Whole Foods Finally Hits the Brakes

AUSTIN, Texas — Wall Street reacted with some dismay last week at the decelerating fortunes of Whole Foods Market here, which reported the lowest comparable-store sales number in its 28-year history — a 2.6% gain for the third quarter that ended July 6.

The stock price fell 18% after the results were announced, and industry analysts said sales and declining earnings could take a while to recover.

“The company's near-term growth prospects have decreased,” Meredith Adler, an analyst with Lehman Brothers, New York, wrote last week, “with constraints on financial resources limiting new-store growth and a structurally challenged business model creating a high expense structure.”

As its cash flow comes under pressure, the company said it was suspending its stock dividend and slowing capital spending.

“Getting to free cash flow comes at a high price of slowing new-store growth, which will limit earnings potential in outer years, even when the economy recovers,” Adler said.

Edward Aaron, the Denver-based analyst for RBC Capital Markets, Minneapolis, said weak financial results and some adjustments in the chain's plans going forward “[provided] more than we bargained for.”

However, he said, the challenges Whole Foods faces “are largely a reflection of a brutal consumer environment, [and] the restructuring efforts should help protect the balance sheet and help offset what will be meaningful contribution margin contraction for stores in the comp base.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said the combination of the intense competitive environment, weak economy and rapid product cost inflation should keep Whole Foods' stock valuation depressed in the intermediate term.

For the third quarter, net income dropped 30.9% to $33.9 million — reflecting a negative impact of approximately $4.9 million, or 3 cents per share, from the ongoing integration of Wild Oats, and operating losses at its six stores in the United Kingdom, amounting to 9 cents per share, the company said. Overall sales for the quarter rose 21.6% to $1.8 billion, with comps up 2.6%.

Comps were up 9% in the first quarter and 6.7% in the second — a deceleration that John Mackey, chairman and chief executive officer, attributed to the economy. “Competition is certainly a factor, and so is cannibalization, but neither is more intense than in the first or second quarters, so it's reasonable to conclude the deceleration is primarily due to the economy,” he said.

Comp-sales growth for the fourth quarter should be “in line with or slightly below our quarter-to-date results of 1.5%,” which would result in comps for the year of approximately 5%, he pointed out.

Mackey said the company's sales growth was driven almost entirely by increased average basket size, “with only a slight increase year-over-year in our transaction count.”

For the 40-week period, net income declined 24.1% to $113 million, while sales jumped 27.2% to $6.2 billion and comps rose 6.4%.

In light of the results for the quarter — and in anticipation of continued weakness in the overall economy — Whole Foods said it is reducing the number of stores it expects to open next year to approximately 15, compared with the range of 25 to 30 it said earlier in the year.

“While we are 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,” Mackey told analysts during a conference call. “We are a resilient company that will adapt in a prudent manner to these uncertain economic times.”

The company said other adaptations include:

• Cutting back on all discretionary capital spending not related to new stores by 50%.

• Implementing unspecified cost-containment measures in general and administrative expenses — but none at store level — for the balance of this year, with expectations those expenses will return to historical levels of approximately 3.2% next year, compared with 3.3% in the third quarter.

• Downsizing the leases at eight stores by an average of 9,000 square feet, based on the belief that stores of 35,000 to 50,000 square feet are more appropriate in most locations than larger units — though Mackey said 80,000-square-foot stores are scheduled to open in Houston, Dallas and a relocation in the Lincoln Park area of Chicago.

• Suspending its quarterly cash dividend for the foreseeable future “because we no longer have excess cash available to distribute to our shareholders, as that cash is needed to fund our growth going forward,” Mackey explained.

Mackey said management is bullish on the company's long-term prospects, citing the fact that comps at the Wild Oats stores are up 7% during the first four weeks of the fourth quarter, and those stores will enter the comp base at the end of August; he also said with fewer stores opening, the impact of cannibalization will be reduced.

He said he expects the chain's increased emphasis on its value offerings — initially in the Center Store, and since the second quarter on perishables — should help improve Whole Foods' image. “We are still misperceived, especially since the media invented the term ‘Whole Paycheck.’ But while we're not sacrificing quality, we are making a greater effort to educate customers about the values we offer,” Mackey said.

In response to a question, Mackey said he has no idea what remedial measures the federal government could take in the Federal Trade Commission's suit against Whole Foods' acquisition of Wild Oats. “You've got me,” he said. “We have no idea what the next move might be.”