How Sustainable Is Whole Foods' Competitive Advantage?

Whole Foods Market Inc. (WFM) is a grocery store chain that focuses on offering organic and natural foods, and has approximately 490 locations as of October 2018. By creating a high-quality customer experience and focusing on its product niche, the company has established an economic moat through brand strength. The company was acquired by Amazon in 2017, but continues to operate as a subsidiary under its original name.

Warren Buffett is considered one of the most famous value investors, and his strategy was founded on identifying firms that produced cash flow growth through sustainable economic moats. Economic moats are secure competitive advantages derived from economies of scale, strong brand identity, intellectual property, the network effect, regulatory protection or superior corporate culture.

Without such a moat, a company's profit margins are doomed to succumb to competitive forces, eventually failing to equal the marginal cost of capital. This equilibrium creates no economic profit and eliminates the incentive to invest.

Whole Foods' scale provides a competitive advantage over its more direct competitors. Profit margins and economic profit metrics confirm the presence of an economic moat. This moat is sustainable as long as larger competitors do not move more directly into the organic and natural food market, but such competition could lead to rapid deterioration of any competitive advantage.

The grocery market is highly competitive and switching costs are essentially zero. Competitive advantages are difficult to gain, and successful firms often choose superior store locations, get better terms from suppliers, operate efficient supply chains and effectively manage their product offering and inventory. Intellectual property, regulatory protection and the network effect are not often consequential among established industry participants.

Whole Foods does not quite have the scale enjoyed by the largest supermarket, hypermarket and discount club stores, such as Kroger (KR), Wal-Mart (WMT), Costco (COST), Albertsons, Safeway and Publix. Although, with Amazon's backing that may change in the near future.

Whole Foods, however, addresses a more specific market, with its focus on organic and natural foods. It has a scale advantage over more direct competitors such as The Fresh Market, Trader Joe's and Sprouts Farmers' Markets (SFM). This scale creates a moat relative to its closest competitors, but does not apply to the broader grocery market. This scale advantage could dissipate if the largest grocers make a strategic push into the organic segment.

Whole Foods' strong brand identity is likely its greatest source of competitive advantage. The company has established itself as the leader in the organic and natural food segment, and has invested heavily in store quality and customer service. These factors differentiate it from other grocers and they have fostered a relatively loyal customer base. To maintain this reputation, the company will have to continue ranking among the industry leaders in facility investment. It will also likely incur high labor expenses to keep customer service up to its high standard. These drags on earnings and cash flow are partially offset by increased pricing power.

Whole Foods certainly has a competitive moat due to its size and brand power, but it is somewhat confined to its niche. The grocery market is ultimately highly competitive and mature. The sustainability of Whole Foods' competitive advantage is dependent, at least in the short term, on its larger competitors' unwillingness or inability to address the organic market.

Economic moats typically result in high and stable profit margins. Whole Foods is an industry leader with gross margins generally above 30%, and its operating margin is also among the highest.