Whole Foods Market (WFM), again

another bidder?

WFM and Amazon (AMZN) announced late last week that the two firms had agreed to a friendly deal under which AMZN would acquire all the shares of WFM for $42 each in cash.

Since the announcement, WFM share have traded on very large volume and almost continuously at prices above the deal.

What does this mean?

deal mechanics

If I’m a holder of WFM and the current deal stands, I’ll receive $42 a share from AMZN in, say, three months.  The value of that future $42 today is slightly less.  It’s $42 minus the interest I could earn on the money in the intervening three months.  Let’s say that amount is $0.25.

If I believe the deal is a sure thing, then, I should pay no more than $41.75 for an AMZN share today.  However, there’s always some risk that the deal will be called off.  The possibilities may be far-fetched–a government agency might forbid the acquisition, there might be something funky in the WFM financial statements…  This means the $41.75 is a ceiling, not a floor, on the stock price.  Typically, trading starts below the present value of the future payment and gradually approaches it as the deal gets closer, and as possible obstacles are cleared.  The amount below varies from deal to deal, depending on perceived risks.

Ithink WFM should probably be trading, at best, in the $41.25 – $41.50 range now, rather than at around $43.

the difference

The $1.50 difference represents a bet by the market that another, better, offer will emerge.  As a practical matter, most often these bets turn out to be correct.  Maybe it’s because the bettors have deep industry knowledge or maybe because they’re acting on information from/about another potential acquirer you and I are not privy to.

For me, this will be an interesting case to watch, since I can’t figure out who the other buyer might be.

 

 

Whole Foods (WFM) and Amazon (AMZN)

I was a big proponent of WFM in its early days but haven’t owned it for a long time.

My quick look at the company’s financials this morning tells me it’s an odd duck among food distributors.  Successful distribution is all about low margins + rapid inventory turnover + shrewd working capital management + rising sales leading to strong profit growth.  WFM exhibits only one of these characteristics:  rapid inventory turnover.  The number I get from the annual report, which I find almost too good to believe, says that WFM’s annual sales are 30x its average inventory.  This compares with 10x for AMZN and 15x for Kroger (KR).

On the other hand, WFM’s operating margin is more than 50% higher than KR’s and nearly triple AMZN’s.  The excess of payables (what a firm owes to suppliers) over receivables (what customers owe the merchant)–and a key measure of operating strength–is about 1% of sales for WFM, while 3.6% for KR and about 15% for AMZN.  In addition, WFM is no longer growing–the main reason, I think, the company’s PE has been cut in half over the past couple of years from about 40x to 20x (pre-AMZN bid).

WFM’s problem isn’t simply that its margins are too high to induce people to buy more than they do of what the company has to offer.  Nor is it the assertion by some that WFM is very inefficient and should be making a higher margin than it actually does.

Rather, it’s that the current market situation is highly unstable, on several fronts:

–WFM-like offerings are increasingly available from less expensive chains like Trader Joe’s or even regular supermarkets

–having severely damaged the profits of incumbent grocers in the UK, deep food discounters from Germany–Aldi and Lidl–have both announced that their next target is the US.  Even if the two are unsuccessful, increased competition is bound to mean lower prices

–AMZN has decided that the time for online food delivery on a large scale in the US has come.  It’s also possible that it too is worried about the potential effect that Aldi and Lidl may have and has sped up its food distribution plans.

 

how will the takeover work out?

It’s hard to know.  WFM’s management hasn’t covered itself in glory over the past decade.  It needed to be bailed out from operating difficulties by Green Equity Investors in late 2008.  And it doesn’t seem to have responded well to increased competition since.  On the other hand, AMZN’s experiments in food delivery have had indifferent success so far. At the very least, though, AMZN brings a strong record in controlling distribution operations, expertise which WFM seems to me to need; WFM brings a brand name and the grocery equivalent of Amazon lockers.

My thoughts:  the one thing I’m confident of is that food prices will generally be lower for consumers in a couple of years than they are now.  I’d prefer to look for places where extra discretionary income can be spent than to try to play food directly.

 

the curious case of Toshiba and the Mitsui keiretsu

The Financial Times, now owned by the Nihon Keisai Shimbun (the Nikkei newspaper)–and which should therefore have a particularly sharp insight into goings on in corporate Japan, had an interesting article the other day about Toshiba.

Toshiba is facing possible bankruptcy and potential delisting from the Tokyo Stock Exchange as a result of the disastrous performance of its nuclear power business.  To avoid this fate, it has decided to sell its flash memory business, which is a world leader in this important class of semiconductor devices and owns essential intellectual property for their manufacture.

The Japanese government is intervening in the matter, with the aim of ensuring that this important asset remains in Japanese hands.  What is distinctly not happening, as pointed out in an FT article two days ago, is any aid being offered by other members of the Mitsui industrial group.  This is very unusual.

background

At the core of Japanese economy in the first half of the twentieth century stood a number of powerful industrial conglomerates, called zaibatsu, which emerged from the samurai culture of shogun-era Tokyo.  The zaibatsu were outlawed after WWII for their role in Japan’s participation in that conflict.  But their dissolution was in name only.  The groups continue to exist in substance but were referred to as keiretsu.

One of the principal features of the keiretsu is mutual assistance in times of trouble.

For example,

Some years ago, Mistubishi Motors tried to buy its way into the US car market with a “0-0-0” financing campaign.  That meant zero down, a zero interest rate on 100% financing, and no loan repayment for the first year.  As it turned out, there was also a fourth zero–no credit checks.  And very large number of buyers (if you can call them that) simply made no payments when the time came.  They continued to drive the cars until they were repossessed.  Mitsubishi Motors as a whole, not just the US subsidiary, was faced with financial failure as a result.

What happened?

The other members of the Mitsubishi group injected hundreds of billions of yen into the auto company so that it remained afloat.  I remember speaking about this at the time with the chairman of Mitsubishi Corp, the group’s trading company.  He was deeply unhappy about having to invest in the auto arm of the group, and knew that this made no economic sense, but felt that his honor demanded that he do so.

today

Fast-forwarding to today and Toshiba     …not a peep from other Mitsui group members.

There may be something unusual about Toshiba.  More likely, the zaibatsu concept, a vital aspect of the samurai culture, may have finally passed its best-by date.  Interesting, too, that this should come while a descendant of the samurai is the prime minister.

calling for higher inflation

Last week a group of prominent economists wrote an open letter to the Federal Reserve arguing that the current Fed target of 2% annual inflation is too low.

Their basic view is:

–circumstances have changed a lot in the US since 2% became the economists’ consensus for the right level of inflation a quarter-century ago, so it isn’t necessarily the right number anymore, and

–the lack of oomph in the US economy is a result of maintaining an inflation target that’s too low.  So let’s try 3% instead.

Having a 3% inflation target instead of 2% isn’t a new idea.  I heard it for the first time about 20 years ago, from an economist at the then Swiss Bank Corp.  Her argument was that getting from 3% to 2% inflation would require an enormous amount of effort without any obvious payoff.  The whole idea of inflation targeting is to eliminate the possibility of the kind of runaway inflation–and associated crazy economic choices–of the kind the US had begun to experience in the late 1970s.  Whether actual inflation is 3% or 2% matters little, just as long as the current level is not the launching pad for a progression of 4%, 6% 9%…

Another way of looking at this would be to say that the nominal figures matter much more than academic economists realize, and that 4% nominal GDP growth (2% trend economic growth + 2% inflation) feels too much like stagnation.  Therefore, it undermines the entrepreneurial tendencies of ordinary people.

 

How to create 3% inflation?  …slower interest rate increases and/or increased government stimulus (meaning tax cuts and infrastructure spending).

 

The letter certainly won’t affect the Fed’s thinking about a rate rise in June.  But it seems to me that the debate on this issue can only intensify.

By the way, I think 3% inflation would be good for stocks, neutral/bad for fixed income.

 

Uber and corporate control

Uber…

The continuing troubles at Uber have placed renewed focus on the dominant form of corporate organization among internet companies in Silicon Valley:  voting control concentrated in the hands of a small number of founding principals, with the vast majority of shareholders having little or no say in corporate affairs.

The companies in question have more than one class of stock.  The shares the public holds have either no say at all or, at best, a small fraction of the voting power each of the founders’ shares have.

Tech entrepreneurs didn’t invent the idea of multiple share classes.  Companies like Hershey, the NY Times or News Corp. have had this structure for decades.  And, yes, it does create problems.  Insiders are free to ignore the concerns of outsiders, who have little recourse other than to sell their holdings.  Of course, in the case of Uber, that’s easier to say than to do.

vs. GE

I think it’s striking, however, that the other prominent corporate name in the news today is GE, a company with a long history and a wide-open corporate register.  GE’s CEO, Jeff Immelt, is being forced to retire after 17 years at the helm–during which time GE has been a chronic underperformer.

I have some sympathy for Mr. Immelt, who, as far as I can see, inherited the terrible mess that his predecessor, Jack Welch, had created at GE by the turn of the century.  Even if we say Immelt’s first half decade was spent cleaning things up, though, it took a subsequent lost decade before the board decided to make a change.  And that is arguably only because an activist began to stir the pot.

…vs. J C Penney (JCP)

Then there’s the cautionary tale of JCP, where an investor group led by Pershing Square took control of the board a number of years ago.  The newcomers carried out a number of disastrous changes in JCP’s strategy that caused the firm’s profits–and its stock price–to crater.  They then convinced the board of directors to repurchase their stock at what I judge to have been an extremely favorable (for them) price–and disappeared.

In this case, having only one class of stock, and no dominant insider, worked to ordinary shareholders’ disadvantage.

my point?

To be clear, I’m not an advocate of having several share classes.  But I don’t think that’s the Uber problem.

As I see it, early investors backing Uber made a bad mistake in their assessment of the quality of the company’s management.  And by not providing enough mentoring they allowed a toxic corporate environment to proliferate.  The fact of multiple share classes makes it harder to rein in a renegade culture.  But take the multiple classes away and Uber would still have become what it is, I think.

 

 

 

 

 

 

last Friday’s US stock movement

Last Friday the S&P 500 opened at 2436, rose to 2446, fell to 2416 and rallied at the end of the day to close little changed at 2432.  Volume was maybe 10% higher than normal.  Sounds ho-hum.

Look at Financials, Energy or Technology and the story isn’t one of a sleepy summer-like Friday.  It’s violent sector rotation instead.

According to Google Finance, the Energy sector was up by +1.4% for the day and Financials by +0.8%.  Technology fell by -2.7%.

But that understates what happened beneath the calm surface.

Oil exploration and production stocks, which have been in free fall recently, rallied by 4% or more.  Large internet-related names fell by an equal amount.  Market darling Invidia (NVDA) rose by 4% in early Friday trading, then reversed course to fall by 15%, and rallied late in the day to close “only” down by 7%+.  That came on 5x recent daily volume.

What’s going on?

Well, to state the obvious, Friday’s stock market action in the US runs counter to recent trends.  To my mind, the aggressive buying and selling are both based on relative valuation rather than any sudden change in the fundamental prospects for any of the companies whose stocks are gyrating around.  It’s an assertion by the market that no matter how grim the outlook for oil, the stocks are too cheap–and no matter how rosy the future for tech, the stocks are too expensive.

This is part and parcel of equity investing.  There’s always someone, usually with a long investment horizon, who is willing to bet against the current trend, on grounds that current price movements are being driven by too much emotion and not enough by dollars and cents.

what’s unusual

What’s unusual about last Friday, to my mind, is how sharp the division between winning and losing sub-sectors has been and how aggressively stocks have been both sold and bought.

For what it’s worth, I also think it’s odd that this should happen on a Friday. Human buyers/sellers of this size tend, in my experience, to worry about whether they can execute their plans in one day, preferring not to let the competition mull the situation over on the weekend.  But that’s a minor point.  (One could equally argue that if the buyers/sells were looking for maximum surprise, Friday would be the ideal day to act.)

If this is indeed a counter-trend rally, meaning that after a period of valuation adjustment the prior trend will reassert itself (which is what I think), the most important investment question is how long–and how severe–the pro-energy, anti-tech rotation will be.

My experience is that it’s never just one day and that a counter-trend movement can run for a month.  On the other hand, this doesn’t look like the typical work of traditional human portfolio managers.  It looks to me more like trading done by computers.  If that’s correct, I’d imagine the buying/selling will cut deep and be over relatively quickly.  But that’s just a guess.  And I know my tendency in situations like this is to act too soon.

For myself, I’ve been thinking for some time that US oil exploration companies have been battered down too much.  As for tech, I still think it will be the most important sector for this year.  So I’m happy to use this weakness to rearrange my overall holdings, nibbling at the fallen tech names and offloading a couple of REITS I own that I think are fully valued.