Consumers love organic food, but they don't have to go to Whole Foods to buy it.
That may not come as a shock to anyone who has seen organic apples, carrots, eggs and milk on shelves at mainstream grocery stores, but it has taken investors by surprise.
Whole Foods Market Inc. slid 18.8 per cent on Wednesday after delivering its fiscal second-quarter results, offering an important lesson in how to avoid similar disasters elsewhere in the stock market.
The results weren't disastrous: Earnings missed expectations, but were merely unchanged from last year, at 38 cents (U.S.) a share. Over the same period, revenue rose 10 per cent.
Demand for organic produce is hardly fleeting, either. The company expects to increase its number of stores to 500 over the next three years, from 379 today. Over the longer-term, it can see 1,200 stores in the United States alone.
The big disappointment came from the company's outlook for 2014, where it sees lower sales growth, lower operating margins and lower growth in per-share earnings as it slashes prices.
"Our tremendous success has created more competition," said John Mackey, co-chief executive at Whole Foods, in a conference call on Tuesday evening. "So, there's a lot more competition, a lot more entrants into the marketplace, as well as conventional supermarkets copying and imitating a lot of what we're doing."
Indeed, the landscape reveals that Whole Foods is struggling to look special as organic food evolves from a high-end niche product to mainstream fare available at supermarkets such as Loblaws, Sobeys, Wal-Mart and others.
According to the Nutrition Business Journal, via The Wall Street Journal, conventional retailers controlled 55 per cent of U.S. natural and organic grocery sales in 2012, up from just 25 per cent in 1998.
Investors weren't the only ones caught off guard by the results and outlook from Whole Foods. Analysts, too, were left scrambling to update their views on the stock, along with their target prices. The average target was slashed by $11, or nearly 19 per cent.
The adjustment, along with the decline in the share price, suggests that Whole Foods took everyone by surprise – but that it was a surprise is, in itself, rather perplexing.
Prior to the release of the quarterly results, Whole Foods traded at more than 33 times trailing earnings, which is a high valuation typically awarded to companies with big growth potential and a clear competitive advantage. (At 26 times earnings, the stock is still pricey.)
Yet Whole Foods had missed revenue expectations for five quarters in a row – now six – indicating that the company was priced for perfection for some time without delivering on it.
More importantly, it didn't take detective work to see the proliferation of organic produce elsewhere, undermining Whole Foods and its pricing power.
However, looking back is easy. What can Whole Foods teach us about our approach to other investments?
The key lesson is something Warren Buffett has reminded us of before: Companies should have enduring moats, or natural defences against competitors. Low costs help, and so do powerful brands, which is why Mr. Buffett continues to invest in Wells Fargo & Co., Coca-Cola Co. and Procter & Gamble.
They probably won't dazzle you with eye-popping rallies, but at the same time they're unlikely to get shredded on the admission that, gosh, the competition is nibbling away at its market share.