Whole Foods (WFM, Financial) had a tough year in 2016. The company’s fourth quarter results, posted on Nov. 2, suggest that there is still plenty of work to do if they want 2017 to be better.
In the fourth quarter, comparable store sales declined by 2.6%, pulling the full year comp decline to -2.5%. As you think about the results for the fourth quarter, remember that Whole Foods' business took a turn for the worse in the third quarter of 2015 after the New York City Department of Consumer Affairs discovered weights-and-measures errors at the company’s stores in New York City. During the second quarter 2016 conference call, Chief Operating Officer A.C. Gallo discussed what this meant for the comparable results in the back half of 2016:
“When that happens in week 11 of this [third] quarter, we will begin to compare against that, and that's going to be a very positive – that's going to have a very positive effect on our comps.”
That “very positive effect” is nowhere to be found in the -2.6% comp reported on Wednesday. Management expected comps to improve as the comparisons became easier. With the fiscal year behind us, we can see that did not happen; in fact, the two-year stack continued to worsen.
In addition to declining comps, Whole Foods is feeling the impact of price investments. In fiscal 2016, Whole Foods gross margins were 34.4%, a decline of eighty basis points from 2015 (34.2% in the fourth quarter). While they managed to cover most of the impact by cutting selling, general and administrative expenses (as a percentage of sales), the company’s EBIT margins declined to 5.5% (it remains to be seen whether cost cuts will impact the in-store experience for customers). The net result for the year was a 5% decline in net income. EPS increased by 4% for the year to $1.55 per share, reflecting sizable share repurchases.
Looking forward, management appears prepared for another tough year. The guidance for 2017 calls for negative comps and lower margins. On the bottom line, guidance is for EPS of $1.42 per share – down 8% from 2016 (management's guidance excludes the impact of repurchases).
The disappointing results point to underlying issues at Whole Foods. They clearly lost market share throughout 2016 despite their attempts to sharpen pricing (oddly, after outlining a goal to lower gross margins by ~200 basis points over two years on the third quarter conference call, the pace of margin compression slowed meaningfully in the fourth quarter). Competitors like HEB, Wegmans, Publix and Costco (COST, Financial) are attracted by the outsized growth in natural and organics. Here is how Richard Galanti, Costco’s CFO, put it on the company’s recent call:
“We expect organic to be up 20% this year… It helps us with millennials. It creates a bigger competitive pricing moat, because we have as good, if not better quality at much better pricing.”
Here is another competitor, Kroger (KR, Financial), at their recent Investor Day. For some context, Kroger had more than $12 billion in natural and organic sales in 2015, with the company’s “Simply Truth” store brand growing revenues more than 50% (cumulatively) in the past two years:
“Long term, these lines [“Natural” gross margins and broader food business gross margins] are going to continue to converge. We don't see any real reason – we don't do anything incrementally to an organic banana versus the traditional banana. And the only difference we think that should be charged to a customer is if there's a difference in the cost of that product. We don't think just because it’s organic it should necessarily get a higher gross profit margin. That has not always been the case, but it's something we've been investing in [price] over time.”
As noted in a previous article, I estimate that Kroger has gross margins in its food business of roughly 25% - nearly 1,000 basis points lower than Whole Foods. Simply put, Whole Foods cannot compete in a head-to-head competition with Kroger (on pricing alone). Based on their commentary during recent conference calls, I think management largely agrees. Whole Foods must be “price relevant” without participating in a “race to the bottom.” To consumers, I think this means they should continue to expect higher prices for nearly identical products when shopping at Whole Foods (to be fair, “identical products” is a stretch in categories like prepared foods, at least in my opinion). Personally, I am not so sure closing the price gap with Kroger by ~20% will be enough to win back the noncore Whole Foods customer. This is all before considering direct competitors (The Fresh Market, Sprout’s (SFM, Financial) and Lucky’s, to name a few) as well as the long-term impact of emerging competition from Amazon (AMZN, Financial).
Whole Foods is struggling in an intensely competitive environment. While management has a few irons in the fire (like a nationwide rewards program, the expansion of the 365 format, a partnership with Instacart and meal kits), I think the tough times will continue. The unit economics are deteriorating. This cannot be fixed by building new stores or buying back stock (with the latter activity adding roughly $1 billion of long-term debt to the balance sheet in fiscal 2016).
My concern is that competitive pressures will intensify in the years to come, not weaken. The Whole Foods of a few years ago – the one that consistently reported mid- to high-single-digit same-store sales growth – is nowhere to be found. Today, simply reporting a positive number would be seen as a win for Whole Foods. It is pretty amazing how quickly fortunes can change in the world of retail.
I think there is a chance Whole Foods' best days are behind them. At the current valuation, investors are paying about 20x forward earnings for a retailer with negative comps and narrowing profit margins. One part of that equation - either the valuation or the fundamentals - will change.
For long-term investors, I do not think Whole Foods is particularly attractive at this point.
Disclosure: None
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