Do Organic Grocers Make Money?

The above question may seem counterintuitive; especially to anybody who has ever seen Whole Foods Market’s (NASDAQ: WFM) prices, but it is a valid one. Recent financial reports call the business model of organic supermarkets into question.

A particularly troubling number at Whole Foods and its competitor, Sprouts Farmers Market (NASDAQ: SFM) is the profit margin. Whole Foods profit margin fell to a four year low of 1.93% on December 31, 2016. That was a drop of 1.32% which is obviously not good.

The discounter Sprouts reported a similar drop, its profit margin fell from 3.03% in December to 1.73% in December 2016. Sprouts is also making less money, it reported a net income of $128.99 million in December 2015 and $124.31 million in December 2016. Whole Foods saw an even steeper drop in net income from $526 million in December 2015 to $445 million in December 2016.

(Photo by Jenny Sparks/Loveland Reporter-Herald)

Whole Foods and Sprouts are Making Less Money

The two national-organic supermarket operators are making less money. Yet both their businesses are growing. Whole Foods’ revenue increased from $15.55 billion in December 2015 to $15.81 billion a year later. Sprouts’ revenues grew from $3.593 billion in December 2015 to $4.046 billion 12 months later.

It looks as if there is a strong market for organic foods but profits it is harder to make money at it. Sprouts cash from operations actually fell in 2016 dropping from $269.76 million in March 2016 to $254.35 million at the end of the year. Meanwhile Whole Foods cash from operations increased significantly rising from $995 million in March 2016 to $1.68 billion in December.

Why are Whole Foods and Sprouts Making Less Money?

Whole Foods and Sprouts are victims of economics and a dramatically changing grocery business. Two developments in particular threaten their business model.

The first is food deflation; grocery prices dropped by .2% in 2016, the Bureau of Labor Statistics reported. This makes it harder for grocers to charge premium prices, and leads to lower profit margins. Sprouts and Whole Foods are particularly vulnerable here because unlike Kroger (NYSE: KR) and Safeway they lack other sources of revenue such as pharmacies and filling stations.

The second is the movement of bulk discounters such as Kroger, Walmart (NYSE: WMT), Amazon (NASDAQ: AMZN) and Aldi into the organic sector. Kroger and Walmart can easily afford to use organics as a loss leader to bring in customers.

Kroger’s presence in the market is growing fast, its natural and organic sales are projected to reach $16 billion in 2017, Market Realist reported. That exceeds Whole Food’s revenues and would make Kroger the industry leader.

The Threat from Kroger

That alone should scare Whole Foods and Sprouts to death because Kroger’s resources are vast. It reported $115.3 billion in revenue on January 31, 2017. Kroger is also an aggressive discounter particularly in areas it wants to dominate such as organics.

To make matters worse for Whole Foods, Kroger is making an aggressive foray into the high-end grocery business. It acquired the upscale grocers; Mariano’s and Harris Teeter, invested in the specialty grocer Lucky, acquired Murray’s Cheese and launched a new upscale grocery brand Main & Vine in the past few years.

Kroger has also been adding such amenities as cafes, craft beer bars, and wine bars to some of its massive Marketplace stores. One reason for that is to expand its presence in the ready cooked meal market.

Part of this offensive is Kroger’s aggressive use of delivery, in addition to delivery experiments in Denver, Harris Teeter is now experimenting with delivery by Uber in Virginia. That too is another effort to snag high end customers, including those likely to shop at Whole Foods.

Whole Foods is certainly feeling the heat its same store sales have been declining for six straight quarters, Business Insider reported. Sales fell 2.4% in fourth quarter 2016, which forced the chain to drop its ambitious plans to grow to 1,200 stores in the United States.

Kroger is Winning the Organic Grocery Wars

The biggest problem that Whole Foods and Sprouts face is lack of resources. Whole Foods reported $724 million in cash and short-term investments on December 31, 2016. Sprouts had just $12.46 million in the bank on the same day.

That puts them in more danger of an implosion such as those at Roundy’s and The Fresh Market in 2015. Last year Fresh sold itself to a hedge fund and Roundy’s; Mariano’s parent, sold out to Kroger to escape the death spiral. I would not be surprised if something like that happened at Sprouts.

Whole Foods is already shrinking it plans to close nine stores this quarter. Not coincidently most of the stores that are closing are in Kroger country. They include locations in Santa Fe, New Mexico, Boulder, Colorado, Colorado Springs, Salt Lake City, Prescott, Arizona, and Chicago. Kroger operates King Soopers in Colorado, Mariano’s in Chicago, Smith’s in Utah, and Fry’s in Arizona. One has to wonder if Whole Foods has found it cannot compete with Kroger.

 

It looks as if Whole Foods, breakneck expansion is over. One has to wonder if Sprouts’ will start contracting next; the discounter competes directly with Kroger in several markets including Denver, Atlanta and Arizona.

All this makes Whole Foods a very suspect investment even though its stock has done well. WFM investors received a return on equity of 13.69% on December 31. The company is scheduled to pay a 14¢ a share dividend on April 5, 2017. One has to wonder how much longer that can continue. Sprouts pays no dividend but its’ investors did receive a 16.07% return on equity on December 31, 2016.

My advice would be to sell both Whole Foods and Sprouts, their inability to compete with Kroger puts the share price and dividend in serious jeopardy at both chains. Expect to see more store closings and sales declines in organic groceries as Kroger ramps up its natural food operation. The organic grocery wars are heating up and Kroger seems to be winning while organic grocers are struggling to make money.