This Niche Industry Continues to Defy Skeptics

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According to data provider Nielson, the organic and natural food segment now accounts for roughly 13% of the grocery business’ total sales. While organic products were once considered to be a passing fad, they have entered the mainstream due to an aging population’s need for improved health through diet. In addition, a rise in childhood health problems, including food allergies, is prompting parents to rethink their children’s food intake. So, how does an investor ride this trend to investment gains?

Go with the leader

With 7 million customers visiting its stores each week, Whole Foods Market (NASDAQ: WFM) is the organic segment’s 500 pound gorilla, offering the widest selection of brand name and proprietary label products.  The company’s locations are more than grocery stores, with in-store cafes that offer community outreach projects like nutrition seminars and cooking demonstrations.  Whole Foods is also a big proponent of buying local, funding a national program that provides micro loan financing for budding food entrepreneurs.

In its latest fiscal year, Whole Foods reported another year of solid financial results, with increases in revenues and operating income of 15.7% and 35.8%, respectively, versus the prior year.  The company continued to add to its national base of stores, with twenty-four new locations, and it delivered a same store sales gain above 8%.  More importantly, While Foods achieved a record operating margin due to greater sales from its proprietary brands and economies of scale from more efficient operations in its new markets.

In 2013, Whole Foods is expecting double-digit sales and income growth once again, as it hopes to add almost 10% more stores to its network. With 349 stores, as of March 2013, the company is only a third of the way to its goal of 1,000 stores in the U.S. Additionally, greater expansion in international markets is a long term opportunity, given the universal need for better food choices.  

If something works, copy it

Of course, success breeds competition and Whole Foods’ challengers have been using the equity markets lately to fund their ambitious growth plans. The Fresh Market (NASDAQ: TFM) had a successful initial public offering in late 2010, as investors hoped to catch another rising star. While the company is only about a third the size of its larger competitor, with roughly 130 stores, it follows a similar strategy of selling locally sourced products in a neighborhood-friendly store format.

In its latest fiscal year, The Fresh Market also performed well, with increases in revenues and operating income of 20% and 21.7%, respectively, compared to the prior year.  Like Whole Foods, The Fresh Market enjoyed strong same store sales, up 5.7% for the period, and an improved gross margin due to a focus on proprietary brand products.  In addition, the company’s profitability gained from its ability to spread its overhead over a larger number of stores, as it expands beyond its southeast U.S. home base. 

Looking ahead, The Fresh Market sees strong domestic growth opportunities and has a long-term goal of 500 stores nationwide, versus the roughly 130 stores in existence today. With almost a quarter of its stores in Florida, The Fresh Market has plenty of metropolitan markets and new customers to attract. While the company is spending heavily on capital expenditures today, it should reap the benefits of a large and more efficient network over time.

Another recent public offering was Natural Grocers by Vitamin Cottage (NYSE: NGVC), a small chain of grocery and nutritional supplement stores that has company roots dating back to the 1950's.  Even more so than Whole Foods and The Fresh Market, Natural Grocers provides nutritional advice to consumers, with accredited health coaches located in each store. The company has growth ambitions that are consistent with its competitors, including an eventual expansion of its domestic store network to over 1,100 locations.

In its latest fiscal year, Natural Grocers outshone its primary competitors, with increases in revenues and adjusted operating income of 26.8% and 46.7%, respectively, versus the prior year.  The company benefited from a 20% increase in its overall store base and a double-digit same store sales increase.  While Natural Grocers is currently operating at negative cash flow, it is banking on national acceptance of its nutritional focus and enhanced efficiencies from a larger network of operations.

The bottom line

Healthy living and eating is definitely in vogue, as indicated by the operating results from the nation’s organic food purveyors.  Consumers’ willingness to pay a premium for natural and organic food products has led to relatively high operating margins for organic grocers compared to traditional grocery stores.  While The Fresh Market and Natural Grocers are still regional stories, Whole Foods has redefined its industry and belongs on investors’ radars.

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Robert Hanley owns shares of Whole Foods Market. The Motley Fool recommends The Fresh Market 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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