Why Whole Foods Shares Need to Be Avoided

Source: Thinkstock

Source: Thinkstock

When I last wrote about Whole Foods (NASDAQ:WFM) a month ago, the stock had been relatively weak compared with the rest of the market. I suggested that investors should consider to stay away given that growth stocks were showing signs of weakness and Whole Foods operates in a pretty competitive environment.

Since then, the stock has plummeted. When the company reported its first-quarter earnings, we learned that the company’s revenue growth is shrinking, its margins are compressing, and going forward the company will face competitive pressure that will force it to lower its prices. Let’s look at the specifics.

Whole Foods reported sales of $3.3 billion in the first-quarter versus $3 billion a year earlier, which is a 10 percent increase. Considering how weak the overall market is, especially in the retail space, this seems great. Unfortunately, if we look at the company’s profits we find that margins are compressing. The company’s operating income rose just 1 percent from $228 million to $231 million, and its net income was flat at $142 million.

This margin compression is the real issue, and it is the reason that the stock is down so much and why it has continued to be weak. It is also the reason why I think the stock remains expensive at 25 times trailing earnings and at 25 times 2014 earnings expectations. It is very difficult to get behind the stock of a company that will not be growing its profits if it trades at 25 times earnings.

This concern becomes more acute when we consider the competitive nature of Whole Foods’ business. Whole Foods operates in the grocery business, and as you know there is an enormous amount of competition from other grocery stores, convenience stores, restaurants, and big box retailers. For a long time, Whole Foods was able to grow despite this competition because of its market niche. Whole Foods was the one company that consumers could rely on for organic fruits and vegetables, as well as meat that didn’t come from animals that were fed antibiotics. As a result, the company was able to generate relatively strong margins.

However, now a lot of other grocery stores are getting into the organic and healthy food businesses, and ironically this is likely due to Whole Foods’ success. Whole Foods will now be facing competition from Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Supervalu (NYSE:SVU), and others. Furthermore, there are other companies that operate grocery stores that are similar to those operated by Whole Foods. Some publicly traded companies include:

  • Sprouts Farmers Market (SFM)
  • The Fresh Market (TFM)
  • Natural Grocers by Vitamin Cottage (NGVC)
  • Fairway Group Holdings (FWM)

These companies are all small, and from an investment standpoint, they are still in early, speculative stages. But the fact remains that Whole Foods faces an incredible amount of competition.

Given these points, I think the stock remains vulnerable to the downside. Right now, the stock trades at $38/share, or with a valuation of about $14 billion. Analysts still remain optimistic, and they have an average price target of about $47/share. This is the case because they expect the company’s growth to continue after languishing for the next couple of quarters. But looking forward, I suspect that the competition is going to be too substantial for Whole Foods to continue its incredible growth rate. Its margins are going to continue to compress, and the company risks losing some of its loyal customers.

That isn’t to say that Whole Foods still isn’t a great company that offers a great product. It still is. But the fact remains that from an investment standpoint, the grocery business is simply too competitive to be very attractive. Given these points, I would continue to avoid Whole Foods shares, and I would use any strength to sell them.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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