Retail Memo: The 'Whole Analysis' - Whole Foods Market Inc's First Quarter Financials, FTC v. Whole Foods...The Natural Grocer At Home and Abroad

Whole Foods Market's flagship store and corporate headquarters in Austin, Texas. [Photo Credit: Whole Foods Market, Inc.]

Whole Foods Market, Inc. reported its first quarter fiscal year sales and profits on Wednesday afternoon (February 18), after the financial markets closed. [You can view Whole Foods' detailed financial release at the link here: Whole Foods Market Reports First Quarter Results.]

The good news

Whole Foods' beat stock analysts estimates in terms of its Q1 profits, despite the fact the natural foods grocery chain's profit dropped by 17% during its first quarter, to $32.3 million, compared to $39.1 million for the same quarter last year. Overall Q1 revenue increased by $2.5 billion over last year's first quarter revenue.

As a result of beating analysts estimates, Whole Foods Market, Inc's stock soared by a whopping 34% in trading on Thursday and Friday, following Wednesday's report. That's a much needed boost for Whole Foods' stock since its per-share value had dropped by about 75% (from its 52-week high) prior to Wednesday.

The bad news

In addition to the 17% Q1 net income loss, Whole Foods Market, Inc. experienced for the first time in the company's history a quarterly drop in same-store sales. Sales at stores open for at least one year decreased by 4% in the first quarter. Same-store sales are an important industry indicator of a retailer's performance.

Whole Foods' senior management has found great pride, as it should, in the fact that same-store sales has increased every quarter, until now, for the natural foods grocery chain.

But in the current severe economic recession, it isn't a surprise to Natural~Specialty Foods Memo (NSFM), nor should it be to investors and industry observers, that Whole Foods Market, Inc. experienced the decrease in same-store sales in its first quarter. Having said that, this is something the natural grocer must reverse in the second quarter.

As we've previously reported, Whole Foods Market made a number of cost-cutting moves last summer, including laying off about 100 employees at its corporate headquarters in Austin, Texas, in hope that in the face of reduced sales it could stem its loses. It's likely that without those cost-reductions the natural and organic foods grocer would have shown poorer Q1 results.

During a conference call with analysts on Wednesday, Whole Foods said it has enacted a salary and hiring freeze going forward as a way to further cut costs.

In the conference call, Whole Foods' CEO John Mackey said the company is seeing early signs that increased sales, do largely to more aggressive pricing and promotions by the retailer, may be stemming the same-store sales decrease experienced in the first quarter. Of course, with the recession continuing to get deeper and worse, it's near-impossible what the next couple of months will bring for more upscale, specialty-oriented grocers like Whole Foods Market.

It's our analysis that Whole Foods still likely has some cutting to do because we believe, as do most experts and analysts, that the recession is going to get worse before it gets better, even with the $787 billion economic stimulus package signed by President Obama, and that the remainder of 2009 will see cash-strapped consumers continuing to trade-down in terms of shopping more at discount food retailers, along with spending less money overall on food and groceries because the plain just have less to spend.

We do see some positive signs, based on store visits and interviews and discussions with shoppers, that Whole Foods' new value emphasis, in which it has lowered some prices, is offering better promotions, including coupons, focusing more on basic items, along with featuring less expensive store brands more often, is beginning to bare some sales fruit at store-level.

FTC v. Whole Foods: The FTC-induced bad news

As Natural~Specialty Foods Memo (NSFM) has been reporting on writing about regularly, Whole Foods Market, Inc. continues to battle the U.S. Federal Trade Commission (FTC) over the natural grocery chain's friendly 2007 acquisition of Wild Oats Market, Inc. At present, Whole Foods and the FTC are in negotiations over a possible settlement to the long and protracted FTC legal case against the deal.

The FTC has a halt of further legal proceedings in place until March 6, while the two parties are negotiating a possible settlement.

Should a settlement not be reached by then, the FTC will go forward with its legal challenge to the merger. The regulatory body has an April 6, 2009 date set to begin an Administrative trial in which an FTC Administrative Law Judge will hear arguments from Whole Foods and the FTC on the deal and rule on its outcome, which could include an order to break-up the now nearly-100% merged grocery chains.

Whole Foods Market, Inc. reported Wednesday that it spent a whopping $11 million in the first quarter alone on legal costs related to fighting the FTC challenge to the merger. This $11 million is a significant contributor to the natural and organic grocer's 17% income loss in Q1.

Since it's our argument that the FTC is wrong in its argument and legal case that a combined Whole Foods-Wild Oats represents a monopoly in 29 U.S. markets, in what the regulator calls the "premium natural and organic retailing segment (PNOS),"we strongly suggest this $11 million expense was an unnecessary one for Whole Foods. In fact, were we an investor in Whole Foods Market, Inc., we would protest the FTC's continued legal challenge to the merger to the President and Congress, arguing that doing so by the FTC is a misuse of taxpayer funds.

Because of the serious challenges Whole Foods is facing due in large part to the the bad economy, along with increased competition from other natural foods class of trade retailers, supermarket chains moving increasingly into the natural and organic products space, and discounters like Wal-Mart, Costco, Target, Trader Joe's and others, it could have used that $11 million for promotional and other merchandising purposes rather than having to spend it on legal counsel.

After all, do Whole Foods' first quarter financials look to any reasonable person reading them like the sales and income numbers of a retailer that holds a monopoly in any so called segment of the U.S. food and grocery retailing industry?

We think not. And just because the company's stock soared by 34% on Thursday and Friday, that means very little in the medium-to-long run. Wall Street plays the expectations game. Whole Foods Market's Q1 numbers were much better than many analysts thought they would be. Therefore, the natural and organic grocer's having beat these estimates, the stock soared. Remember, what goes up, particularly in the stock market, also comes down -- and often times nearly as rapidly as it went up. Investors also were looking hard for companies to invest in last week, which helped fuel a flight of cash into Whole Foods' stock.

It's our analysis and opinion that the FTC case against Whole Foods Market, Inc. has actually become an economically punishing one for the company and its shareholders. This at a time when the federal government is spending hundreds of billions of dollars of taxpayer money to keep companies in other industries -- financial services, automobile manufacturing -- alive.

General Motors is now asking Congress and President Obama for another $21 million and Chrysler, which is majority-owned by the Cerebus private equity firm (about 80% ownership) is asking for an additional $5 billion.

Meanwhile, an agency of this very same government, the FTC, is prosecuting a legal battle against Whole Foods Market, Inc. that cost the retailer and its investors $11 million in the first quarter, millions more before that, and possibly million more in the next couple months unless a settlement is reached with the FTC.

This is just wrong. The FTC argument is folly, in our analysis. And at a time when the federal government is bailing out a host of companies, it is doubly-wrong that the FTC is pursuing a course of action that is significantly contributing to severe struggles by Whole Foods Market, Inc., as well as costing its investors money.

There is some indication our argument, and those of others, has sunk into the heads of some of the FTC Commissioners -- and we hope it has -- which could be one of the reasons they've decided to work towards a settlement agreement with Whole Foods.

The 'whole' conference call

There were a number of other announcements and points of information of interest during the analysts' conference call with Whole Foods on Wednesday. Below is a summary of those key points of interest as stated in the conference call by the company's senior executives:

~"Although transaction count and basket count are still down, the decline in transaction count has improved slightly. While it is obviously still too early to say our sales are stabilizing, we (Whole Foods) are encouraged by these trends."

~"Competition continues to be a factor as retailers fight over fewer food dollars being spent. Cannibalization also remains a factor, but to a lesser degree."

~"Whole Foods Market private label SKU count increased 11% year-over-year, accounting for 22% of our total grocery and Whole Body sales."

~"We (Whole Foods) plan to roll out a 5-Step Animal Welfare Rating system beginning in our United States stores later this year."

~"We (Whole Foods) reduced our planned new store openings by 50% for fiscal year 2009 to 15 from a prior range of 25 to 30. We terminated 11 leases in development, totaling approximately 570,000 sq ft, and down-sized nine leases by an average of 10,000 sq ft each."

~"We (Whole Foods) spent a lot of time in Q1 really focusing on values especially in produce, meat and seafood. And we've seen a lot of very good reaction to our promotions that we've done in those areas."

~"We (Whole Foods) believe the long-term growth and return potential in the United Kingdom is much greater than Canada, and we're taking some proactive steps to improve our operations there."

Whole Foods United Kingdom

This last point about Whole Foods Market's favoring the long-term growth and return potential in the United Kingdom over that in Canada (those are the only two international markets the company operates in outside the U.S.) is extremely interesting.

During the conference call Whole Foods' said it is breaking up its UK stores into separate geographical regions, similar to what it does in the U.S. That shouldn't be too hard a task at present since all of its UK stores are located in London, England.

Whole Foods Market, Inc. currently operates five stores in the UK, all in London, England, as mentioned above. Only one of the five stores, its nearly 80,000 square foot natural-organic and premium food emporium in the huge The Barkers Building on 63-97 Kensington High Street in London, has operated under the Whole Foods banner since it was opened, which was in 2007. The other four London stores have operated under the Fresh & Wild banner. Fresh & Wild was a small, UK-based natural products chain Whole Foods Market, Inc. acquired a few years ago.

Whole Foods is in the process of changing the name of the remaining Fresh & Wild banner stores to its Whole Foods banner, so that all of its UK (read just London for now) stores operate under the same banner -- Whole Foods. The rebranding is set to be completed by the end of this month. [You can view a list of Whole Foods' UK-London stores here.]

The nearly 80,000 square foot Kensington High Street Whole Foods banner store the retailer opened about two years ago has been a struggle for the natural grocery chain. During its first year of operation, 2007, the aisles of the huge market were almost always empty. However, beginning towards about the end of the first quarter in 2008, business started to pick up considerably at the market, after Whole Foods made a number of changes to the store, along with initiating more aggressive promotions and other merchandising and marketing initiatives.

But beginning in about October of last year, business dropped at the upscale store, as it began doing at most all of Britain's premium and natural foods-focused food stores because of the financial-credit crisis and deepening of the global economic recession. The struggle in the down UK economy continues for the Kensington High Street Whole Foods, as it does for other natural grocers and upscale UK supermarket chains like Waitrose and Marks & Spencer.

Like in the U.S. at present, British consumers are flocking to discount stores where they can save money on their food and grocery purchases. The fastest-growing food retailer in the UK in terms of sales and market share growth over the last year has been Aldi-UK, the British division of the global small-format, hard-discount Aldi International chain, which is based in Germany.

Aldi's U.S. division, Aldi USA, which operates almost 1,000 small-format, hard-discount stores in the U.S., also has seen a dramatic increase in business during the recession. It's growing fast and plans to open 100 new stores in the U.S. this year, including moving into the new markets of New York and Texas, where Whole Foods market is based. Aldi USA also moved into Florida for the first time in late 2008.

Aldi-UK is increasingly (more so than Aldi USA) offering natural, organic, specialty and premium food and grocery products in its UK stores, in most cases under one or more of its various store brands. These items sell for 15% -to- 30% less everyday than comparable items at UK natural foods stores and upscale supermarkets like Waitrose. As a result, Aldi-UK is taking some share away from these format stores in the natural and specialty categories just like it's taking share away from leading UK supermarket chain Tesco in the basic food and grocery segment.

During the Wednesday conference call, Whole Foods Market, Inc. CEO John Mackey said the natural foods chain has determined that the nearly 80,000 square-foot Kensington High Street Whole Foods store is just plain too big, which he said is the primary reason for its struggles in the UK. Mr. Mackey announced that going forward, any new Whole Foods stores opened in the UK would be in the 20,000 square foot range, which by UK standards is still a good-sized food store.

Natural~Specialty Foods Memo (NSFM) reported and detailed last year in this March 4, 2008 piece [Retail Memo: Whole Foods Market to Dramatically Expand in the United Kingdom; Will Open Up To 30 New Stores in the U.S. in Fiscal 2009] how at the time Whole Foods Market was aggressively looking for new store sites in the UK, particularly in and around London. Those store locations-sites were closer to the nearly-80,000 square-foot size rather than the 20,000 square foot model the natural grocer now says it will follow in the UK. (Note to the March, 2008 linked piece. As we've reported since, Whole Foods Market reduced the number of planned new stores to about 15 for this year. Another cost-cutting move.)

But Whole Foods' aggressive search for new store locations in the UK has cooled dramatically in the current recessionary climate. As far as we are aware, the natural-organic grocer has no new UK store openings planned for 2009.

Further, we aren't sure a UK growth strategy, even long-term, is a good one for Whole Foods. The UK, particularly Britain, and especially England, is a very retailer brand loyal market. For example, just four grocery chains -- Tesco, Wal-Mart-owned Asda, Sainsbury's and Morrisons -- control a whopping 73%-75% of the total food and grocery sales market share.

If you add in the Cooperative Group chain, which last year acquired the Somerfield supermarket chain, making the Co-op the UK's fifth-largest grocer after number four Morrisons (Tesco is number one, Asda number two, Sainsbury's number three), the five chains control about 82% of all grocery sales in the country. All also sell plenty of natural, organic and specialty-premium food products.

There is room for niche players, such as upscale Waitrose and Marks & Spencer, which combined control about 9% of the remaining 18% of share in the nation -- that leaves about 9% for everybody else, and about half of that 18% is controlled by the UK hard-discount grocers Aldi, Lidl, Iceland and Netto -- but it's a tiny niche. And, there are numerous UK-based natural products retailers, such as Boots and others, filling a big part of that tiny niche.

Whole Foods could make it in the UK -- but not without spending a considerable amount of money on marketing and advertising, in our analysis. And the retailer needs to do a much better job of adapting to the British style of food retailing to do so. However, in its quarterly financial report, Whole Foods said its UK operations were a major contributor to the company's overall income loss, which isn't a good sign going forward right now.

And even if Whole Foods can do well in the UK down the road, one has to ask at what level? In other words, can the UK really contribute a significant amount of sales and profits to Whole Foods Market, Inc. over the next five, or even ten years, to make it worth the effort? The jury of course is out on that -- but we think it is something worth looking at closely by Whole Foods in its strategic planning process.

Whole Foods Canada

Last month we heard a rumor that Whole Foods Market, Inc. could be considering selling its stores in Canada, assuming of course it could find a buyer in the current frozen credit market. We have been unable to substantiate such rumors to date.

The conference call comments by CEO John Mackey -- that the UK holds far more long term promise for the natural foods grocery chain than Canada does -- are interesting ones though in light of those rumors.

The reason this is interesting -- and it is based on deductive reasoning and not source information -- is because Whole Foods has historically been a growth-based retailer in all of its markets. Therefore if it believes Canada holds minimal long-term growth potential then selling the stores there might make good sense. The natural-organic grocer could then use the cash from such a sale to grow the business in the UK and for other purposes.

Whole Foods Market, Inc. currently operates six stores in Canada. Four of the stores are located in Vancouver, British Columbia. The other two stores are in Ontario; one in Toronto and the other in Oakville. [Click here for a list of the Canada stores.]

With only six stores in the entire country of Canada, and in only two market regions (Vancouver and Ontario) to boot, Whole Foods' really can't make much of an impact in the country at present. And, based on the conference call comments, it doesn't sound like any additional stores are planned in Canada in the near or even medium-to-long term. Therefore, selling the stores starts to make even better sense.

One likely candidate, should Whole Foods decide to sell its stores in Canada, would be Canadian natural products retailer Planet Organic, Inc. Planet Organic has been growing fiarly rapidly in Canada and even entered U.S. natural foods retailing in 2008 when it acquired the Mrs. Green's chain of 11 natural foods stores based in upstate New York.

However, Planet Organic had to back out of a deal to acquire Santa Cruz, California-based New Leaf Natural Markets last year because it couldn't raise the about $15 million needed to do the deal. Planet Organic had floated a new stock offering on the Vancouver stock exchange for about that amount, which it was planning to use to make the acquisition, but decided to pull the offer because of the financial-credit crisis and the related drying up of investment capital, after it determined there wasn't an investor appetite for the new offering by the company.

But, since the Whole Foods stores are right in Planet Organic's backyard -- it just might be better able to find the money should the Austin, Texas-based natural foods grocery chain decide to unload its stores in British Columbia and Ontario, Canada.

FTC v. Whole Foods settlement deal

Meanwhile, Whole Foods Market, Inc. needs to come to a settlement agreement with the FTC so that it can get back to focusing on what it does best, merchandising and selling natural, organic and premium food and grocery products, rather than fighting legal battles. It also needs to reach a settlement, assuming one that's not to devistating to its acquisition of Wild oats, so that it can stop burning cash paying for legal fees related to the legal case.

We say this, that a settlement deal needs to be reached between Whole Foods and the FTC, despite the fact we believe the FTC's case is pure folly.

At this point though, reaching a decent settlement deal is far better for Whole Foods Market, Inc. than continuing to have to fight the FTC in court, the end result of which could be a break-up of the now combined Whole Foods-Wild Oats, which at this point in Whole Foods Market, Inc.'s nearly 100% integration of Wild Oats could be a very costly process and end result.