The 9 Reasons Why Amazon Buying Whole Foods Is A Good Idea

The 9 Reasons Why Amazon Buying Whole Foods Is A Good Idea

Whole Food flagship store in Austin, Texas.

Amazon announced it was paying $13.7B to buy Whole Foods.  While not without risks, there are a lot of reasons this is a great idea:

1 – It makes Amazon a national grocery competitor overnight

Building any retail chain takes a long time.  Due to the intensity of competition, and low margins, building a grocery chain takes even longer.  Amazon would have spent decades trying to create its own chain.  Now it won’t lose all that time, and it won’t give competitors more time to figure out their strategies.

2- Now Amazon can get the necessary “deal dollars” to compete in groceries

Few people realize that no grocer makes money selling groceries. Revenues do not cover the costs of inventory, buildings and labor. On its own, selling groceries loses money.  Grocers survive on manufacturer “deal dollars.”

Companies like P&G, Nabisco, etc. pay grocers slotting fees to obtain shelf space, they pay premiums for eye level shelves and end caps, they pay new product fees to have grocers stock new items, they pay inventory fees to have grocers keep inventory on shelf and in back, they pay advertising fees to have signs in the stores and products in circulars, and they pay volume rebates for meeting, and exceeding, volume goals.  It is these manufacturer “deal dollars” that cover the losses on the store operations and create a profit for investors.

One reason Whole Foods prices are so high is they stock less of the mass market goods and thus receive fewer deal dollars.  Now Amazon can use Whole Foods to increase its volume in all products and dramatically increase its deal dollar inflow.  Something that Amazon sorely missed as a “delivery only” grocer.

3 – Amazon obtains a grocery distribution system

Grocery distribution is unique.  For decades grocers have worked with manufacturers, cooperatives, growers and other suppliers to create the shortest, most efficient distribution of food with the lowest inventory. In many instances replenishment quantities are shipped based on manufacturer access to real grocer sales data. Amazon is the best at what it does, but to compete in groceries it needed a grocery distribution system – and with Whole Foods it obtains one at scale without having to create it.

Additionally Amazon will obtain the corporate infrastructure of a grocer, without having to build one on its own.  All those buyers, merchandisers, real estate professionals, local ad buyers, etc. are there and ready to execute – something building would be very hard to do.

4 – Amazon obtains great locations

Whole Foods has 460 stores, and almost all are in great locations. Whole Foods focused on upscale, growing and often urban or suburban locations – all great for Amazon to grow its distribution footprint.  And hard sites to find.

These can be used to sell other products, such as other grocery items, or some selection of Amazon products if that makes sense.  Or these can be used to augment Amazon’s distribution system for local delivery – or as neighborhood drop-off locations for people who don’t want at-home delivery to pick up Amazon-purchased products. Or they can be sold/leased at very attractive prices.

5 – Amazon can change the Whole Foods brand in important, positive ways

“Whole Paycheck” has long been the knock on Whole Foods.  As mentioned before, the lack of mass market items meant their products lacked deal dollars and thus had to be priced higher. And their stores are large, and not the best use of space. The result has been a lot of trouble keeping customers, and one of the lowest sales per square foot in the grocery industry.

Amazon can easily use its low-price position to alter the Whole Foods brand concept to include things like Pepsi, Coke, Bounty, Gain – a slew of branded consumer goods previously eschewed by Whole Foods.  Adding these products could make the stores more useful to more customers, and greatly lower the average cost of a cart full of goods.  On its own, this brand transition has been impossible for Whole Foods.  As part of Amazon remaking the brand will be vastly easier.

6 – Amazon can personalize grocery shopping like it did general merchandise

If you shopped Amazon you know they really figure out your needs, and help you find what you want.  Amazon keeps track of your searches and purchases, and makes recommendations that often help the shopping experience and delight us as customers.

But today all that information on grocery shopping is un-mined.  Despite using a loyalty card, traditional grocers (and WalMart) have been unable to actually mine that information for better marketing. Now Whole Foods will be able to use Amazon’s incredible technology skills, including big data mining and artificial (or augmented) intelligence to actually help us make the grocery shopping experience better – less time intensive, and most likely less costly while still allowing us to fill our carts with what we need and what makes us happy.

7 – The deal is cheap

$13.7B is only 65% of the cash Amazon had on hand end of last quarter.  And Amazon has only $7.7B in long-term debt.  With a $460B market cap Amazon could easily take on more debt without adding significant financial risk.

But even more important, Amazon has the amazingly cheap currency that is Amazon stock.  Even at the offering price, Whole Foods trades at 34x earnings.  Amazon trades at 185x earnings.  Thus by swapping Amazon shares for Whole Foods shares Amazon lowers the price 80%!  Amazon isn’t spending real dollars, it is using its stock – which is an incredibly valuable move for its shareholders.

8 – This is a serious attack on WalMart

For the last several years WalMart’s general merchandise sales have been declining due to the Amazon Effect and growing on-line competitor sales.  For the last 3 years overall revenues have not grown at all.  To maintain revenue Walmart has shifted increasingly to groceries – which account for well over half of all WalMart revenues. By purchasing Whole Foods, Amazon takes direct aim at the only part of WalMart’s “core” business that it has not attacked.

Walmart’s net profit before taxes is ~4%. If Amazon can use Whole Foods to combine stores and on-line sales to take just 3% of WalMart’s grocery business away it could remove from Walmart ($485B revenues * 60% grocery * 3% market share loss) a net revenue decline of ~$9B.  Given that the cost of grocery goods sold is about 50% – that would mean a net loss in contribution of $4.5B – which would cut almost 25% out of Amazon’s $20B pre-tax income.  Raise the share taken to 5% and Amazon could cut WalMart’s pre-tax income by $7.25B, or ~35%.

The negative impact of declining store sales on the fixed costs of WalMart is atrocious. Even small revenue drops mean cutting staff, cutting inventory, cutting store size and eventually closing stores.  Look at how fast Sears and Kmart fell apart when sales started declining.  Like dominoes falling, declining sales sets off a series of bad events that dooms almost all retailers – as the quickened pace of retail bankruptcy filings has proven.

9 – This could be a huge win for Amazon shareholders

The above analysis, taking 3-5% out of Walmart’s grocery sales, say over 3 years, would be a huge gain attributed to the creation of a new Whole Foods combined with Amazon’s e-commerce.  Growing grocery revenues by $9-$14B would mean practically a doubling of Whole Foods.  Which sounds enormous – and most likely impossible for Whole Foods to do on its own, even if it did launch some kind of e-commerce initiative.

But this is not so unlikely given Amazon’s track record.  Amazon has been growing at over 25%/year, adding between $20-$25B of new revenues annually. In 3 years between 2013 and 2016 Amazon doubled its revenues.  So it is not that unlikely to expect Amazon puts forward an extremely ambitious push to turn around Whole Foods, increase store sales and use the combined entities to grow delivery sales of groceries and other general merchandise.

Is there risk in this acquisition?  Of course.  Combining any two companies is fraught with peril – combining IT systems, distribution systems, customer systems and cultures leaves enormous opportunities for missteps and disaster.  But the upsides are enormous.  Overall, this is a bet Amazon investors should be glad leadership is making – and it is a great benefit for Whole Foods investors.

Why EPS and Share Price Don’t Predict Future Performance

Why EPS and Share Price Don’t Predict Future Performance

Most analysts, and especially “chartists,” put a lot of emphasis on earnings per share (EPS) and stock price movements when determining whether to buy a stock.  Unfortunately, these are not good predictors of company performance, and investors should beware.

Most analysts are focused on short-term, meaning quarter-to-quarter, performance.  Their idea of long-term is looking back 1 year, comparing this quarter to same quarter last year.  As a result, they fixate on how EPS has done, and will talk about whether improvements in EPS will cause the “multiple” (meaning stock price divided by EPS) will “expand.”  They forecast stock price based upon future EPS times the industry multiple.  If EPS is growing, they expect the stock to trade at the industry multple, or possibly somewhat better.  Grow EPS, hope to grow the multiple, and project a higher valuation.

Analysts will also discuss the “momentum” (meaning direction and volume) of a stock. They look at charts, usually less than one year, and if price is going up they will say the momentum is good for a higher price.  They determine the “strength of momentum” by looking at trading volume.  Movements up or down on high volume are considered more meaningful than on low volume.

But, unfortunately, these indicators are purely short-term, and are easily manipulated so that they do not reflect the actual performance of the company.

At any given time, a CEO can decide to sell assets and use that cash to buy shares.  For example, McDonald’s sold Chipotle and Boston Market.  Then leadership took a big chunk of that money and repurchased company shares.  That meant McDonalds took its two fastest growing, and highest value, assets and sold them for short-term cash.  They traded growth for cash.  Then leadership spent that cash to buy shares, rather than invest in in another growth vehicle.

buying your own stockThis is where short-term manipulation happens.  Say a company is earning $1,000 and has 1,000 shares outstanding, so its EPS is $1.  The industry multiple is 10, so the share price is $10.  The company sells assets for $1,000 (for purposes of this exercise, let’s assume the book value on those assets is $1,000 so there is no gain, no earnings impact and no tax impact.)

Company leadership says its shares are undervalued, so to help out shareholders it will “return the money to shareholders via a share repurchase” (note, it is not giving money to shareholders, just buying shares.  $1,000 buys 100 shares.  The number of shares outstanding now falls to 900.  Earnings are still $1,000 (flat, no gain,) but dividing $1,000 by 900 now creates an EPS of $1.11 – a greater than 10% gain!  Using the same industry multiple, the analysts now say the stock is worth $1.11 x 10 = $11.10!

Even though the company is smaller, and has weaker growth prospects, somehow this “refocusing” of the company on its “core” business and cutting extraneous noise (and growth opportunities) has led to a price increase.

Worse, the company hires a very good investment banker to manage this share repurchase.  The investment banker watches stock buys and sells, and any time he sees the stock starting to soften he jumps in and buys some shares, so that momentum remains strong.  As time goes by, and the repurchase program is not completed, selectively he will make large purchases on light trading days, thus adding to the stock’s price momentum.

The analysts look at these momentum indicators, now driven by the share repurchase program, and deem the momentum to be strong.  “Investors love the stock” the analysts say (even though the marginal investors making the momentum strong are really company management) and start recommending to investors they should anticipate this company achieving a multiple of 11 based on earnings and stock momentum.  The price now goes to $1.11 x 11 = $12.21.

Yet the underlying company is no stronger.  In fact one could make the case it is weaker.  But, due to the higher EPS, better multiple and higher share price the CEO and her team are rewarded with outsized multi-million dollar bonuses.

But, companies the last several years did not even have to sell assets to undertake this kind of manipulation.  They could just spend cash from earnings. Earnings have been at record highs, and growing, for several years.  Yet most company leaders have not reinvested those earnings in plant, equipment or even people to drive further growth.  Instead they have built huge cash hoards, and then spent that cash on share buybacks – creating the EPS/Multiple expansion – and higher valuations – described above.

This has been so successful that in the last quarter untethered corporations have spent $238B on buybacks, while earning only $228B.  The short-term benefits are like corporate crack, and companies are spending all the money they have on buybacks rather than reinvesting in growth.

Where does the extra money originate?  Many companies have borrowed money to undertake buybacks. Corporate interest rates have been at generational (if not multi-generational) lows for several years.  Interest rates were kept low by the Federal Reserve hoping to spur borrowing and reinvestment in new products, plant, etc to drive economic growth, more jobs and higher wages.  The goal was to encourage companies to take on more debt, and its associated risk, in order to generate higher future revenues.

Many companies have chosen to borrow money, but rather than investing in growth projects they have bought shares.  They borrow money at 2-3%, then buy shares – which can have a much higher immediate impact on valuation – and drive up executive compensation.

This has been wildly prevalent. Since the Fed started its low-interest policy it has added $2.37trillion in cash to the economy. Corporate buybacks have totaled $2.41trillion.

This is why a company can actually have a crummy business, and look ill-positioned for the future, yet have growing EPS and stock price.  For example, McDonald’s has gone through rounds of store closures since 2005, sold major assets, now has more stores closing than opening, and has its largest franchisees despondent over future prospects.  Yet, the stock has tripled since 2005!  Leadership has greatly weakened the company, put it into a growth stall (since 2012,) and yet its value has gone up!

Microsoft has seen its “core” PC market shrink, had terrible new product launches of Vista and Windows 8, wholly failed to succeed with a successful mobile device, written off billions in failed acquisitions, and consistently lost money in its gaming division.  Yet, in the last 10 years it has seen EPS grow and its share price double through the power of share buybacks from its enormous cash hoard and ability to grow debt.  While it is undoubtedly true that 10 years ago Microsoft was far stronger, as a PC monopolist, than it is today – its value today is now higher.

Share buybacks can go on for several years. Especially in big companies.  But they add no value to a company, and if not exceeded by re-investments in growth markets they weaken the company.  Long term a company’s value will relate to its ability to grow revenues, and real profits.  If a company does not have a viable, competitive business model with real revenue growth prospects, it cannot survive.

Look no further than HP, which has had massive buybacks but is today worth only what it was worth 10 years ago as it prepares to split.  Or Sears Holdings which is now worth 15% of its value a decade ago.  Short term manipulative actions can fool any investor, and actually artificially keep stock prices high, so make sure you understand the long-term revenue trends, and prospects, of any investment.  Regardless of analyst recommendations.

Yahoo – Another Disappearing Giant Has Nowhere To Hide

Yahoo – Another Disappearing Giant Has Nowhere To Hide

This week Yahoo announced it is spinning off the last of its Alibaba holdings.  This is a big deal, because it might well signal the end of Yahoo.

Yahoo created internet advertising.  Yahoo was once the #1 home page for browsers across America.  But the company has floundered for years, riddled with CEO problems, a contentious Board of Directors and no strategy for dealing with Google which overtook it in all markets.

mayer-yahoo

To much fanfare the Board hired Marissa Mayer, a Google wunderkind we were told, in July, 2012 to mount a serious turnaround. And during her leadership the company’s stock value has tripled – from about $14.50/share to about $43.50.  You would think investors would be thrilled and the company would be on the right track.

Only almost all that value creation was due to a stock investment made in 2005 – when Jerry Yang invested $1B to buy 40% of Alibaba.  And Alibaba in 2014 became the most valuable IPO in history.

Yahoo today is valued at about $46B.  The Alibaba shares being spun out are valued at between $40B and $44B.  Which means that after adjusting for the ownership in Yahoo Japan (valued at $2.3B) the core Yahoo ad and portal business is worth between $2B and $4.7B.  With just over $1B shares outstanding, that puts a value on Yahoo’s core business of between $2.00-$4.70/share – or about 1/6 to 1/3 the value when Ms. Mayer became CEO.

A highest value of $4.7B for the operating business of Yahoo puts it on par with Groupon.  And worth far less than competitors Google ($347B) and Facebook ($212B).  Even upstart, and often maligned, social media companies Twitter ($24B) and LinkedIn ($27B) have valuations 5 times Yahoo.

Unfortunately, this latest leader and her team haven’t been any more effective at improving the company’s business than previous regimes.  Under CEO Mayer Yahoo used gains from Alibaba’s valuation to invest about $2.1B in 49 outside companies – with $2B of that being acquisitions of technology companies Flurry ($200M), BrightRoll ($640M) and Tumblr ($1.1).  Under the most optimistic view of Yahoo, leadership spent 40% of the company’s value in acquisitions that have made no difference to ad revenues or profits.

In fact, Yahoo’s business revenues, and profits, have declined for 6 consecutive quarters.  Despite the CEO’s mandate that employees could no longer work from home.  A kerfuffle that proved yet another management distraction, and apparently an effort to cut staff without it looking like a layoff.

Meanwhile there have been big efforts to boost people going to the Yahoo portal. Such as hiring broadcaster Katie Couric to beef up the news section, and former New York Times tech columnist David Pogue to deepen tech coverage and New York Times Magazine political writer Matt Bai to draw in more readers.  But these have done nothing to move the needle.

Consistently declining display advertising has left search ads a bigger, and more profitable, business.  And while Yahoo’s CEO has been teasing ad agencies that she might begin another big brand campaign, including TV, to bring Yahoo more attention – and hopefully more advertisers – there is no evidence anyone cares as more and more dollars flow to “programmatic” ad buying where Google is king.  In the digital ad marketplace Google has 31% share, Facebook 7.75% share and Yahoo a meager 2.36% share.

Soon there will be little left of the once mighty Yahoo.  It has pretty much lost relevancy.  Large investors are crying for a merger with AOL, whose inability to grow its portal, ad and media businesses has left its market cap at a mere $3.7B.  But combining two companies that are market irrelevant, and declining, will probably have the same outcome as happened when merging KMart and Sears.  The Yahoo growth stall remains intact, and revenues will decline along with profits as the market continues shifting to powerful and growing competitors Google, Facebook and other social media companies.  Only now Yahoo’s leaders won’t have the Alibaba value mountain to hide behind

Why You Don’t Want To Own IBM

Why You Don’t Want To Own IBM

IBM had a tough week this week.  After announcing earnings on Wednesday IBM fell 2%, dragging the Dow down over 100 points.  And as the Dow reversed course to end up 2% on the week, IBM continued to drag, ending down almost 3% for the week.

Of course, one bad week – even one bad earnings announcement – is no reason to dump a good company’s stock.  The short term vicissitudes of short-term stock trading should not greatly influence long-term investors.  But in IBM’s case, we now have 8 straight quarters of weaker revenues.  And that HAS to be disconcerting.  Managing earnings upward, such as the previous quarter, looks increasingly to be a short-term action, intended to overcome long-term revenues declines which portend much worse problems.

This revenue weakness roughly coincides with the tenure of CEO Virginia Rometty.  And in interviews she increasingly is defending her leadership, and promising that a revenue turnaround will soon be happening.  That it hasn’t, despite a raft of substantial acquisitions, indicates that the revenue growth problems are a lot deeper than she indicates.

ibm4-1

CEO Rometty uses high-brow language to describe the growth problem, calling herself a company steward who is thinking long-term.  But as the famous economist John Maynard Keynes pointed out in 1923, “in the long run we are all dead.”  Today CEO Rometty takes great pride in the company’s legacy, pointing out that “Planes don’t fly, trains don’t run, banks don’t operate without much of what IBM does.”

But powerful as that legacy has been, in markets that move as fast as digital technology any company can be displaced very fast.  Just ask the leadership at Sun Microsystems that once owned the telecom and enterprise markets for servers – before almost disappearing and being swallowed by Oracle in just 5 years (after losing $200B in market value.)  Or ask former CEO Steve Ballmer at Microsoft, who’s delays at entering mobile have left the company struggling for relevancy as PC sales flounder and Windows 8 fails to recharge historical markets.

CEO Rometty may take pride in her earnings management.  But we all know that came from large divestitures of the China business, and selling the PC and server business.  As well as significant employee layoffs.  All of which had short-term earnings benefits at the expense of long-term revenue growth.  Literally $6B of revenues sold off just during her leadership.

Which in and of itself might be OK – if there was something to replace those lost sales.  (Even if they didn’t have any profits – because at least we have faith in Amazon creating future profits as revenues zoom.)

What really worries me about IBM are two things that are public, but not discussed much behind the hoopla of earnings, acquisitions, divestitures and all the talk, talk, talk regarding a new future.

CNBC reported (again, this week,) that 121 companies in the S&P 500 (27.5%) cut R&D in the first quarter.  And guess who was on the list?  IBM, once an inveterate leader in R&D has been reducing R&D spending.  The short-term impact?  Better quarterly earnings.  Long term impact????

The Washington Post reported this week about the huge sums of money pouring out of corporations into stock buybacks rather than investing in R&D, new products, new capacity, enhanced marketing, sales growth, etc.  $500B in buybacks this year, 34% more than last year’s blistering buyback pace, flowed out of growth projects. To make matters worse, this isn’t just internal cash flow going for buybacks, but companies are actually borrowing money, increasing their debt levels, in order to buy their own stock!

And the Post labels as the “poster child” for this leveraged stock-propping behavior…. IBM.  IBM

“in the first quarter bought back more than $8 billion of its own stock, almost all of it paid for by borrowing. By reducing the number of outstanding shares, IBM has been able to maintain its earnings per share and prop up its stock price even as sales and operating profits fall.

The result: What was once the bluest of blue-chip companies now has a debt-to-equity ratio that is the highest in its history. As Zero Hedge put it, IBM has embarked on a strategy to “postpone the day of income statement reckoning by unleashing record amounts of debt on what was once upon a time a pristine balance sheet.”

In the case of IBM, looking beyond the short-term trees at the long-term forest should give investors little faith in the CEO or the company’s future growth prospects.  Much is being hidden in the morass of financial machinations surrounding acquisitions, divestitures, debt assumption and stock buybacks.  Meanwhile, revenues are declining, and investments in R&D are falling.  This cannot bode well for the company’s long-term investor prospects, regardless of the well scripted talking points offered last week.

 

 

Why acquisitions often don’t work – MySpace and NewsCorp.

The business media get really excited about acquisitions.  And it is clear that many executives still think acquisitions are a good way to grow – especially when wanting to enter new markets.  Even though all the academic research says that acquirers inevitably overpay, and that almost all acquisitions don't really have "synergy."  In fact, most acquisitions significantly reduce shareholder value.  While this doesn't keep execs from going forward, if we understand why acquisitions go badly better performance can be obtained.

As reported at Financial Times in "The Rise and Fall of MySpace" the problem with acquisitions is very tied to the "owner and acquired" thinking that emerges.  NewsCorp wanted to get into social media, so it moved early.  And the investment looked brilliant when a quick deal with Google appeared to make payback a year from new ad revenues.  MySpace was an early social media winner, and it looked to be potentially transformative for NewsCorp.

Until NewsCorp decided that things were too undisciplined at MySpace.  NewsCorp thought, like almost all acquirers, that it was more "disciplined" and "structured" and could apply its "better management" to the growth at MySpace.  Of course, all of this is code for pushing the NewsCorp Success Formula onto MySpaceWhat was acquired as White Space was quickly turned into another NewsCorp division – with the decision-making processes and overhead costs that NewsCorp had.  Quickly Behavioral and Structural Lock-ins that were prevalent in NewsCorp were applied to MySpace in management's effort to "improve" the acquisition.

But applying the acquirer's Success Formula to an acquisition soon removes it from White Space. Even though NewsCorp felt sure that it's higher caliber IT staff, big budgets and strong management team would "help" MySpace, it was robbing MySpace of its tight link to a rapidly shifting/evolving marketplace and replacing that with "NewsCorp think."  Quickly, competitors started to take advantage of market shiftsFacebook took advantage of the now weighted-down MySpace to rapidly bring on more users, while the additional ads on MySpace simply frustrated formerly happy customers more than willing to trade platforms. 

Scott Anthony on the Harvard Business Review blog "MySpace's Disruption, Disrupted" points out how in just 4years MySpace went from market leader to almost irrelevant.  MySpace lost its position as market disruptor as it increasingly conformed to demands of NewsCorp.  As the NewsCorp Success Formula overwhelmed MySpace it stopped being a market sensing project that could lead NewsCorp forward, and instead became a now money-losing division of a newspaper and TV company.  NewsCorp started trying to make MySpace into a traditional media company – rather than MySpace turning NewsCorp into the next Amazon, Apple or Google.

If a company wants to acquire a company for new market entry, that acquisition has to be kept in White Space.  It has to be given permission to remain outside the acquirer's Lock-ins and separate from the Success Formula.  It has to be allowed to use its resources to develop a new Success Formula toward which the acquirer with migrate – not "brought into the fold." 

Unfortunately, acquirers tend to think like previous century conquerers.  In Gengis Khan fashion they almost always end up moving to change the acquired.  Often in the name of "discipline" or "good management practices."  And that's too bad, because the result is a loss of shareholder value as the investment premium is dissipated when the acquisition fails to reach objectives.  Acquisitions can be good, but they have to be kept in White Space — like we see Google doing with Facebook!