Economy, Costly Merger Crimp Whole Foods Profits

Austin-headquartered Whole Foods couldn't live up to Wall Street analysts' consensus forecast for the fiscal second quarter ended April 13, posting earnings of 29 cents a share, down from 33 cents a share in the year-ago period. Analysts expected, on average, 30 cents a share, according to a Thomson Financial survey.

Management attributed weaker earnings to cost tied to the $565 million acquisition of rival Wild Oats Markets in August. Charges reduced earnings by six cents a share, according to the company.

While total sales rose 28% to $1.9 billion, same-store sales, a key measure of retailing strength, rose 6.7%, below many analysts' estimates and down from the previous two quarters. Same-store sales rose 9.3% in the first quarter of fiscal 2008.

The second half of the year won't provide any surprise lift, management warned.

"Including the impact of Wild Oats, we expect to see moderation in year-over-year declines in income," even before the impact of expanding its current number of stores, Chief Executive John Mackey said on a late Tuesday conference call. The broader economic decline could be hitting the high-priced supermarket a little harder, he said.

"We don't know why our comps are high, and we don't know when they go down low. I mean, we just make guesses," Mackey told an analyst. "We don't really know. I mean, we can see if there is an impact from cannibalization, we can see in a competitor opens up nearby, but on the margin, we don't really know if it is the economy, or if competitors in the neighborhood have sharpened up, and it is impossible to break it out with any kind of true accuracy."

Analysts expected the company to earn 35 cents a share in the fiscal third quarter and $1.27 a share for all of fiscal 2008.

Analysts at RBC Capital Markets, UBS and Lehman Brothers all lowered their 12-month price targets on the stock Wednesday morning.

While many luxury retail outlets are the last to feel the sting of a spending slump, food costs are an easy way to make cutbacks. That means, as Credit Suisse analyst Edward Kelly wrote Wednesday, as "Whole Foods sales growth has slowed materially over the last few months," the upscale grocer is "not recession resistant after all."

"The company's fundamental outlook remains weak, as consensus estimates appear overly aggressive, we view OATS as a poor acquisition, new stores continue to penalize returns, and liquidity management is a developing concern," he wrote.

The combination of Whole Foods' expansion plan — it's opening about 20 stores this fiscal year and 25 to 30 in fiscal 2009 — and its need to accelerate sales growth aggressively in a weak economy presents a daunting scenario in the near term.

Gross margins were a bright spot, rising 65 basis points at identical stores and 35 basis points throughout the chain.

"Only gross margins came in above our pessimistic expectations," Think Panmure analyst Suzanne Price wrote.

"In this retail environment, it appears that Whole Foods is having a difficult time growing sales as fast as we had hoped, and we are lowering our estimates for revenues going forward. Though we believe that expenses will continue to be challenging, it seems that margins are not as bad as we had feared," her Wednesday report said.

But the patterns of high-end stores resisting the economic bite holds up with Whole Foods. Compared over the last 52 weeks to Safeway (SWY), the upscale chain thrived for a while, even as the first impacts of the subprime mortgage collapse were starting to trickle out into the broader consumer economy. Now that the bite is being felt across the economic spectrum, the two chains' shares show much greater correlation. (See stock chart below.)

"Consumers are much more focused on value and managing the grocery bill amid all of this food inflation that's getting pushed through," Morningstar analyst Mitchell Corwin says.

But when the penny-pinching subsides, he points to the strength of the brand and highly productive stores that can generate $900 in annual sales per square foot.

"What's important for long-term investors is that they still operate some of the highest-volume stores, and that current stores are performing well," he says. "As they cycle through the costs for Wild Oats and reach an inflection point on their new store growth I think you'll start to see earnings really accelerate."

The path to the rebound won't take place in the express lane, though, and it's worth waiting to see how the next couple of quarters unfold before taking these shares to checkout.

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