at Kroger (NYSE: KR), H-E-B, and Wegman's. Indeed, Kroger recorded its 50th consecutive quarter of same-store sales growth in June, reporting comps that rose 2.4% when excluding fuel sales.

Moreover, Kroger recently made a strategic investment in specialty grocery store chain Lucky's Markets, a chain of 22 stores featuring natural, organic, and locally grown products. That follows its attempt to buy The Fresh Market (which was subsequently bought by private equity firm Apollo Global Management for $1.4 billion) and its acquisition of Roundy's, which also operates the Chicago region's popular Mariano's Fresh Market.

Further, more competitors are opening up smaller, more conveniently located stores, so customers who were once willing to drive some distance to shop at a Whole Foods no longer feel compelled to do so, particularly since it's still largely viewed as a pricey place to buy groceries.

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Gorging itself on discounts

Which is why there's concern that 365 by Whole Foods will ultimately siphon some sales away from its parent's stores. Given that they feature the grocer's store brand products and much of the same fresh produce, it's not so far-fetched to imagine that some customers will switch formats. And a comparison of prices by the Today show found 365's to be comparable to or lower than Trader Joe's.

But so far, that hasn't happened. Its Lake Oswego and Silver Lake stores in the Los Angeles area haven't seen much cannibalization of sales from its established stores at all -- if any -- but it has learned a thing or two about 365 customers.

For example, they're actually buying more than the usual customers at its Whole Foods stores -- so much so that it is redesigning the front checkout area at the 365 stores to account for the difference. It's also found the "Friends of" partnerships to be working out better than expected. Whereas its Chloe partner in Lake Oswego was off to the side, Next Level Burger at Silver Lake was right within the store itself, and has had a bigger impact. Whole Foods will be incorporating that design into future 365 stores, and will eventually migrate the partnership program to Whole Foods stores too.

An affinity for growth

Whole Foods Market is also building out its customer loyalty program, which should continue to give it insights into its clientele's needs. By closely monitoring how its customers shop and what they buy, the company will be able to target them better. But the 365 stores have their own program called Gimme 10 that provides customers with a 10% discount off select items. In the first six weeks since rolling it out, Whole Foods says the app has been downloaded16,000 times, and every 365 store that opens hereafter will have that program available.

The problem for Whole Foods is it's running short on time and investor patience. It continues to suffer from a sales deceleration that's turned a two-year stack of 0.6% comps growth in the first quarter into a 1.3% decline in the second, and the potential for this to remain negative in 2017 remains high.

Attacked from all sides

At the same time it remains under pressure to reduce its cost structure while investing heavily in pricing and initiatives that lure more customers to its stores. Part of that has meant scaling back its capital investments, and reducing square footage growth to 6% this year compared to 7% last year.

Which explains why Whole Foods needs this 365 concept to succeed without hurting sales at flagship stores. That would let it grow its base but stop the cannibalization that has occurred as it opened up new namesake stores.

The early indications are that it will achieve its goals, but this new Seattle area store -- and the fourth 365, which will open in Ohio -- will be the real tests of the concept. Investors should watch closely what Whole Foods Market has to say during its fourth-quarter conference call to see if the organic grocer can avoid eating itself alive.

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John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.