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Whole Foods Plans More Organic Growth

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

It's a tired cliché that everything's bigger in Texas, but I had to agree when I visited Houston two years ago. The wide freeways, sprawling subdivisions, and megachurches were foreign to me. So were the mammoth supermarkets.

Yet it was against this unlikely backdrop that America's leading chain of health foods stores was born, albeit in famously hip Austin, the state capital. Yes readers, Texas is the home state of Whole Foods Market  (NASDAQ: WFM) (and local rival mini-chain Central Market, operated by H.E. Butt) and this fact makes sense when you consider how large many Whole Foods stores have become.

Food courts redolent of the great markets of Europe, counters dedicated to the best of charcuterie, seafood, and meat, and shelves brimming with exotic, natural foods are the hallmarks of Whole Foods Markets. The chain introduced me to Greek yogurt, crusty baguettes, and nitrate-free deli meat, a tale repeated in thousands of households. It emptied my wallet but expanded my palate, stimulating demand for foods I never thought I needed.

Alas, the chain soon earned the moniker "Whole Paycheck." Its ever-expanding list of in-store amenities, including sit-down cafes and gelato bars, which brought the chain's prototype store to 50,000 square feet as of 2007.

The New Whole Foods

As the economy worsened, Whole Foods took action to lower its prices. It promoted its 365 private label more heavily, started offering guided "value tours" of its stores, and began printing more coupons. But this push was just the first phase of its evolution.

As of October 29, trade magazine Supermarket News reports on its website that Whole Foods is opening smaller stores as the chain aims for its target of 1,000 markets worldwide.

Measuring 38,000 to 40,000 square feet, the smaller stores cost less to build ($248 per square foot in 2011, a 22% decrease year-on-year according to Kate Wendt of Wells Fargo Securities) and are highly productive. As store size has decreased, sales per square foot have increased. Stores averaging 38,000 square feet generate $786 in sales per square foot, or $575,000 per week. In 2011, stores averaged 39,400 square feet and brought in $754 per square foot; in 2010, they averaged 42,600 square feet and brought in $652.

Smaller stores are more nimble and require fewer employees. Shelf space is limited, so they only stock the best sellers. Likewise, their smaller prepared-foods departments center on self-service areas such as the salad bar, which operate at higher margins than the more labor-intensive departments offered in larger stores.

The smaller prototype also allows Whole Foods to make inroads into secondary markets such as Des Moines, Lincoln, Neb., and Wichita, Kan., as well as underserved urban areas such as Harlem in New York City. (Supermarket News fails to mention that limited real estate in the largest cities often means that the highest-traffic locales host the smallest stores. This factor may also account for the high sales volume generated by small stores.)

Expansion on both fronts will help the company make progress towards its target of 1,000 stores worldwide in the U.S., Canada, and the U.K. The company has opened 14 stores in the first three quarters of 2012, less than the 100 per year that CEO John Mackey has said it is capable of, but reasonable enough that its culture and values aren't diluted. Analysts do not foresee any major acquisitions, although piecemeal deals for independents in desirable locations are possible.

The new stores include locations throughout the country, in both new and existing trade areas as diverse as suburban Parsippany, N.J., beach town Wilmington, N.C., Des Moines, and Oklahoma City. Domestic expansion, however, will focus largely on the Midwest, a region CEO Mackey said was once a source of frustration but is now the company's fastest-growing. Gradual international expansion in the form of three new U.K. stores, one in Markham, Ont., and possibly some in Ottawa, Montreal, and Calgary are also planned.

The diverse patchwork of new Whole Foods locations gives credence to Whole Foods execs' comments that they are starting to reexamine their notions of the types of communities that can sustain a Whole Foods Market, assisted by what Wendt terms the company's "unique regionalized operating structure [or] 'secret sauce'" that allows for decentralized decision-making, merchandising tailored to local tastes, and pricing determined by market conditions.

Getting Competitive 

Whole Foods' clear intention of moving even further into the mainstream stands in contrast to rival Safeway Inc.'s (NYSE: SWY) attempt to differentiate itself through an expanded array of organic foods and a renewed emphasis on wellness. But Safeway, or any publicly traded conventional supermarket for that matter, may not be Whole Foods' strongest competition.

Instead, privately held Trader Joe's is a looming threat as it expands into new states, such as Florida, that already host Whole Foods Markets. Run by the billionaire brothers behind German discounter ALDI, it has a reputation for lower prices, operates stores that make Whole Foods' latest model look gargantuan, and keeps staffing costs down by eliminating in-store bakeries, butchers, delicatessens, and fishmongers.

A Wells Fargo study by Wendt and featured in the August 27 issue of Supermarket News found Trader Joe's prices for a representative basket of 100 items to be 4% lower than Whole Foods, which nonetheless beat those of smaller rival The Fresh Market (NASDAQ: TFM) by 14% and Safeway by 7%. This finding is particularly striking when Whole Foods' greater level of service, stronger focus on organics, wider variety of merchandise, and more upscale reputation are taken into account.

Finally, Whole Foods' 6% operating margin is impressive compared to Safeway's 2.5%, but lags behind The Fresh Market's 8%. Safeway's higher prices don't seem to be winning enough fans to compete on the same plane as Whole Foods, and its relatively high cost structure and labor issues certainly don't help its profitability either. Meanwhile, The Fresh Market's more conventional - as opposed to organic or all-natural - products somehow command higher prices and are more profitable than either competitor's. The chain seems to be enjoying the first-mover advantage of having entered smaller markets, such as Albany, N.Y., and Destin, Fla., before Whole Foods.

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Whole Foods has been on a tear, making its customers and investors happy over the past year, but is its push into the heartland with smaller stores still working? And is it maintaining its mojo? We'll find out on Wednesday, November 7, when it releases its latest earnings report.


whywalkrandomly has no positions in the stocks mentioned above. The Motley Fool owns shares of Whole Foods Market. Motley Fool newsletter services recommend The Fresh Market and 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.If you have questions about this post or the Fool’s blog network, click here for information.

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