Whole Foods Cooked

Austin, we have a problem.

Whole Foods (WFMI) 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).

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) 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.