Thursday, November 7, 2013

Can Whole Foods ever be cheap?

Whole Foods Market, historically, has not competed on price. That's been a successful strategy, because its educated, affluent shoppers assume that quality must just come at a premium. They're willing to shell out significantly more for pesticide-free pears and artisanal cheese than they might at the Kroger or Safeway down the road.

The price isn't simply a function of the cost of goods, though. Whole Foods' profit margins have been significantly fatter than the supermarket industry's notoriously slim one for years now, at some 3.8 percent to the average of 0.7 percent, to investors' delight: The stock trades at about twice the price of its rivals. Some of that comes from a product mix that skews more toward prepared foods, which command higher prices, but it also benefits from a squishy perception cushion that prevents customers from comparison shopping quite as ruthlessly.

"I think that the conditioning, right or wrong, may be that organic product costs more than genetically modified product," says Joe Feldman, a grocery analyst at Telsey Advisory Group. "So, buying the natural oat-bran cereals, people may just assume this is a natural organic product, and I'll pay a little more for that."

That perception game has stopped working, though. And Whole Foods is trying to figure out if it can catch up. Other grocers, especially in the urban markets that Whole Foods has started to saturate -- even convenience stores! -- are getting on the local and natural bandwagon. Economies of scale are bringing down the cost of organics, which might lead consumers to adjust their expectations about how much they should pay. And yet, Whole Foods continues to go head to head with other grocers: As a case in point, it just announced plans to open in Northeast Washington, blocks away from a brand-new Giant and not much farther from a high-end Wal-Mart.

For a while now, Whole Foods has been trying to strategically lower prices to match surrounding competitors -- "price investments," in industry jargon -- that lower profits in certain stores. It's also opening new stores in low-income parts of Detroit and New Orleans, with fewer staff, more frozen and packaged food, and a new message: This stuff doesn't have to cost quite as much.

Profit margins continued to do well for a while, as the company found ways to economize by reducing "shrinkage," or spoiled food. But the strategy is finally taking a toll on sales growth, which slowed over the past quarter, even as the company added stores at a quick clip. On the company's earnings call Wednesday, analysts wanted to know why lower prices hadn't led to more sales, as they're supposed to; executives chalked it up to a challenging macroeconomic environment and cannibalization from new Whole Foods outlets that have opened close to each other.

Long term, Whole Foods thinks it can bend the cost curve through growth. Thus far, it's managed to have a nationwide footprint with only 367 stores by sourcing locally, rather than having the massive centralized distribution centers that feed regional supermarkets such as Kroger and Fred Meyer. It aims to get to 1,000 stores, and adding more in certain markets -- like it's doing in the District and Boston -- would allow it to achieve the same efficiencies as its competitors on nonperishable stuff.

And competition is only growing. Natural and gourmet foods retailers Sprouts and Fairway went public this year, giving them the capital to go national. Even Wegmans is experimenting with smaller, urban-format stores.
br> At this point, the fact that Whole Foods has gotten away with sky-high margins for so long may be working in its favor. If it has to make less money to retain customers, well, it's only a recognition that it's in the same business as everybody else.

Source: Washington Post

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