Whole Foods Investment Could Spur Change

ELLIOT ZWIEBACH

AUSTIN, Texas — Whole Foods Market here has hit the wall.

The business model that once looked unstoppable has developed unforeseen flaws, challenging management to figure out how to keep the company on course in an economic downturn during which comparable-store sales have slid from double-digit growth into negative territory.

The announcement earlier this month that Whole Foods has agreed to sell 17% of its equity to a subsidiary of Los Angeles-based Leonard Green & Partners to help finance existing expansion commitments may be the first of several upheavals in the company's business as it tiptoes its way through the weak retail environment, industry analysts told SN.

The changes it makes could be accelerated by the addition of two new directors from the investment group to the company's six-member board, which has been considered management-friendly, observers pointed out. The proposed directors are Jonathan D. Sokoloff and Jonathan A. Seiffer.

Karen Short, a New York-based analyst with FBR Capital Markets, Arlington, Va., said if the infusion deal gets finalized next month and if the new directors are appointed, they are likely to seek to implement some changes.

“They will certainly bring a new perspective to a company that has pretty much reflected the philosophy of [Whole Foods chairman] John Mackey, and while dramatic changes may not necessarily be positive, I would not rule out a change in top management, because much of the significant destruction of the company's value has been self-inflicted,” she said.

Chuck Cerankosky, an analyst with FTN Midwest Securities, Cleveland, said he's not sure what impact the new directors will have. “But if somebody contributes hundreds of millions of dollars and takes two board seats, I would expect them to contribute to board deliberations, and I would expect those new directors to exert some influence.”

According to Scott Van Winkle, a Boston-based analyst with Cannacord Adams, Vancouver, British Columbia, “The moves Whole Foods makes over the next couple of years will permeate management's thinking there for a long time.”

Short told SN she believes Whole Foods is facing a tougher road dealing with the economy than other supermarket operators, “because while others have experience dealing with a tough economic environment, Whole Foods does not. As a result, it finds itself in the midst of a perfect storm, with a leveraged balance sheet, a tough integration of Wild Oats and an economic environment that's turned against it — one in which many competitors have better balance sheets.”

Cerankosky said he believes the $425 million cash infusion will provide a short-term respite that will enable Whole Foods to work its way through some of the economic challenges. “With that money, Whole Foods can tolerate a spell of weak economic growth in the U.S.,” he explained. “But if that weakness persists for too long, shoppers could become less and less enchanted with Whole Foods' merchandising efforts.”

Van Winkle said he was surprised by the size of the investment. “It looked to me like Whole Foods had less than $50 million of wiggle room before it needed to start using cash for capital expansion,” he said, “so looking for money from outside the company was definitely the right thing to do. What's debatable is whether it needed to dilute shareholder value by going after $425 million when perhaps $250 million would have been sufficient.”

For Van Winkle, the No. 1 challenge facing Whole Foods as it moves forward is to change its high-cost perception among consumers.

It's already begun stressing value in CPG product in its advertising, he pointed out, but the bigger challenge remains whether it can make changes in the perishables mix “to maintain the perception of being the premium food retailer while altering the cost perception — convincing consumers that a Grade A apple deserves to be more expensive than a Grade B apple, for example.”

That could be a difficult challenge, Short pointed out, also citing apples as an example.

“Whole Foods sells Granny Smith apples that are twice as large as the Granny Smiths at conventional supermarkets, and they are priced accordingly. Some customers go to Whole Foods because they want an apple that size, and they're willing to pay the price. But if the company downsizes that apple and charges a slightly lower price, the customer may decide she might as well go to A&P.”

Cerankosky said he believes Whole Foods might need to reconsider its value image more than it's done already.

“For example, it could offer grab-and-go sandwiches at a lower price point; or it could switch from wild salmon to organic farm-raised salmon — something that doesn't represent a real change in quality but that would mean a lower price point.”

At the backstage level, Whole Foods has done a good job over the last 18 months buying better and offering a higher mix of private label to offset the higher pricing on the perishables side of the store, Van Winkle said.

But there are other aspects of the business Whole Foods can explore as it works its way through the economic challenges, he added. “For example, it can consider cutting back on labor — possibly by offering some prepared foods in a self-service mode; or by sharing personnel between departments instead of allowing each department to assign its own labor and set its own hours.”

Van Winkle said Whole Foods could reduce capital costs by subletting some of the space at larger units to which it's already committed; or by reducing store size, “even if nasty phone calls or lawsuits from landlords follow.”

That's already happened in Seattle, where a developer has sued the chain for breach of lease.

According to local reports, Whole Foods initially sought to reduce the size of a Seattle-area store from 60,000 square feet down to 40,000 square feet and subsequently said that, because of cash flow problems, it wanted to halt construction and push the opening date back a year, until late 2009. When Whole Foods ultimately terminated the lease in September, the lawsuit was filed, the reports said.