Competition that Brought Down the Market

By Chad Henage - July 16, 2012 | Tickers: SWY, TFM, KR, WFM | 0 Comments

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It's one thing to love a stock because it displays all of the traits that you want in a company. It's something else to love a company because they are one of the few doing business a certain way. In a recent article by Nicole Seghetti of The Motley Fool, she suggests that Whole Foods Market (NASDAQ: WFM) is a stock she loves. I've written before, that this stock seems destined to leave some investors heartbroken. With a 26.8% gain since January when I last looked at the company, the story seems to just get more risky.

In Nicole's article, she points out that Whole Foods' advantage is the company operates with a focused mission of serving the organic food segment of the grocery market. Since organic food is one of the fastest growing segments of food retail, it makes sense that the company would benefit. Where I start to get concerned is when I hear statements like this segment is, “growing at 17% to 20% for the past several years and is expected to continue at this pace.” The thought that immediately comes to mind is a comment by Peter Lynch. He said that some industries can get so hot that no one makes any money there anymore. Clearly if organic food is going to show this type of big-time growth, other companies are not going to just sit on the sidelines and let Whole Foods take over the industry. While the company plans to triple its footprint of stores in the U.S., and same-store sales have increased by, “7% over the past 10 years on average,” these trends might not be enough to justify the company's multiple.

Just for point of comparison, let's look at a few companies that Whole Foods competes directly against. I know in the past, that I've gotten chided because I dared to compare Whole Foods to traditional grocers like Safeway (NYSE: SWY) and Kroger (NYSE: KR), but these are real competitors. Both of these chains sell their own private-label organic-food products. While this isn't their primary business, if they see bigger growth coming from their organics, you better believe they will expand this selection. Additionally, Whole Foods is not alone in the organics market. With just 116 stores, The Fresh Market (NASDAQ: TFM) operates a similar business, and is actually expected to grow faster than Whole Foods. Look at these companies side-by-side:

You can see that the two companies focused on the organics market are expected to grow much faster and their stocks are being valued accordingly. What is interesting is, while both Whole Foods and The Fresh Market are selling for nearly twice their growth rates, Kroger and Safeway are both selling for multiples below their growth rates. If you are looking for income, Kroger and Safeway are the only real options. Ironically, if you believe in organic-food growth, you could make a case that The Fresh Market could be a better value. The company sells for a slightly higher multiple, but is expected to grow faster than Whole Foods. In addition, while Whole Foods' gross margin is slightly higher, The Fresh Market has about one-third of the stores, so the company's runway for growth should be longer.

The bottom line is, Whole Foods is going after a fast growing part of the grocery market. As the company grows in size and consumers continue to demand better quality organics, other grocers and retailers will move to carry a larger selection. Whole Foods might be a decent play on this market today, but over time competition will eat into profit margins. At over 38 times forward earnings, I know the stock is loved. To my eyes though, this looks like looking for love in all the wrong places.

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