A Big Delivery for Whole Foods

As Americans' appetite for pricey, upscale food waned, Whole Foods Market (WFMI) needed a helping hand. The organic supermarket chain, often known jokingly as "Whole Paycheck" for its premium-priced offerings, got what it was looking for on Nov. 5 in the form of a $425 million investment from private equity firm Leonard Green & Partners.

The deal is the latest evidence of the pain suffered by retailers that cater to Americans' more expensive tastes. Analysts and investors disagree on how badly Whole Foods needed a financial cushion, but the extra $425 million should make it much easier for the retailer to weather the financial storm—and continue to grow despite the potential for a severe recession. The stock market's reaction to the capital infusion reflected the mixed outlook for Whole Foods. Whole Foods' stock on Nov. 6 at one point surged almost 19%, but then closed just 1.65% higher at 10.48.

The private equity money comes at a steep price and also reflects the retailer's serious problems. "We're in very uncertain economic times, and we're not certain what's going to happen," Whole Foods Chief Executive John Mackey told analysts on Nov. 5 when asked why the $425 million was needed.

Piper Jaffray (PJC) analyst Mark Miller said the extra money "should be a tremendous relief to investors." Others, however, were more pessimistic about the investment. By giving Leonard Green & Partners a 17% stake in Whole Foods, the deal dilutes existing shareholders' stakes. Also, the private equity firm gets a generous 8% dividend on its preferred stock investment in Whole Foods. Credit Suisse (CS) analyst Edward Kelly wrote: "Whole Foods provided further evidence that it has serious cyclical and structural issues."

Whole Foods shares have slid almost 75% so far in 2008, and there are many reasons: Its 2007 acquisition of the Wild Oats chain has run into many problems, including a challenge from the Federal Trade Commission. Kelly calls the acquisition "highly questionable."

Destination Store

When times were better, Whole Foods was also very generous with dividends to investors, and that's cash the retailer probably should have saved for a rainy day, says Andrew Wolf, an analyst at BB&T Capital Markets.

Also, Wolf adds, to many people Whole Foods is a "destination store." Customers drive past their local supermarkets to get the higher quality food at a Whole Foods outlet. But customers are driving less because of high fuel prices. "The gas prices—even though they're [now] coming down—have trained people away from that behavior," Wolf says.

Finally, Whole Foods merchandise includes plenty of pricey items that, in a recession, many customers have stopped buying. "What's happening to them is not much different form what's happening to other discretionary retailers," says Morningstar (MORN) analyst Mitchell Corwin.

In Whole Foods' fourth quarter, which ended Sept. 28, same-store sales fell 0.5%. And conditions are getting worse. In the first five weeks of this quarter, same-store sales have dropped 3.3%.

Expansion Plans

Despite all these challenges, Whole Foods plans to open 66 stores in the next four years. Although it has cut back some expansion plans, the retailer has signed leases that make it expensive to cut back growth entirely. That's one reason Whole Foods needed the extra cash, says Standard & Poor's equity analyst Joseph Agnese. "Where everybody else can cut back on growth, Whole Foods is stuck in these commitments," Agnese says. "It's tying their hands." (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

For Whole Foods, and also for the chain's private equity investors, the key question is how deep and how long the recession will be. "As long as it can hold its own in this downturn, once the company emerges it should be a lot stronger," Morningstar's Corwin says. That should allow Leonard Green & Partners to exit its investment with a substantial profit.

"The trend among consumers is still to eat healthier and go organic," says Agnese, arguing this is a durable trend that should help Whole Foods in the long term. But if the recession is painful enough, it could significantly alter consumers' tastes for Whole Foods' healthy, organic offerings. In that case, the retailer may need to procure a whole lot more lettuce—the financial, not the organic kind.

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