more on Whole Foods (WFM) and Amazon (AMZN)

I was reading an article from Fortune magazine about the AMZN takeover of WFM.  Although it echoed much of what the rest of the press is saying, I was struck by it–mostly because my expectations for Fortune are higher than for financial reporting in general.

Three ideas in the article stuck out in particular:

–that AMZN’s goal with WFM is to compete head-to-head in groceries with Wal-Mart (WMT)

—the implication that because the margins of grocery chains are low they have a poor business model

–that the price cuts made by AMZN on Monday are small, therefore they make no difference.

my take

–ten campers, including yourself, are being chased by a bear.  If the goal is purely personal survival, you don’t need to outrun the bear.  You only need to outrun one of the other nine.

Put a different way, the goal of, say, Zara or Suit Supply is not to compete head-to-head on price with WMT.  that would be suicide.  Instead, those firms intend to provide differentiated clothing to a more focused audience.  Yes, it’s still clothing, but it’s different clothing.  Initially, at least, that’s AMZN’s goal with WFM.  It wants to expand WFM’s appeal to a smaller, younger, more affluent audience, not steal traffic from WMT.

–the key to profitability in a distribution business is to turn inventory over rapidly, taking a small markup on each transaction.  This is surprisingly badly understood by most professional investors, as well as virtually all the financial press–and by WFM, as well.  This is one reason that as an investor I love distribution companies.

Low markups defend against competition and create customer loyalty; continual effort to keep the growth in inventory under the growth in sales creates positive operating leverage.

WFM appears to me to have chosen do pretty much the opposite–to take large markups on each transaction, a “strategy” that has stunted sales growth.  Inventory turns are higher for WFM than for other grocers, although I suspect that this is a function of differences in product mix.  In any event, something else (or, more likely, a bunch of other something elses) in WFM’s organizational structure is all messed up.  The income statement shows that its very fat gross margins are frittered away almost completely by high overhead expenses.

If I were AMZN, I’d figure I’d attack what I think is the abundant low-hanging fruit in operating inefficiency and lower food selling prices as I made gains there

–it’s very easy to lower prices.  It’s extremely hard to raise them again–a key reason that couponing is a favorite supermarket strategy.  So it would be crazy for a merchant to lower prices across the board on day one.  $.49 a pound bananas, displayed prominently by the store entrance, is aimed at setting customer expectations about pricing throughout the store.  It’s a symbol, a promise   …at this point, nothing more.

 

gains for Berkshire Hathaway (BRK) on GE and BofA

Every investment company has to make public filings with the SEC that disclose its quarter-end investment positions.  Comparing the changes between filings allows anyone to see the investment moves of high-level professionals, even though this comes with a lag.

Recently, the press has picked up on the results of two investments made by Warren Buffett/BRK during the financial crisis.  He provided finance to Bank of America (BAC) and to General Electric (GE), two companies whose operations were under great stress because of recession.  As he has done in other instances, Buffett demanded, and received, a long-running option to convert what were essentially commercial loans into the companies’ common stock at 2008 prices, in the case of GE, and 2011 prices, in the case of BAC.

BRK and GE, BAC

BRK has recently cashed out of its position in GE completely and has converted the BAC preferred stock it bought into common.  Back of the envelope, here’s how Mr. Buffett made out:

–BRK lent GE $3 billion and received a total of $4 billion back, including the sale of all the stock bought through warrant exercise;  a gain of 33.3% over nine years, during which time the S&P 500 gained 250%+.

–BRK lent BAC $5 billion.  It has received about $2 billion in dividend payments and has a gain of about $11 billion on the BAC stock it now owns.  That’s a gain of 260% over six years, during which time the S&P 500 gained about 110%.

Together:  BRK lost $6.5 billion by its investment in GE vs. holding an S&P 500 index fund;  it has gained $8 billion vs the index so far on holding BAC.

evaluating results

A more interesting question:  did BRK do well or badly?

On GE, the answer is clear.  The investment did very poorly.

On BAC, the answer is also clear.  The investment gave BRK more downside protection, and higher income, than the common during a time when BAC was in hot water.  And it came just before BAC began its long run of outperformance against the S&P 500.   So this was a home run.

Regular readers will know that my overall view on Mr. Buffett is that he persists in using a manual typewriter in a Word (or Google docs) world.  You have to hand it to him on BAC.  But GE’s salad days were long gone when he put BRK’s money into it.

Whole Foods (WFM) and Amazon (AMZN)

Most of the talk I’ve heard about AMZN’s acquisition of WFM revolves around the idea that AMZN plays a long game.  That is, the company is willing to forgo profits for an extended period in order to achieve market share objectives–which will ultimately lead to an earnings payoff.  After all, it took eight years to get its online business into the black.

What’s being lost in the discussion, I think, is the present state of WFM.  It’s not a particularly well-run company.  Analyst comments, which have surfaced publicly only after it became clear that WFM would be acquired, suggest the company has antiquated computer control systems.  It has waffled between emphasis on large stores and small.  We know that it needed a private equity bailout during the recent recession.    It has begun a down-market expansion through “365 by Whole Foods” stores; in every case I can think of, except for Tiffany, this has been a sure-fire recipe for destroying the upmarket main brand.

The easiest way to see management issue, I think, is to compare WFM with Kroger (KR), a well-run supermarket company.  Their accounting conventions aren’t precisely the same, but I don’t think that makes much difference for my point.   (Figures are taken from the most recent 10Qs.).  Here goes:

–gross margin:  KR = 19.7%;  WFM = 33.8%

–pretax margin:  KR = 1.2%;  WFM = 4%

–inventory turns/quarter:  KR = 5.8x; WFM = 7.7x.

What do these figures mean?

–WFM turns its inventories much faster than KR, which should give WFM a profit advantage

–WFM marks up the items it sells by an average of about 50% over its cost of goods;  the markup for KR is half that.

–the combination of faster turns and much higher markup should mean a wildly higher pre-tax margin for WFM

–however, 14 percentage points of margin advantage for WFM at the gross line almost completely evaporates into 2.8 percentage points at the pre-tax line.

–this means that WFM somehow loses 11.2 percentage points in margin between the arrival of goods in the store and their delivery to customers, despite the fact that stuff sells significantly faster at WFM than at KR.

my take

Yes, AMZN can expand the WFM customer base.  Yes, it can cross-sell, that is, deliver non-food goods, like Alexa, through the WFM store network and the 365 brand through the AMZN website.  Yes, using the Amazon store card will likely get customers a 5% rebate on purchases.  Yes, WFM’s physical stores may even serve as depots for processing AMZN returns.  That’s all gravy.

But if AMZN can eliminate what’s eating those 11.2 percentage points of margin (my bet is that it can do so in short order) it can lower food prices at WFM by a huge amount and still grow the chain’s near-term profits.  This is what I think activist investor Jana Partners saw when it took a stake in WFM.

 

21st century retailing: my trip to Home Depot

This is another mountain-out-of-a molehill thing.

We have Toto toilets in our house.  Toto is the leading brand in Asia and has been making significant inroads in the US over close to two decades.  Yes, they’re the toilets that play music, heat the seat, double as a bidet and make fake urinating noises (a Japanese must)–but we just have plain old toilets.

The other day, I went to the local Home Depot, which, by the way, sells Toto toilets, to get a replacement part for one of ours.  A friendly employee showed me where the replacement parts were–all aftermarket brands, not Toto, but that was ok with me–and which was the right one. The replacement didn’t look much like the broken part, but the employee assured me that it would work.

It didn’t.  And, in fact, in looking back on my trip, the HD employee may, strictly speaking, have only told me that that was all they had.  If so, kind of embarrassing for me, since for most of my working life I was on the alert for verbal gymnastics aimed at papering over problems.

Rather than launch a telephone search for a plumbing supply store in the neighborhood that might carry the part I needed, I found it on Amazon.

 

Around the same time, I found I needed a replacement part for a Weber grill.  Same story.  HD sells Weber grills, but not replacement parts.  So, after a wasted trip to the local HD store, I ordered from AMZN.

 

What’s interesting about this?

In the early days of the internet, there was lots of speculation about the “long tail,” meaning that e-retailers like AMZN would make most of their money from selling obscure items that potential buyers couldn’t find in bricks-and-mortar stores.

A great story   …just not the case back then.  Just like bam, online exhibited the “heavy half” phenomenon, i.e., 80% of the business came from 20% of the items.

 

But maybe the long tail is beginning to come true.  It’s not because weird stuff that no one really wants has suddenly come into vogue.  Instead, I think computer-driven inventory control programs that eliminate slow-moving items from a store’s offerings may have gone too far.  Yes, carrying fewer items has the beneficial effect of requiring fewer employees and less floor space.  But at some point, the process begins to have negative consequences, as well.

For instance, it’s training me not to go to a physical DIY store, so I’m not passing by enticing end cap displays or being tempted by the sparkly high-margin junk arrayed along the checkout line.

 

My experience as an analyst has been that any cost-control measures always seem to go too far.  They work for a while, but the continual application of the same process somehow eventually ends up creating the opposite of the intended effect (yes, experience has made me a Hegelian, after all).  This may be what is starting to happen with inventory control programs that retailers use.

If I’m correct, this is another plus for AMZN.

 

21st century retail: my trip to Rite-Aid

I went to Rite-Aid the other day to get some Aleve.  I was away from home, in a rural area more than 100 miles from the nearest Costco, and not at a place where I could get same-day delivery from Amazon (270 Aleve tablets for $18 ($0.07 each).

I had several choices:

–100 generic (naproxen sodium) tablets for $9 ($.09 ea.),

–200 generic for $14 ($.07 ea.)

–100 Aleve for $11  ($.11 ea.),

–200 Aleve for $20 ($0.10 ea.), or

–270 generic for $14.50 ($0.05 ea.).

I took the 270.

What really struck me was the fact that I got the final 70 tablets for a total of $0.50.  That’s $0.007 each.  Assuming that Rite-Aid wasn’t paying me to cart them away, the most it could have paid for the tablets was $0.0072 apiece.  Multiply by 270 and you get about $1.90.

Doing the analysts’s mountain-out-of-a-molehill thing, and assuming Rite-Aid buys from the manufacturer, I conclude that $1.90 is the most it could have paid for the container of tablets I bought.

The $12.60 that remains is the cost of packaging, distribution, promotion …plus profit.  (Overall, Rite-Aid isn’t making money, even though it has a positive gross margin of about 22%.  SG&A pushes it into loss, so delete “profit” from the packaging… list.)

That Rite-Aid can’t make money despite a 600%+ markup says a lot about the company.  But it also says something about bricks-and-mortar retail, the way Rite-Aid gets its products in front of customers.

This is the AMZN success story in a nutshell:  all it has to do is deliver a $2 item to a customer and spend less than $12.60 to do it.

 

My trip to Home Depot tomorrow.

 

 

 

 

 

 

 

thinking about retail: Dicks Sporting Goods (DKS)

DKS reported disappointing earnings Monday night.  Its stock dropped by 23% in Tuesday trading.  So far this year it has lost 49% of its value, in a market that’s up by 10%.  …this in spite of the bankruptcies of rivals Sports Authority and Gander Mountain, which should arguably have cleared the way for better results.

The obvious culprit here is Amazon (AMZN).

I’m sure that AMZN is a factor.  On the other hand, although AMZN is growing at 4x the +5% rate of annual expansion of sporting goods sales in the US, the online giant represents only about 4% of the total sporting goods market.  DKS alone is 50% bigger–and its bricks-and-mortar competition has shrunk considerably.  So online can’t be the whole story.

I think two other general factors are involved:

–Millennials vs. Boomers, with DKS, to my mind, clearly oriented toward Baby Boomers’ tastes.  This issue here is that although Boomers have more money than Millennials, their star is waning as Millennials’ is rising.

–a “normal” business cycle.  During most time periods and in most parts of the world, in my experience, consumers are constrained in their buying by the limits of their income.  As new households form and families rent/buy a residence, rent/mortgage and, sooner or later, things like furniture become significant purchase categories.  This means less money for other purchases–like new golf clubs.

From the late 1990s through 2007, however, that wasn’t the case. Universal availability of home equity loans enabled consumers to avoid budgeting and prioritizing purchases.  So the typical pattern of contraction in some retail categories while housing-related, expands was absent for an extended period.

Now it’s back.  My sense is Wall Street has yet to catch on.

As an investor, I’m not particularly interested in the sporting goods category.  But I think the pattern I see here isn’t an isolated phenomenon.  If I’m correct, we should be doubly careful of any traditional retailer.

 

 

paying for brokerage research

As part of an EU overhaul of the financial industry, the UK has recently concluded an inquiry into pricing practices for mutual fund and other products offered to individual investors.  Press commentary is that the good luck for an industry with a bewildering array of prices (much higher than in the US) and little link between cost and value is not having been referred to the law enforcement authorities for criminal prosecution.

One big issue has been “soft dollars,” that is, paying brokers higher than usual commissions in return for their research, or for trading machines, or even newspapers–items that customers generally believe (and rightly suppose, in my view) they are paying for through management fees.   …but no!

Asset managers have been proclaiming that this is a weighty and complex issue, that the don’t know how to proceed.  They’ve generally been gnashing their teeth.

To me, this is all somewhat comical.  For decades, firms that do business in the US have been following an SEC mandate to keep meticulous records of the amount of their soft dollar expenses and what is being paid for.   The general rule was that if you stayed in line with industry practice, meaning doing whatever Fidelity did, you’d be ok legally.  They know exactly what they’ve been doing.  Also, the EU inquiry (see the link above) has been going on for three years.

There are two real issues:

–there’s a lot of money at stake, and

–handling the potential outcry from customers when they realize they’ve been paying twice (management fee + soft dollars) for research expenses.

An example:

A mutual fund has $50 billion in assets.  It turns those assets over at the industry average of 50% per year.  That means $50 billion in buys and $50 billion in sells.

Let’s say: the average stock trades for $40; the soft-dollar markup is $.02 per share; and the markup is taken on 20% of all shares traded (maybe slightly high, but the math is easier).

So, the fund “service” includes giving up $10 million a year of customer money on brokerage commissions in order to get the management company free goods and services.  That’s even though they’re collecting something like $250 million in management fees from the same customers.

disclosure vs. restructuring

Internally, I think disclosure is the lesser of the two issues.  The more difficult one is that industry revenues are stagnant or falling and by far the largest expense of any investment manager is salaries.  So, whose pocket does the lost soft dollar revenue come out of?

Vanguard, this decade’s Fidelity

Just prior to the 2007 financial crisis, Fidelity decided to turn up the competitive heat on fund management rivals by declaring it was unilaterally going to stop using soft dollars.  This time around, it’s silent so far.

Last week, Vanguard made a similar announcement.