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Whole Foods Faces Tough Economic Times

Jim Prevor’s Perishable Pundit, August 7, 2008

Whole Foods announced its earnings and held a conference call in which, among other things, it announced some major changes — such as suspending dividends:

While we are still producing strong cash flow, the challenging economic environment appears to be negatively impacting our sales and bottom line. This, combined with our commitment to maintaining financial flexibility and investing prudently in our long-term growth, has led us to announce the following proactive strategy:

We are lowering our expected new store openings in fiscal year 2009 to 15 from our prior range of 25 to 30. While we were ready to execute on the acceleration in our store openings, we now wish to take a more conservative approach to our growth and business strategy over the short term.

We have cut all discretionary capital expenditure budgets not related to new stores by 50 percent. We believe our existing store base is in very good shape based on our philosophy of continual investment and do not expect this decision to have any negative consequences over the short term in terms of our customers’ in-store shopping experience.

We are focused on the right size store for each market and, since announcing in Q3 of 2007 our intent to decrease the size of several leases in development, we have downsized eight leases by an average of 9,000 square feet each. Throughout our history, we have continued to push the envelope on store size. When we opened our enormously successful 80,000 square foot store in Austin, it had a ripple effect on store size and format throughout the company. With hindsight, reflection, and some data points in front of us, we see that the really large stores are very powerful in limited markets and circumstances, and that smaller stores can also produce great returns for us. We believe that a store size of 35,000 to 50,000 square feet is more appropriate in most circumstances to maximize return on investment and EVA, and we expect the majority of our stores to fall within that range going forward. We are also actively working to drive down the average development cost per square foot.

G&A was 3.3 percent of sales in Q3, reflecting certain cost containment measures that have already been implemented. For fiscal year 2009, we expect G&A to return to our historical levels of approximately 3.2 percent of sales.

We are also announcing the suspension of our cash dividend. At this time, we no longer have excess cash available to distribute to our shareholders, as that cash is needed to fund our growth going forward.

We believe that through these decisions, which we have not undertaken lightly, our company will emerge stronger and better positioned to realize our growth potential and fulfill our long-term mission and core values.

Perhaps… but the reaction on Wall Street and in the media to its announcements was not positive. Here is how Business Week played the news:

Whole Foods’ Big Markdown

Shares of the U.S. natural foods leader plunge after it posts a 31% profit drop, as economic troubles hit the organic grocery market

Investors tossed aside Whole Foods’ (WFMI) shares like they were wilted arugula on Aug. 6 after the company reported rotten third-quarter results.

What is the key problem? Business Week summarizes it in this way:

AMID SLOWDOWN, HIGH-QUALITY IMAGE HURTS

For years, the Austin (Tex.)-based company has fed off the popularization of organic foods, seeking to cater to “customers aspiring to a healthier lifestyle” with organic vegetables, high-quality meats, and gourmet cheeses. The company, which runs 271 stores in the U.S., Canada, and Britain, booked $6.6 billion in 2007 revenue.

But as inflation and growing unemployment have taken a bite out of consumers’ purchasing power, some are shunning the store’s high-quality image in search of cheaper alternatives. After the temporary boost in May from government stimulus checks, inflation-adjusted disposable income for U.S. consumers dropped 2.6% in June. As a result, according to a recent 70-person survey from equity research firm ThinkPanmure, 19% of organic food shoppers said they were purchasing less natural and organic food than they did in the past, because of difficulities such as falling home prices, lower job security, and commodity inflation.

“I had thought that once you start buying natural organic, you don’t go back,” says Susanne Price, vice-president for research at ThinkPanmure. “But the fact that 19% were willing to shift backwards was surprising.” Price says that a wider survey range would probably bring about an even greater percentage of those willing to trade down for groceries.

There are some specific problems. The UK operation is hemorrhaging money, having lost 18 million dollars in the last twelve months — although the company sees these as start up losses similar to what it once experienced in Canada — now a profitable operation. It 80,000 square foot superstores are turning out to not be optimal for profits — so future growth is mostly expected to be stores between 35,000 and 50,000 SF

More broadly in a time of tight capital markets the company has simply been spending more cash than it was taking in — thus the slowdown in capital investments and elimination of the dividend. Here is how the company described the situation this quarter:

During the quarter, the Company produced approximately $110 million in cash flow from operations and received approximately $2 million in proceeds from the exercise of stock options. Capital expenditures were approximately $125 million, of which approximately $110 million related to new stores and approximately $8 million related to Wild Oats stores.

In addition, the Company paid approximately $28 million in cash dividends to shareholders. At the end of the quarter, the Company had total debt of approximately $840 million, including $106 million drawn on its credit line. The Company increased its credit line to $350 million during the third quarter and currently has $123 million available on the facility.

With $110 million in cashflow and capital expenditures and dividends of $153 million, the negative cashflow was $41 million or, in other words, with $123 million on its line of credit, in three more quarters such as this one, the company would have been out of cash.

In these credit markets, slowing capital expenditures and cutting the dividend is the only prudent course of action.

Yet one wonders what the future holds for Whole Foods. Its growth has brought it far beyond that core audience of deeply committed aficionados, so many of its customers are now likely to find alternatives if times turn tough.

Even those deeply committed to organic have many opportunities at every supermarket — Wal-Mart, Costco, Target etc. — than they have in the past.

Also Whole Food’s emphasis on its Whole Body spa products line places it deeply into the discretionary consumer spending area and away from the core food business.

Whole Foods has been trying hard to get away from its “Whole Paycheck” image, but this is a difficult game for Whole Foods.

Its core appeal is to consumers who believe that cheap food isn’t really cheap — that it imposes costs on the environment or that we pay in poor nutrition or lapses in food safety or taste. The more Whole Foods attempts to promote economic value — the more its core customers will think it has sold out.

It may put Whole Foods between a rock and a hard place.

One possible answer: Tesco. Tesco has coveted Whole Foods for a long time, but its pricey stock has made an acquisition prohibitive. But with a stock price down from $53.65 less than a year ago to a trade as low as $18.26 after its earnings were announced, the price is starting to make sense.

Besides they have complementary problems. As Whole Foods drains cash in the UK, Tesco hemorrhages money from its Fresh & Easy division in the US. Yet together both the UK and the American division would be profitable.

Perhaps the Fresh & Easy stores could be rebranded: Whole Foods Petite.

Of course, there is another retailer whose CEO is focused on things organic, sustainable and the other values Whole Foods stands for. The name: that would be Wal-Mart.

That acquisition would be tougher to get approved by anti-trust authorities. In fact, Whole Foods finally got its Wild Oats acquisition approved by arguing that there was no separate category of “natural foods supermarkets.” As such Whole foods and Wild Oats were just tiny players in a big food business. Wal-Mart would have to argue the opposite — that “natural food supermarkets” are a different market in which it does not currently compete.

Far fetched? Perhaps. But stranger things have happened.

What is clear is this: with Whole Foods putting the breaks on growth, organic producers will have to rethink their own growth plans.

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