This article is part of our Rising Star portfolio series.
There's already been plenty of coverage of Whole Foods Market's (NAS: WFM) amazing recent quarter. However, in the company's conference call, analysts anchored on and obsessed about one element of the report: This quarter's incredible quarterly gross margin percentage isn't sustainable.
Hitting the ceiling?
Whole Foods' gross margin hit 36.3% in the second quarter, one of several record-breaking quarterly metrics. However, management said to keep on expecting annual gross margin of 34% to 35%, its historical range.
Analysts spent an awful lot of time on the conference call asking about the gross margin comment. Basically, Whole Foods is acknowledging competitive elements and the need to keep some prices low for its customers. Analysts may not like the idea of how this might look next quarter, but long-term investors should be on board.
Whole Foods President A.C. Gallo discussed "price investments" to keep the top-line sales robust. Co-CEO and founder John Mackey continued when the margin questions kept on coming, "And so, since we're in this for the long haul, and not just trying to jack up quarterly earnings, you can expect that to trend back down to historical averages. ... Because we're managing our business for the next 20 years, not the next quarter or two ... we feel like there is a strategy, that we want to continue to increase the value for our customers, in terms of lower prices."
Several months ago, Costco (NAS: COST) CFO Richard Galanti explained the retailer's falling margins to analysts: "We continue to invest in price to strengthen our business long term. ... This [lower gross margins] continues to be due to our decision to hold prices on many items, even as some commodity prices have increased. You have heard that again and again. That is what we do."
Doing what they do
Granted, Whole Foods isn't a discount retailer like Costco is; Costco's competitive strength in retail relies on very good deals. However, when it comes to the "that is what we do" concept, both retailers are interested in keeping their customers happy above all else. Both also generally attract a higher end customer demographic and have similar worker-friendly initiatives in place.
Despite recessionary characteristics in the U.S., Whole Foods has managed to adjust its pricing in order to compete admirably in a tough marketplace. It had to be nimble in an environment where the old "whole paycheck" joke might not go over well with consumers.
Obviously, it was successful when many probably would have guessed it couldn't be. In Whole Foods' last two fiscal years, it increased its sales by 12% each year, same-store sales increased by 7.1% and 8.5%.
Speaking of gross margin, Whole Foods is a gem in the industry. That 34% to 35% target Whole Foods has been achieving for years is amazing when you compare it to rivals.
Compare it to Safeway (NYS: SWY) , which has seen its gross margin drop to about 28% from 29.9% in the year ended January 2010. Kroger (NYS: KR) has been experiencing a pretty regular gross margin decline from 24.4% in the year ended February 2008; in the 12 months ended January 2012, its gross margin had dropped to 21.5%. Even Harris Teeter Supermarkets (NAS: HTSI) lags Whole Foods; its gross margin has trended at about 30% for years.
Decades, not days
Whole Foods Market has long differentiated itself in a crowded, highly competitive grocery subset of retail, well-known for skimpy profit margins. (Here's more on gross margins and retail.)
This most recent quarter simply reminded me of why Whole Foods remains one of my favorite stocks. Given the stock's tremendous run over the past year, potential investors might want to wait a bit to see if some temporary bearishness might produce a lower price for purchase, but over the long haul, Whole Foods is worth its historical premium.
I aim to buy shares of solid long-term companies for the real-money Rising Star portfolio I'm managing for Fool.com; indeed, these purchases so far have included shares of both Whole Foods and Costco.
When companies commit to building their businesses for the next 20 years instead of simply next quarter's expectations, then they're speaking long-term investors' language. Count me in.
If you're seeking other retail stock ideas, check out The Motley Fool's Top Stock for 2012; it's the "Costco of Latin America." Click the link for the free report.
At the time this article was published Alyce Lomax owns shares of Whole Foods Market in her personal portfolio. The Motley Fool owns shares of Whole Foods Market and Costco Wholesale. Motley Fool newsletter services have recommended buying shares of Whole Foods Market and Costco Wholesale. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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