In our piece Can Whole Foods Survive Prolonged Economic Downturn? we said that the company was running out of financial flexibility and we said it had five options:
- Muddle through. By paring back capital expenditure and utilizing its credit lines, Whole Foods may make it through but if we are in for a long recession, there is a real risk that the company could eventually run out of money.
- Whole Foods may have to sell stock even at this stock price to raise capital and sustain its operational plans.
- Whole Foods may find a partner for its British operation that is willing to put in capital to sustain the operating loss and capital expenditures needed to grow the division.
- Whole Foods could shutter its UK division and staunch the bleeding.
- Perhaps Whole Foods could sell itself to another retailer better able to carry it through the recession.
Well, Whole Foods announced its earnings and simultaneously announced it had chosen option two by accepting an investment from Leonard Green & Partners, L.P.
The quarterly results were tough. Although overall sales were up 13%, identical store sales fell 3.3%.
Total earnings dropped almost 96% to $1.5 million or $0.01 per share.
Although the company identified a number of non-recurring charges that hit profitability hard and thus said the earnings situation wasn’t quite so bad, many of these charges were troublesome for other reasons.
For example, the company paid $5.5 million, or $0.02 a share, to terminate leases on 13 stores in development, which makes you feel they either didn’t have the capital to fixture and inventory the stores or weren’t convinced they would be profitable.
Also the company took a tax hit of $6.1 million, or $0.04 cents a share, to repatriate $60 million in earnings from Canada. Once again, this seems to imply either diminished opportunity — no useful way to invest the money in Canada — or a need for cash down in Austin.
The Wild Oats acquisition seems to be a big loser. The FTC lawsuit against Whole Foods is projected to cost another $15 to $20 million in legal fees in fiscal 2009. Also there are 40 idle Wild Oats stores, and Whole Foods had to increase its reserves associated with these stores, because the downturn in the real estate market means Whole Foods can’t sell or sublease these properties, at least not at what had been the assumed values. This cost $14.7 million, or $0.05 cents per share, in the quarter. The company also estimates that Wild Oats operations lost over $25 million, or $0.09 cents per share, in the quarter. In addition, buying Wild Oats means Whole Foods took on debt at a time when it probably wishes it did not.
Although the company raising $425 million through a preferred stock issue was good news — and the market initially reacted favorably to it before slipping back — it was good news because the company was operating with thin capital. Now, as a better financed company it can probably afford to wait out the recession.
The fact that they sold the issue on the terms they did indicates the company really needed capital. A year ago people were buying stock in Whole Foods for $50 a share; now Whole Foods just sold the right to buy 17% of the company at $14.50 a share and agreed to pay a dividend while the investor holds the preferred. Initially the dividend is 8% and can be lowered after 3 years if the stock price of Whole Foods is sufficiently high.
Interestingly enough, the preferred stock sale contains a PIK, or Payment In Kind, option whereby Whole Foods can pay the dividend due in additional securities. This gives Whole Foods flexibility if earnings are poor and cash is tight — but it also means that Leonard Green & Partners, L.P. could end up owning more than 17% of the company.
For vendors, the investment is great news as it makes the company much stronger financially, though a recent conference call offered this nugget:
We are pleased to announce that Michael Besancon, former president of our Southern Pacific region, has accepted the newly created position of Senior GVP of Purchasing, Distribution and Marketing, reporting to our co-Presidents, Walter and AC. Our goal with this new position is to create a collaborative vision for our purchasing, marketing and distribution teams at the regional and global levels. With over 30 years of experience in purchasing, Michael has created a regional program that has produced strong margins primarily through offering differentiated products and effectively telling the story behind the products within the store. We are excited about Michael spreading his vision and best practices throughout the company.
We read this as saying that Whole Foods, which has always had a very division based procurement system, is going to try and leverage its total buying power to get better deals. Well, why shouldn’t they join the club? Every retailer does this. Though it can be difficult to sustain a focus on ‘differentiated product’ if the focus shifts to reducing costs.
We continue to think that the executives at Whole Foods are attempting to do something that just can’t work. We took this from the same conference call:
The Whole Foods Market brand stands for the highest quality, and over the last several years we have worked hard to increase the value choices within our grocery and Whole Body departments without sacrificing our standards. We believe our efforts have been successful since these departments are continuing to produce positive comps. While we saw a decline in average transactions in grocery, our average basket size was up, which we believe is a reflection that customers are making fewer trips but stocking up with more on each trip.
Our Whole Deal program, launched in July, has helped to highlight the values we offer within perishables. The program includes a quarterly in-store guide providing specially priced product discounts, money-saving coupons and tips, as well as budget recipes. For the July through September period, we saw a lift on all items included in the Whole Deal program with perishables driving a significant majority of the sales lift.
There are some signs of customers trading down within the store as evidenced by sales in our own brands growing three to four times that of branded product.
While we realize we are not going to change perceptions overnight, our efforts are gaining some traction in the media, which we hope will help positively reinforce to our existing customers that we are offering great values in terms of high quality at a competitive price, as well as helping to educate and entice prospective new customers as well.
They really think there is a ”perception problem” that needs to be “changed,” but we think that any change in “perception” will alienate the core customer base. As we said in our earlier piece:
Whatever Whole Foods does, as we mentioned here, there is a real danger to its attempting to shake its image as high-priced. The core of the clientele at Whole Foods values shopping there because of a conviction that high prices enable Whole Foods to offer better quality, better food safety and to buy and operate more justly and more sustainably. If tomorrow Whole Foods lowered its prices to match Wal-Mart, it would alienate its core customers as they would assume that paying Wal-Mart prices means that Whole Foods bargained its suppliers down to what they presume to be Wal-Mart standards.
That seems every bit as true today as before Whole Foods issued its earnings. Its only choice is to batten the hatches and live to fight another day.
