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.

 

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 $0.007 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.

 

 

 

 

 

 

 

Whole Foods Market (WFM)–final round

As I pointed out last week, WFM has gross margins that are much higher than the average supermarket’s.  WFM also turns its inventory in a little less than two weeks, which is two or three times the rate of a typical grocery store.  Over the past several years, it has been generating over a billion dollars in annual cash flow.

On the other hand, sales are falling.  The largest use WFM has been making of the money it generates is to buy back stock ($2 billion worth over the past three years).  Its working capital management seems to produce much less cash for it than rivals–although this may be the result of an unusual product mix and/or worry that the current poor sales trend will continue.

In addition, it appears WFM is attempting to extend its brand downmarket with the opening of 365 stores–a tacit acknowledgement that its core high-end market is saturated.  In my experience, though, this strategy rarely works.  Its main effect is typically to degrade the upscale image of the main brand.  Tiffany is the only exception I can think of.

what interests Amazon (AMZN)

–WFM has a well-known brand name, that stands for healthy, high-quality, and ethical behavior.  But it also stands for “whole paycheck,” an attribute that AMZN can most likely eliminate without damaging the rest of the image

–an ironic plus, WFM doesn’t appear to have kept up with the times in pricing, computerization or inventory control.  So there’s arguably low-hanging fruit to be picked

–WFM has a physical distribution network that culminates in 430+ physical stores covering most major markets in the US

–the NPD Group, a leader in consumer marketing research, points out that:

—-WSM stores are located in areas that are younger and more affluent than average

—-52% of online grocery buyers are members of Amazon Prime, and therefore arguably disposed to by groceries through AMZN if the company had an adequate delivery mechanism

—-60% of Millennials bought at least one item from AMZN last year vs. 24% who bought something from WSM.  So AMZN has, at least on paper, the potential to deliver a large new audience to WFM

–according to a Morgan Stanley survey, which I read about in the Wall Street Journal, 62% of WSM’s current customers are already members of Amazon Prime.  Arguably, there’s a big opportunity for AMZN to increase the frequency/amount of WSM purchases through the Prime network.

my take

From its high in early 2015, the WFM had almost been cut in half–in a market that was rising by 15%–before Wall Street began to anticipate a couple of months ago that the company would be either restructured or sold.  Although I’m by no means an expert on WFM, that negative price action is hard to ignore.  So, too, the declining sales trend.

The picture that emerges to me is of an high-end retailer that has saturated its niche and whose chief product–healthy, but expensive, food–is being commoditized by rivals.  To date, management has marshaled no adequate response to this competitive threat.

AMZN provides a face-saving way for WSM to retain its counterculture self-image while turning over its market problem to more competent hands.

 

 

 

 

Amazon (AMZN) vs. Apple (AAPL)

I changed radio channels from the morning news to Bloomberg Radio while I was in the car yesterday.  It was about 9am, so I figured I’d get some market news while avoiding the Today-like chitchat that begins on Bloomberg at 10am.

What I heard instead was an expression of disbelief about the relative valuation of AMZN and AAPL, with the former being inappropriately trading at 3x the price/free cash flow of the latter.   The senior talking head presented this as being so self-evidently true as to need no further discussion.

I’m not sure why this howler bothered me, but it it did.

Three points:

–Both companies were formed by visionary entrepreneurs who transformed the landscape of their industries.  However, Jeff Bezos is still innovating and AAPL hasn’t produced a big new product in the past five years.

AAPL is a high-end smartphone company.  Today, that’s a mature product that depends on replacement demand.  There are no new customers.  Network operators are trying to stretch out the replacement cycle as a way of lowering their costs.

In contrast, AMZN is all about web services, a business that’s in its infancy and growing like a weed.  And the world is increasingly shifting to online purchasing.

In other words, AAPL and AMZN are very different companies.

–The accounting principles AMZN uses are more conservative than AAPL’s.  What might appear on the AAPL income statement as $1 in profit might only be, say, $.75 on AMZN’s. That alone doesn’t explain why one should trade at 3x the other.  But the comparison is far from clean.  Dollars to donuts the talking head I heard had no idea.

–I don’t get why free cash flow generation is an appropriate metric to use in making the comparison in the first place.

Free cash flow is the money a firm generates from operations minus the capital it invests in building/maintaining the business (and, for me, minus any mandatory debt repayments, as well).  Free cash flow is the “extra” that can be used to pay dividends.  Good for income-oriented investors.  If it’s very large, free cash flow may even attract potential acquirers in related industries who have investment opportunities that are greater than their ability to fund.

At the same time, large free cash flow can signal that a business has no new investment opportunities.  So the large free cash flow may simply mean the company has gone ex growth.  That’s bad.  On the other hand, a firm may have little or no free cash flow because it has lots of new investment opportunities and huge capacity to grow.  A growth investor will pick the second over the first any day of the week.

Personally, I don’t have a strong opinion on AMZN vs. AAPL.  For years I’ve been bemused by the strength of AAPL shares despite the clear evidence that the smartphone market was nearing saturation.  I’ve also been surprised by how well AMZN shares have done.

My point is that there was a children-playing-with-matches aspect to the discussion I heard.  There was no recognition that AMZN and AAPL are very different kinds of companies and the comparison metric was, yes, a little more sophisticated than PE–but completely wrongly used.

Maybe CNBC isn’t so bad, after all.

 

big day for Amazon (AMZN)–why?

AMZN reported 2Q15 results after the close last night.  They were very good.

Sales were up 20% year-on-year; expenses rose by 17%, three percentage points less.  As a result, the company reported an operating profit of $464 million vs. a loss in the second period of 2014.

More than that, AMZN’s cloud services division, AWS, had revenue growth of 81% yoy and a quintupling of segment profits (basically operating profits less stock option expense) to $391 million.  AWS, broken out as a separate segment for the first time after 1Q15, remained a bit more than a third of the AMZN total.

 

AMZN posted an overall profit of $.19 a share for the quarter, vs. analysts’ expectations of a loss of $.13 a share and a deficit of $.27 per share in the year-ago quarter.

On the announcement, the stock immediately rose by 15% in aftermarket trading.

AMZN opened up by 20% this morning, before drifting down steadily during the day to close +9.8% in a market that was down just more than 1%.

 

Why the strong advance?

I have no good explanation, although I do have some ideas.

1. The obvious factor that changed overnight was the earnings announcement.

It contained a significant positive earnings surprise, one that makes it more likely that the company will earn, say, $1- a share in the current year. It makes the analyst consensus of $2.78 a share for 2016 more believable.   On the other hand, the stock was trading at $482 before the earnings report, or 173x the 2016 consensus.  Looking at the stock price another way, let’s say that at maturity for its businesses (whenever that may be), AMZN shares will be trading at 20x earnings.  To sustain the pre-earnings report price, that would imply a burst of rapid growth that shoots earnings up to around $24 a share.  That would be something like a doubling of earnings each year for the next five or six.

That’s already baked in the cake.  A buyer of the stock at this level must believe that $24 a share in eventual earnings is way too low.

I find it hard to believe that a $.32  per share earnings surprise during one quarter–when expectations were already sky-high=-would be enough to add 20%, or even 10%, to AMZN’s perceived market value.

2.  A second hypothesis…

What if investors are beginning to separate AMZN into two parts, AWS and everything else, and are doing a sum-of-the-parts evaluation.  To me, this sounds a little more plausible.  What would the numbers look like?

Let’s say that in 2016 AWS will comprise half of AMZN’s earnings and AMZN Retail the remainder.  To make the figures easier, let’s say each half earns $1.50 a share next year.

Let’s assume AMZN retail can grow in earnings at 20% a year for a long time, and that we’d be willing to pay 50x current results–a big number for a retail stock–for that future profit stream.  If so, AMZN Retail is worth $75.  To reach a sum-of-the-parts value of $482, AWS must therefore be worth about $400, or close to 270x its 2016 eps.  Ok, while I personally wouldn’t be willing to pay that much for AWS, I can see how someone else might.  However, I still don’t understand why confirmation that a holder at 270x earnings isn’t insane would cause the multiple to expand.  (Also, before I’d be comfortable valuing AWS as a separate company, I’d want to know more about how AMZN apportions revenues and costs among segments to ensure the published numbers don’t flatter AWS.  I’d also think long and hard about the possible effect of stock options.)

3.  The explanation for AMZN’s rocket ship ride that I’m leaning toward, however, is more technical.  Two factors may be involved.  At what Google Finance reports as 21+ million shares, today’s trading volume in AMZN was 7x normal.  The sharp opening spike suggests to me that algorithmic trading computers were at work reacting to the earnings report, not humans.  Humans, I think (?!?), would have a better sense of valuation.  I also suspect that the report and immediate upward move triggered a lot of short covering.

I’m partial to #3 because I think the whole reaction is a little  crazy.

Why is any of this important?  AMZN is a high-profile, large-cap stock with almost two decades of operating history.  There’s got to be a way to make money from the possibility that something like AMZN’s big move will occur with other similar names.