Can Whole Foods Maintain Its Margins?

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the organic and natural grocery business Whole Foods (NASDAQ: WFM) is the largest player in its market, with over 350 stores and annual revenue of $12 billion. Whole Foods also has extremely high margins compared to traditional grocers, achieved by charging higher prices for its high-quality products. But are these margins sustainable? As the company grows to 1,000 stores, which the company has set as its target, will Whole Foods continue to enjoy these lush margins?

The problem with Whole Foods

Sometimes called Whole Paycheck, Whole Foods charges higher prices than traditional supermarkets on many items. There are some products that are cheaper at Whole Foods, but on the whole a typical grocery trip will be far more expensive at Whole Foods. And it's not just the unique items which you can only find at Whole Foods that are expensive--brand name items are often sold at significant premiums compared to other supermarkets. One example, which I noticed at the Austin, TX store recently, is a bag of King Arthur flour that was selling for $4.99. This is a 25% premium over another supermarket in the area.

In areas with a high-concentration of health-concious individuals with decent incomes, Whole Foods can charge these types of prices. But many areas are not like Austin. And at 350 stores my guess is that the company is running out of high-margin opportunities. Earlier this year the company announced that it would become more aggressive on price in order to appeal to a broader customer base. So far this hasn't affected margins due to increased efficiencies, but as competition heats up in the space Whole Foods won't be as able to charge such high prices any more.

It's getting crowded

While Whole Foods certainly has the first-mover advantage, there are several companies gunning for the company's top spot. Sprouts Farmers Market (NASDAQ: SFM), a chain of about 160 smaller grocery stores focused on fresh and healthy foods, had its IPO last week. Currently located in just 8 states, the IPO will provide capital to rapidly expand to new markets, and the company expects to grow its store count by 12% or more annually for at least the next five years.

Sprouts dedicates a significant fraction of its floor space to produce, an area that health-conscious shoppers care about. Here is a typical store layout:

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This is very different than a traditional grocery store, with packaged goods often getting center stage. The focus on natural products, often with lower prices than Whole Foods, makes Sprouts a serious competitor.

Traditional grocers, left behind by the organic and natural foods craze, are finally getting in on the act. Kroger (NYSE: KR), the largest grocer in the country, recently acquired small upscale chain Harris Teeter. Harris Teeter is known for fresh foods and produce, and Kroger believes the chain has room to expand. Kroger may also improve its own stores by learning from Harris Teeter's approach to fresh foods.

This deal gives Kroger a piece of the upscale grocery market and represents another obstacle for Whole Foods. If traditional grocers like Kroger can start carrying wide varieties of organic and natural items at lower prices, Whole Foods will almost certainly see its margins decline.

The biggest threat to Whole Foods, though, may very well be privately-held Trader Joe's. Trader Joe's has nearly 500 stores, although about half are located in California, and the typical store size is much smaller than Whole Foods. About 80% of products sold are private label, allowing Trader Joe's to offer extremely low prices on high quality goods. The company achieves $1,750 in revenue per square foot, more than double the rate of Whole Foods.

Trader Joe's is rapidly expanding, and the company is set to soon open three stores in Austin, where Whole Foods was founded. With prices often lower than Whole Foods, albeit with less of a variety of items, Trader Joe's may force Whole Foods to lower their prices even further.

The bottom line

Whole Foods is facing an assault on its high margins. New stores, built in less prosperous and more competitive areas, will likely drag down margins company-wide. And competition, especially from Trader Joe's, will cause Whole Foods to lower prices in order to compete. It seems that the days of Whole Foods being the only healthy grocer available in many markets are coming to an end, and with the stock trading at such a high premium any margin compression or slowing of same-store sales growth will likely lead to a significant drop in the stock price. Following the crowd into Whole Foods is probably a bad idea.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends 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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