Whole Foods Market Inc. (WFMI) said on Wednesday it will buy smaller rival Wild Oats Markets Inc. (OATS) for about $565 million to compete better with larger traditional grocers, which are increasingly encroaching into its organic and prepared foods niches.

Shares of the world's largest natural and organic grocery chain, which is facing slowing growth at established stores, rose 5 percent following the announcement, while Wild Oats shares soared more than 17 percent.

The news came as Whole Foods reported a 7.7 percent drop in quarterly earnings. Even though total sales rose, sales at stores open at least a year rose 7 percent in the quarter — about half the 13 percent rise a year earlier.

Organic and natural foods are gaining popularity as consumers try to eat better, but growth has not been as strong as some expected a year ago when Wal-Mart Stores Inc. (WMT) said it was doubling its offerings of organic products.

At the same time, Safeway Inc. (SWY) and other traditional grocers have also added more organic fare, while niche retailers like privately held Trader Joe's are expanding rapidly, and Whole Foods on Wednesday said it aimed to cut prices on some products in the face of competition.

"This is not a move being made from a position of strength," said Rob Campagnino of SeaRock Capital Management.

Whole Foods will pay $18.50 a share in cash for Boulder, Colorado-based Wild Oats — an 18 percent premium to the company's closing share price on Wednesday. Whole Foods will also assume $106 million of Wild Oats' debt. The deal is expected to close in April.

"The growth opportunity in this category has led to increased competition from many players, most of whom are not dedicated natural and organic foods supermarkets, but are considerably larger than we are," Whole Foods Chief Executive John Mackey said in a statement, adding that the deal timing "could not have been better."

On a conference call with analysts, Mackey said he approached Wild Oats after CEO Perry Odak resigned in October and the company did not name a permanent replacement.

"OFFENSE IS THE BEST DEFENSE"

With the deal, Austin, Texas-based Whole Foods will keep Wild Oats out of the hands of a traditional grocer, which could have used the chain to compete better against Whole Foods.

"Offense is the best defense," said Ken Harris of consulting firm Cannondale Associates. "They were either going to buy Wild Oats, or somebody else was going to do it."

Whole Foods said the addition of Wild Oats' 110 stores to its 190-store base will give it access to new markets and increase its presence in the Pacific Northwest, Rocky Mountain region, and Florida. Whole Foods stores are generally larger with about twice the sales per square foot.

"They're buying it for enhanced market presence, rather than going through the tough process of securing good real estate and building stores," said Tim McNamara, Northeast broker for SullivanHayes property management and leasing.

Whole Foods said it earned $53.8 million, or 38 cents per share, in its fiscal first quarter, compared to a profit of $58.3 million, or 42 cents per share, a year earlier.

Wall Street analysts, on average, had been expecting earnings of 36 cents per share, according to Reuters Estimates.

Sales rose 12 percent to $1.87 billion.

In November, Mackey said fiscal 2007 would "be a transition year" for Whole Foods, and forecast same-store sales growth of 6 percent to 8 percent. The company on Wednesday backed that forecast, which is below the double-digit increases it has posted for the last three years.

Whole Foods shares were at $48.06 in after-hours trade after closing at $45.70 on Nasdaq. Wild Oats' stock, meanwhile, soared to $18.44 after closing at $15.72.

Yucaipa Companies, a Los Angeles-based private equity firm, owns 15.2 percent of Wild Oats' shares.

Whole Foods shares trade at about 31 times analysts' average 2007 earnings estimate, well above the multiple of 18.9 for Safeway's stock.