What Whole Foods Can Learn From This Turnaround Retailer

Whole Foods Market Inc stock continues to go from bad to worse. Same-store sales have flattened, and profits have been cramped by rising competition. Meanwhile, the company's image problems have compounded, with a New York City investigation finding the chain's packaged goods to be wrongly weighed and priced, while a photo of $6 asparagus water went viral.

Earlier this year, the company was criticized by the financial media when it announced that it would go downscale with a separate chain of stores known as 365 by Whole Foods, and shares fell as a result of the announcement. The new chain will consist of smaller-footprint stores offering lower-priced goods, and is targeted at millennials.

Source: Whole Foods

While some commentators insisted the new chain was a sign of capitulation from Whole Foods and that its business model is failing, the move is actually reminiscent of steps taken by a number of department-store chains that have found success by going smaller and cheaper.

Macy'ssaid it would begin opening its bargain-based Backstage stores this summer, following the lead of rivals such Saks Off Fifth, Neiman Marcus Last Call, and Nordstrom Rack. Of those three, Nordstrom Rack offers the best example of the power of an off-market brand.

A little historyNordstrom opened the first Rack in 1973 in Seattle as a clearance outlet for its full-line stores, but it wasn't until the last decade that the brand really took off.Rack's store count has more than doubled since 2010, growing from 86to 178 as of last count, now outnumbering its full-line store. The retailer expects to have 300 of the smaller stores by 2020,while Nordstrom's full-line store count is growing at a much more average pace. It's clear from that divergence that the company is counting on Rack to be its primary growth driver for the foreseeable future.

The off-price brand is a natural response to the success of discount brands such asTJX Companies-owned T.J. Maxx and Marshall's, and it makes sense for a high-end company such as Nordstrom to reach out to a younger demographic that wouldn't ordinarily shop at its full-line stores. Indeed, Rack's own success has been self-evident. Sales have increased by double digits every quarter for 26 quarters, driven primarily by new store openings, and the line is on track to deliver $4 billion in revenue this year.

Management also addressed concerns about cannibalization on last week's earnings call by sharing that 1 million Rack customers started shopping at the full-line stores or nordstrom.com last year. Far from taking away from the company's principal business, the Rack stores have introduced a new generation of customers to the brand, reinforcing it instead of weakening it. Nordstrom investors have been rewarded handsomely, with the stock up seven times since the recession.

What it means for Whole FoodsWhole Foods occupies much the same space within the supermarket industry as Nordstrom does in department stores. As high-end department stores were undercut by outlets and discount chains, Nordstrom responded in kind with Rack. Whole Foods is experiencing a similar unraveling as its stranglehold on organic food has been upset by mainstream chains likeKrogerandWal-Mart,which have stocked up on organics, as well as alternative players known for lower prices like Trader Joe's.

Responding with the Rack-like 365 will help Whole Foods regain some of the share it's lost by better competing for the customer who doesn't need the full Whole Foods experience and wants to save a few bucks. A smaller footprint will also make it easier to find space in densely packed cities where millennials congregate, and bring in new shoppers who may be skeptical of the Whole Paycheck image into the brand, creating potential lifelong customers.

With only five 365 stores set to open next year, the rollout and the bottom-line impact will be slow initially, but 365 has the potential to reinvigorate the brand for the long term. Just as Rack has done for Nordstrom, 365 could not only be a success in its own right, but also pump up its not-so-fresh parent.

The article What Whole Foods Can Learn From This Turnaround Retailer originally appeared on Fool.com.

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

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