UPDATE: FTC Challenge To Whole Foods Could Hurt Deal, Operations

NEW YORK (Dow Jones) -- The government challenge to Whole Foods Market Inc.'s takeover of smaller rival Wild Oats Markets Inc. is a setback for the deal, analysts said Wednesday.

The Federal Trade Commission on Tuesday approved a complaint challenging the $ 565 million tie-up of the natural-foods grocers, citing concerns that the reduced competition in the category could prompt Whole Foods to raise prices and cut its quality and services.

The FTC also said it would seek a temporary restraining order and preliminary injunction to halt the deal.

Whole Foods, for its part, said the competitors include traditional supermarkets, which have boosted their offerings of natural and organic products.

Both companies said they would fight the FTC decision.

Morgan Stanley analyst Mark Wiltamuth cut his rating on Whole Foods to equal- weight from overweight,

"For a stock already struggling with poor core earnings performance, uncertainty over the merger only adds to near-term investment risks," Wiltamuth wrote in a note to clients. "While we believe Whole Foods has a valid argument that the FTC should look at the broader grocery market, we believe risks are greater for no deal, significant store divestitures and a delaying timing if a deal is allowed, and management distraction caused by the dispute."

Shares of Whole Foods were down 3.6% at $39.01 in morning trading, while Wild Oats shares slipped fractionally to $17.05.

In February, Whole Foods (WFMI) announced a plan to acquire Wild Oats (OATS) for $18.50 a share. In March, the companies received a second request for additional information from the FTC.

UBS analyst Neil Currie cut his price target on Whole Foods to $50 a share from $60 and said that he has to assume that the deal won't go through.

"While we are somewhat bemused by the FTC's ruling, we feel that its lawsuit, aimed at blocking the deal, is a major obstacle that could prove difficult to overcome," Currie wrote in a note to clients.

The popularity of organic and natural foods, personalized service and ready- made meals has helped drive shoppers to so-called supernaturals Wild Oats and Whole Foods, but competition has come from several directions -- such as the expansion of the Trader Joe's chain; evolving product lineups at conventional supermarkets such as Safeway Inc. (SWY) , Supervalu Inc. (SVU) and Kroger Co. ( KR) ; and the efforts of discount giants Wal-Mart Stores Inc. (WMT) and Costco Wholesale Corp. (COST) to expand market share in groceries.

"The FTC has failed to recognize the robust competition in the supermarket industry, which has grown more intense as competitors increase their offerings of natural, organic and fresh products, renovate their stores and open stores with new banners and formats resembling Whole Foods Market," Whole Foods Chairman and Chief Executive John Mackey said in a statement.

Goldman Sachs analyst Simeon Gutman said the FTC challenge is a "moderate setback" for Whole Foods as the FTC is focusing on the store format and customer base rather than on the product category.

"We regard this development as a setback for Whole Foods, in that the transaction may well take 6-9 months longer to complete (if at all) during which time Oats' business, not that strong to begin with, could weaken further, thus necessitating incremental investments in labor/price to restore top-line health, " Gutman told clients.

The traditional supermarket category has seen its share of turbulence in recent years, with dozens of chains folding and a string of takeovers. Most recently, Great Atlantic & Pacific Tea Co. (GAP) , also known as A&P, in March said it would acquire Pathmark Stores Inc. (PTMK) for $1.3 billion in cash, stock and debt, to increase its footprint in the competitive Northeastern grocery-store market.