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.

 

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.

 

 

 

 

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.

 

Whole Foods (WFM) and Millennials

What should we make of the announcement by WFM that it’s launching a new chain of supermarkets–smaller stores, selling less expensive merchandise, targeted to Millennials?

preliminaries

I was an early investor in WFM.  My family shops there on occasion.  But I haven’t followed the company for years.

Over almost any period during the past decade, the traditional supermarket chain Kroger (KR) would have been a better investment.

The stock’s strong performance from the depths of the recession comes in part from its starting point–a loss of over 3/4 of its stock market value and the need for a $425 million cash injection from private equity firm Green Equity Investors.

my thoughts

new brand–As I once heard a hotel marketing executive say, “You don’t start selling chocolate ice cream until the market for vanilla is saturated.”  Put a different way, if there’s still growth in the tried and true, it’s a waste of time to segment the market.  Therefore, the move to a second brand signals, at least in the minds of the managers who are doing this (and who presumably know their company the best), the end to growth in the first.

less expensive food–Pricing and brand image are intertwined.  Paying a high price for goods can confer status both on the product and the buyer.  Lowering prices can do the opposite.  It seems to me that WFM judges it can’t lower prices further in its Whole Foods stores without risking the brand’s premium image.  It may also be that WFM thinks it needs the pricing to pay for the big stores/prime locations it already has.  That would be worse.

smaller stores–This is less obvious.  The straightforward conclusion is that WFM has exhausted all the US locations where the demographics justify a big store.  My impression is that this happened years ago, however, when WFM began to decrease the square footage of its new stores.  On the other hand, it may also be that in their search for “authenticity,” Millennials react badly to big stores.

Millennials–Millennials and Baby Boomers are each about a quarter of the population.  Boomers have about twice the income of Millennials.  But as Boomers fade into retirement, their incomes will drop.  Millennials, in contrast, are just entering their prime working years, when salaries will rise significantly.  So targeting Millennials makes sense.

 

It’s not surprising that WFM shares dropped on the news.   It signals the end of the road for the proven brand and a venture into the unknown for which no details have been provided.  Why announce this now in the first place?