To an outsider it all may seem a bit crazy. Americans are readily paying a hefty premium on the price for the most basic commodity in the world - food, when it is labeled “natural” or “organic.” But wasn’t all food by definition organic? And if not, what are we actually eating when buying regular, non-organic food?

It is hardly a surprise that in the US efficiency-crazy environment, legislature permits food to be genetically modified and agricultural production to be enhanced through antibiotics, growth hormones, toxic chemical pesticides and fertilizers, and all the achievements of modern science. The focus on profitability and cost-effectiveness has turned “naturalness” into a rare and an expensive commodity.

Whole Foods (WFMI: chart), Wild Oats (OATS: chart), and their suppliers like United Natural Foods (UNFI: chart) have been able to capitalize on the health-consciousness of the more affluent and educated consumers by selling as an exclusive high-end commodity what in most parts of the world is… just food.

The natural and organic food retailers enjoy higher profit margins than the traditional grocery stores, greater loyalty from their customers, and are less threatened by the competition of low-cost and massive-scale retailers like Wal-Mart (WMT: chart) and Costco (COST: chart). These specialty retailers have tapped into a lucrative and growing market. The organic food business in the U.S. is estimated to total $13 billion in 2003, up nearly 20% from $11 billion in 2002.

Retail consultant Retail Forward estimates that the organic-food business is growing at about 10% a year compared to 2.5% growth rate for traditional supermarkets. More than 10% of Americans are eating organic foods, while more than 50% of the population has at least tried them.

Recently, the U.S. Department of Agriculture created a National Organic Program to create a national standard for 'organic' certification, a move that shows that organic eating is not just a fad but is here to stay.

The Leader of the Health-Minded Pack

The natural food retail sector has a very clear leader. Whole Foods Market not only pioneered and established the supermarket concept in health foods retailing, but also bought most of the existing competition and hasn’t stopped growing. Different from traditional supermarkets, the company enjoys profit margins of about 3%, twice the 1.4% net profit in the grocery industry.

It all began in 1978, when current chief executive, John Mackey, opened Safer Way Natural Foods in Austin, Texas. He merged with another store in 1980 to create Whole Foods Market. The company accelerated its expansion in the late 1990s and currently operates 154 stores in 26 states.

Although health and natural foods stores have long existed as a niche market, they typically offer a limited range of health foods and related products, such as nutrition supplements. Building supermarkets stocked with organic bread, meat, poultry and fish, and even coffee and wine, has been a rather innovative concept.

Expansion Through Acquisitions

Whole Foods has largely been built by acquisitions, which the management considers a key part of the growth strategy. Instead of taking the risk of building supermarkets in unproven markets, the company usually buys successful ventures and then brings in its know-how and infrastructure. The company also has worldwide ambitions – it recently made its first overseas step by acquiring U.K.’s Fresh & Wild for roughly $38 million in stock.

Growth vs. Valuation

The greatest concern of investors regarding Whole Foods’ stock is that it is rather richly valued. But there are good reasons for the high valuation. In the past 10 years Whole Foods has managed to increase same-store sales by an average 8.5% annually. Total sales have consistently grown by 17%-23% each year.

The company sports gross margin of 34%, unusually high for food retailing, and operating margin of 6%. By the end of the decade, Whole Foods forecasts $10 billion in annual revenues and 300 stores. Analysts expect that revenues and earnings could rise around 20% annually.

In April, Moody's Investors Service upgraded all ratings of Whole Foods because of the company’s pattern of internally funding the store development program, the strong sales performance at new and existing locations, and continued improvement in fixed charge coverage.

And while the valuation may prompt for cautiousness at the current levels, any dips in the stock price without a substantial change in fundamentals should make this stock a must-have investment.

The Runner-Up Wild Oats

Although Wild Oats is the 3-rd biggest natural foods supermarket chain in the US in terms of sales after Whole Foods and privately-held Trader Joe's, its outlook is quite different from that of the leader. So far the company has been unable to ride the wave of healthy eating as it is struggling to solve operational issues.

In 2002, in an effort to cut costs, the company changed its primary distributor from United Natural to Tree of Life. Later, Wild Oats outlined major supply chain problems, such as products being out of stock or difficulties with stock-keeping unit designations. Now it is back with United Natural Foods, but gross margins are falling.