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. But some Wall Street pros think the sell-off was overdone.

On Aug. 6, the largest U.S. organic grocery chain saw shares fall nearly 20% in mid-day trading after it reported third-quarter profits of $33.9 million, a 31% decline from the previous year. The announcement held more bad news for investors: The company said it planned to reduce the number of new store openings by up to 50% and suspend its 20¢ quarterly dividend. It also reported that sales growth at stores open more than one year slowed to 2.6%, from 6.7%.

In Whole Foods' Aug. 6 conference call with analysts, the company's chief executive, John Mackey, said that the perfect storm of higher gas prices, a slowing economy, and higher food costs has scared consumers away from the upscale grocer and thinned the company's margins. Shares, off more than 60% from a 52-week high of 53.65, rebounded slightly at the end of the Aug. 6 session, to end the day down 12% at 20.04.

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.

Analysts worry that the tepid 2.6% increase in comparable-store sales portends more weakness. During the first four weeks of the fourth quarter, same-store sales were up only 0.9%, and company management revised yearly sales estimates downward from a 30% increase to 23%. Furthermore, the number of store transactions—every time a customer makes a purchase—was flat in the third quarter. "It means people aren't shopping there more, and they're not buying more stuff," says Price. A recent note from UBS (UBS) indicated that the risk of owning Whole Foods stock outweighs the potential reward.

Wall Street Warms to "Management Capitulation"

But the company's third-quarter announcements might actually be a good sign, says Scott Van Winkle, managing director of equity research at Canaccord Adams. Whole Foods acknowledged it needs to tone down some of its overly aggressive growth strategies, says Van Winkle, who adds that the upscale grocer's new stores in Britain have been "hemorrhaging money" over the last 12 months, with $18.4 million in losses. Also, Whole Foods emphasized its efforts to shed the quasi-luxurious image by placing "value gurus" in its stores—employees who direct customers to various food discounts and savings opportunities.

In the conference call, CEO Mackey said Whole Foods plans to cut all discretionary capital expenditures that aren't related to new stores by 50%, and is also "actively working to drive down the average development cost per square foot" in its stores. Those moves could signal a turnaround mentality and a push for greater efficiency, say analysts. "I think there was much better communication with Wall Street and much better recognition about weakness in the environment," says Van Winkle. "Oftentimes I tell our clients to buy stocks when there's a market capitulation. In this case there's a management capitulation, and I think it's definitely a positive."

Wrote Mark Miller, a research analyst at William Blair & Co., in an Aug. 6 research note: "The weaker current trends are causing management to pull back on capital spending today, which does set the stage for improving returns in the business when the economy improves."

Natural Food Companies in Danger?

The other question for investors is whether the natural food industry is in jeopardy as a whole. To that end, most analysts agree that companies like Whole Foods are seeing short-term weakness stemming from lackluster consumer confidence, but the long-term industry outlook is healthy. "We believe the market niche for high-quality natural and organic food will expand over time," says William Blair's Miller.

While Whole Foods should benefit from strong long-term demand, those best positioned right now are independent organic food companies like Hain Celestial Group (HAIN) and United Natural Foods (UNFI), according to a research note from Citigroup's (C) Gregory Badishkanian. Consumers have been trading down from restaurants to grocery, but they've also traded down among grocery stores—which hurts a "higher price-perceived retailer" like Whole Foods, he says.

Investors shouldn't be concerned about the store's concept or the organic marketplace, but rather how Whole Foods may be shifting from a growth stock to a value stock, says Van Winkle. "The story is it's really the best in-class operator becoming a little more of a staple than a growth story," he says.

And if Whole Foods is indeed a value stock, it's a whale of a lot cheaper now.

(Note: Citigroup does investment banking for Whole Foods and Hain, and owns or controls 1% or more of Whole Foods stock. William Blair & Co. owns 1% or more of Whole Foods stock. ThinkPanmure makes a market in Whole Foods securities. UBS makes a market in Whole Foods securities and one of the report's writers, project members, or one of their household members holds a long position in Whole Foods stock. Canaccord has Whole Foods as a non-investment bank securities-related client.)

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