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Whole Foods Cooked

Marc Lichtenfeld

Austin, we have a problem.

Whole Foods (WFMI Quote) reported lower-than-expected second-quarter earnings and sales late Wednesday, sending the shares down more than 8% to $42.01 in after-hours trading.

The Austin, Texas-based retailer was hit from all angles -- lower comps, higher costs, competition and a possible objection by the Federal Trade Commission to its proposed acquisition of Wild Oats (OATS Quote).

During a subsequent conference call, Whole Foods CEO John Mackey summed up his company's troubles: "We're no longer differentiated on the basis of products."

That was exactly what distinguished Whole Foods. If the company is not differentiated on products, why will customers pay a premium for said products? Yes, the stores look nice and the customer service is usually great, but much of the appeal was being able to get higher-quality groceries, particularly perishables, not available elsewhere.

Management acknowledged that competition from Safeway's (SWY Quote) new Lifestyle Stores, Trader Joe's and other supermarkets are affecting the business and may constrain pricing power in the future.

Now, suddenly the ability to leverage the top line has been compromised, and rising expenses are having more of an impact.

Higher costs led management to state that operating margins before pre-opening expense should stay constant throughout the year, clearly disappointing investors used to better margins. Health care, workers compensation and costs of new stores were among the factors that pinched margins.

Based on the company's sales guidance of 13% to 17% growth and its margin guidance, I expect Whole Foods to earn $1.30 a share for the fiscal year, which ends in September. The current consensus is $1.43. Also, CFO Glenda Chamberlain implied that higher costs and lower margins may stick around for a while.

Mackey defended his company's same-store sales figures. Year to date, the company's comps stood at 6.6%, sharply lower than the 11.5% five-year average. Most retailers would be thrilled with a 6% comp. However, Wall Street analysts wanted to know how far the number would fall. Mackey wouldn't take the bait, but reminded investors that Whole Foods never posted less than a 5% comp in the company's 29-year history.

I sympathize with Mackey. The company has become a victim of its own success. After three straight years of double-digit comps, it's perfectly logical that as the company grows and stores get older, those kinds of numbers will be unattainable.

Whole Foods' proposed merger with Wild Oats was set back, as the company extended the expiration date for its tender offer, due to the FTC raising concerns about competition issues. Mackey seemed befuddled by the government's actions and was afraid to comment because, "We don't want to piss the FTC off." He questioned whether the issue was political rather than commercial.

It seems far-fetched that the FTC would block the deal as anticompetitive while the company is admitting to being stung by competition (although that acknowledgement might not be an accident). So, I do believe this deal will go through. However, just because it gets completed doesn't mean it's a slam dunk. Whole Foods may be biting off more than it can chew.

Whole Foods is a great company. Management is top-notch, and personally, I love to shop there. But like so many hot retailers before it, there comes a time when the bar has been set so high that there's no way the company can continue to match its prior accomplishments, simply due to size.

Even including the after-hours selloff, the stock is trading at 29 times consensus estimates, which will certainly come down -- as will its expected growth rate. Until Wild Oats is integrated into the company and management has a clearer idea of what its contribution will be to the bottom line, I believe the stock should trade down to $35.

Whole Foods is still a good business and will continue to put food on the tables of its employees and millions of customers. But its days as a highflying growth stock are over.