Whole Foods Market Inc.'s real estate cart continues to fill up.

In August, the country's largest grocer of natural and organic foods finally closed on its long-awaited deal to buy Wild Oats Markets Inc. for $565 million. About the same time, the Austin, Texas-based grocer decided to shutter nine Wild Oats stores and shed 35 small Henry's and Sun Harvest locations (all in California and Texas) in a $166 million deal to warehouse store operator Smart & Final Inc. Meanwhile, Whole Foods set a company record, opening 21 new stores in fiscal 2007, ended September 30, and currently has more than 90 stores primed in its development pipeline.

As a result of the merger and ongoing expansion, the company's real estate portfolio is on track to grow nearly 60 percent in two years. By the end its 2008 fiscal year, Whole Foods expects to operate some 300 stores, up from the 186 at the close of 2006. The upshot? By opening more stores and shuttering a handful, Whole Foods is creating a myriad of opportunities for both the retail and real estate industry.

As they ponder the chain's growth, Whole Foods executives recognize that bigger isn't always better. The company reduced the footprint of half a dozen planned stores and is experimenting with a “grab and go” concept in Boulder, Colo., that's significantly smaller than its traditional store. Although executives are checking out smaller spaces, Whole Foods remains on track to add more than 5 million square feet of new stores over the next several years — or 70 percent of its pre-Wild Oats footprint.

Analysts at Toronto-based investment firm CIBC World Markets Inc. say Whole Foods's new-store strategy overshadows that of any other chain in the grocery business. Whole Foods closed fiscal 2007 with 200 stores and sales of $8 billion; up 42.8 percent from the $5.6 billion in sales in 2006. And, those 2007 figures do not include the 74 Wild Oats outlets that came under the Whole Foods umbrella in August.

“Whole Foods has at least nine more years of rapid growth without extending or altering its brand or format,” according to a May 31 report from CIBC World Markets. “However, the company will be challenged by increasing conventional competition, the complexities of managing the Wild Oats acquisition, plus the costs of an accelerating new-store program.”

Those costs are staggering. In announcing its third-quarter results July 31, Whole Foods revealed for the first time its average store development cost per square foot: $282 through the first three quarters of 2007, up from $258 in 2006. Still, Scott Mushkin, an analyst at New York City-based investment firm Banc of America Securities LLC, in a recent report indicated the majority of new Whole Foods stores are coming in at or below budget — “something that has not happened for some time.”

Analysts at Chicago-based investment firm William Blair & Co. point out that Whole Foods “may have been overly exuberant” with the size of some stores in the development pipeline, so the retailer scaled down six of the planned stores by an average of 9,000 square feet and is reviewing all locations on the drawing board. In some instances, Whole Foods may hang on to an entire leased space but build out 5,000 to 10,000 square feet less, says Walter Robb, co-president and COO at Whole Foods. Its average store exceeds 36,000 square feet, while the average store in development is 53,000 square feet.

“We believe our sweet spot for most markets is a footprint between 45,000 and 60,000 square feet, which allows us to create the exciting shopping experience we are known for while simultaneously maximizing our return on invested capital,” Whole Foods Chairman and CEO John Mackey told financial analysts July 31. “But in some cases, we can operate stores that would be very successful and have a very high return on invested capital that are 25,000- to 45,000-square-foot stores.”

As such, the retailer is undertaking an experiment dubbed Whole Foods Market Express. An 18,500-square-foot store in Boulder — the birthplace of Wild Oats — will be converted into what Whole Foods calls “a convenience-focused concept” that will offer “a value-oriented product mix” and grab-and-go products.

Trimming the fat

Although the Whole Foods/Wild Oats deal means the two retailers no longer battle head-to-head for space, the death of the rivalry may spur the combined company to expand more quickly since Whole Foods's margins should improve amid the reduced competition, says Daniel E. Hunt, president of Hunt Associates LLC, a commercial real estate development firm in Minneapolis. “Generally, they are a good tenant and cause small higher-end retailers to follow them.”

Aside from plotting new stores and concepts, Whole Foods must figure out how to pump up sales at the 74 Wild Oats stores it acquired. While the deal gave Whole Foods more of a presence in the Rocky Mountain region, the Pacific Northwest and Florida, it also caused Whole Foods some indigestion.

For one, Wild Oats stores are smaller and in less desirable locales than their Whole Foods counterparts, industry experts say. Before the acquisition, the average Wild Oats store was 24,000 square feet, about 10,000 square feet less than the average Whole Foods.

According to Banc of America Securities, most of the Wild Oats portfolio tends to be in suburban community shopping centers, while a big chunk of Whole Foods locations are in the densely populated urban areas of Boston, Los Angeles, New York, San Francisco and Washington, D.C. Whole Foods intends to spruce up the Wild Oats locations; remodeling a grocery store costs roughly $65 per square foot, according to the Food Marketing Institute.

Some smaller Wild Oats stores could be expanded or relocated in the future, says Bob Gorland, vice president of Clark, N.J.-based grocery consulting firm Matthew P. Casey & Associates. “I have a feeling that most Wild Oats stores won't need major remodeling,” adds Mark Lilien, a management consultant at Stamford, Conn.-based Retail Technology Group. “Many are younger than seven years old. It's not like buying a 40-year-old supermarket chain.”

To help right the real estate ship, Whole Foods is shuttering nine Wild Oats stores and relocating another eight. Wild Oats stores that are being closed are in Hillsdale and Tualatin, Ore.; Louisville, Ky.; Littleton, Colo.; Mission, Kan.; Omaha, Neb.; Portland, Maine; Saugus, Mass.; and West Vancouver, British Columbia. Wild Oats outlets that are being relocated are in Indianapolis; Littleton, Colo.; Naples, Fla.; Nashville; Pasadena, Calif.; Reno, Nev.; Salt Lake City; and St. Louis.

However, before the deal closed, it was reported Whole Foods would close approximately 30 Wild Oats locations. As for the relocations, Whole Foods is shifting its focus to sites it already had in development in those areas. This month, for instance, Whole Foods is scheduled to unveil a 76,770-square-foot store in Pasadena — its largest location in the western United States.

In 2006, Wild Oats closed 11 stores that were small, old or underperforming. Last year, Wild Oats checked out with $1.9 billion in sales.

Industry observers, including David Larson, a partner at retail brokerage firm Legend Retail Group LLC in Denver, speculate national retailers such as Barnes & Noble, Bed Bath & Beyond, Office Depot, T.J. Maxx and CVS Pharmacy will step up to fill the empty Wild Oats spaces. Even regional, small or independent grocers will be attracted to former Wild Oats stores, says Michael Krestell, a research analyst at Toronto-based investment bank M Partners Inc.

The soon-to-be-cast-off Wild Oats stores represent “a great opportunity for other retailers to expand in those markets,” says Hunt, the Minneapolis developer.

Another dilemma in this deal: Per-store sales at Wild Oats lag well behind those at Whole Foods. Before the acquisition, Wild Oats eked out about $450 in sales per square foot. During the third quarter of 2007, Whole Foods notched per-square-foot sales of $933, up 7 percent from a year earlier. In the first quarter of fiscal 2007, Wild Oats's same-store sales inched up just 0.3 percent.

“It will take some TLC to get them up to the Whole Foods performance level,” says David Livingston, head of Pewaukee, Wisc.-based DJL Research LLC, a grocery consulting firm.

Protein boost

But Whole Foods executives don't anticipate much of a transition as they transform Wild Oats locations.

“We really think that Wild Oats has improved their stores quite a bit in the last few years, but we think we can help them improve even more,” Mackey said in February. He predicted Whole Foods could increase Wild Oats same-store sales at a double-digit growth rate.

But as Whole Foods works to achieve its goal of doubling Wild Oats sales within five years, the company faces increased competitive pressures from traditional grocers who have increased offerings in organic departments and offer more prepared meals — two of Whole Foods's biggest strengths.

Ironically, it was that competitive pressure that helped salvage the acquisition following the Federal Trade Commission's attempts to block the deal.

The Wild Oats purchase was announced in February; six months later, a federal appellate court cleared the way for the deal. Federal judges failed to buy the FTC's contention that the Whole Foods/Wild Oats combination would stifle competition in the natural and organic grocery business and drive up prices.

Instead judges agreed with Whole Foods's stance that competition abounds in that business. For example, Kroger Co. and Safeway Inc., the country's two largest grocery chains, and Wal-Mart Stores Inc., the world's largest retailer, have rolled out natural and organic food products. On November 8, Britain's Tesco PLC, the world's third largest grocery chain, was to open its first six U.S. stores, all in the Los Angeles area. Tesco's U.S. format, Fresh & Easy, sells Whole Foods-like products in neighborhood markets averaging 10,000 square feet. By the end of the year, additional Fresh & Easy stores are set to debut in Las Vegas, Phoenix and San Diego.

Paula Rosenblum, managing director of London-based retail research firm Retail Systems Research, calls “neighborhood” grocery markets in the vein of Fresh & Easy “a retailing Holy Grail.” As for Whole Foods, she thinks its Express platform will complement, not replace, its current store format. Analysts say retailers are watching the Tesco model carefully to see if the smaller stores offering top-quality products alter the conception of convenience stores.

Whole Foods's future

In the meantime, Whole Foods faces one other potential obstacle as it digests Wild Oats. Some have speculated that if the chain's stock falters, it could find itself as a takeover target. In that case, the most likely acquirer would be Oakland, Calif.-based Safeway, according to CIBC World Markets. But that doesn't appear to be in the offing anytime soon, if at all. Whole Foods's stock has risen over the past few months, closing at $48.06 on October 18, compared with its 52-week low of $36 and high of $66.25.

Wall Street analysts applauded the Whole Foods/Wild Oats union, as the Fortune 500 company knocked off a weak competitor. Nevertheless, the race to bolster Wild Oats is in the early stages.

“It's a pretty high hurdle to jump over, but we do think we can improve the productivity of the Wild Oats stores,” Mackey said in February. “But it will take time…. It usually takes a couple of years to fully integrate stores, so we are not going to work miracles here the first month.”

Shopping List

Whole Foods is looking to have 200 stores in operation by the end of 2008. It's hoping to open between 20 and 30 stores per year. What does Whole Foods look for when selecting locations? They've put together a list of criteria.

  • At least 200,000 people within a 20-minute drive
  • A 40,000-square-foot to 75,000-square-foot space
  • Large numbers of college-educated residents
  • Abundant parking available for exclusive use
  • Easy access from roadways, including a stoplight-equipped intersection
  • Excellent street-level visibility
  • Area with high volumes of vehicular traffic

Source: Whole Foods Market Inc.