Amazon - Whole Foods Is A Game Changer

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Amazon is changing the grocery landscape with the acquisition of Whole Foods.

The deal makes things very difficult for traditional grocery players, which have taken on some leverage and offer merchandise at non-competitive prices.

Wal-Mart and Costco have the ability to effectively compete on scale and price, but many others are highly challenged if Amazon succeeds.

Amazon adds another great addressable market as its increasing future retail dominance makes it worth to own on sizable dips.

Amazon (NASDAQ:AMZN) has officially sent a shockwave through the grocery industry a day after Kroger (NYSE:KR) already reset expectations for the industry. The purchase of Whole Foods Market (WFM) changes the retail landscape, and this time the grocery market, in a big way. As the Seattle-based online company is going offline, it creates severe competition for every bricks and mortar retailer.

I understand why investors are fleeing the grocery industry, which is set to become very tough or perhaps even uninvestable following this event. Amazon will add another huge market to its already very large addressable market, but this acquisition will become more capital-intensive than past expansion moves. I like this move, but the valuation remains an issue, as has always been the case.

That said, I am a buyer on dips, as I have been in the past, perhaps if investors become worried during a technology sell-off what this move implies for near- to medium-term cash flow generation.

The Deal Announcement

The deal terms are pretty simple and not that interesting. Amazon is paying $42 per share for Whole Foods Market, equivalent to $13.7 billion if net debt is included. Amazon CEO Jeff Bezos praised Whole Foods and stressed that he wants to continue to offer the best natural and organic foods, providing healthy food for people. For that reason, Amazon will continue to run the WFM brand.

While the $13.7 billion deal is huge in absolute terms, it is just a rounding error in relation to the $500 billion market capitalization of Amazon, trading at around $1,000 per share. The interesting feature is that both Whole Foods and Amazon cater notably to higher-end customers, which creates a nice overlap in the customer base and in both online and offline purchases. Connecting these data streams effectively gives the company almost a scary amount of insight into that customer.

A Shockwave

Note that Whole Foods has a good store footprint both in terms of locations and productivity. Its sales of $15 billion make it a relatively small part of Amazon, which could easily post sales of $160 billion this year, ex-Whole Foods. Even if Amazon is not very profitable, it has tremendous cash flows, a very strong net cash position, very strong valuations, and a loyal investor base if it needs to raise cash in order to finance physical expansion.

The move sent a shockwave through the sector. Wal-Mart's (WMT) $500 billion in sales are in part at risk. Of course, given the current footprint of Whole Foods, the risks to sales erosion at Wal-Mart in the near term will be limited. However, over time this could change the landscape dramatically. The 6% drop in Wal-Mart's shares alone is equivalent to the deal price paid for Whole Foods. The 3% jump in Amazon's share price ironically corresponds to the value being paid for Whole Foods as well.

Other players like Kroger and Costco (NASDAQ:COST), each generating around $120 billion in sales, are set to suffer as well. This applies specifically to Kroger, which focuses more on service than price and also carries quite a bit of debt. Costco, on the other hand, has a very strong balance sheet and very competitive pricing.

Other potential victims include Target (NYSE:TGT), which suffers in the department store business, as well as Ahold Delhaize (OTCQX:ADRNY) and smaller players like Dollar Tree (NASDAQ:DLTR), Sprouts Farmer Market (NASDAQ:SFM), and Supervalue (NYSE:SVU), among others. I have not even included privately held Albertson as a victim, as all these players will suffer from the planned invasion of German discounters Aldi and Lidl as well.

The players mentioned above, everything from Wal-Mart to the dollar stores, combined post sales of probably close to $1 trillion in the U.S. The bet and worry is clearly that Amazon could quickly scale up and perhaps generate $100 billion in grocery sales in a year or three by expanding Whole Foods, driven by superior execution, purchasing power and distribution capabilities. The secular retreat in retail makes sure that sufficient real estate is available to make expansion possible, even at this point in the economic cycle.

Already, very slim margins in the industry will become even slimmer, as the mere announcement of this deal will change the supermarket landscape in the coming years. If Amazon succeeds, it's probable that the likes of Kroger, Target, Albertson and other players will undergo the same future as department stores have to some degree, which have already steadily lost sales to the Seattle-based giant.

Amazon Gets a Thumbs Up

Investors in Amazon like the deal and the market reaction says it all. Investors see this as another investment round into the promise of delivering on greater cash flows in the future by pleasing the customer. The company is not only on the verge of disrupting the grocery business, it has obtained distribution points at prime spots across the nation. As such, other merchandise could be distributed from these locations as well.

If the company could grab a $200-$300 billion share of the grocery market in a decade or so, and runs this business well thanks to effective distribution, its sheer scale and technology, I don't think that it's impossible for the grocery segment to post margins of 4%. That means that grocery could add $10 billion in operating earnings rather easily decade from now, and even in that case its profits would only come in at 30%-40% of those reported by Wal-Mart. That makes the $14 billion deal look cheap, even if the company still has to execute and make large investments along the way.

I think that the business is well on track to post sales of $500 billion to $1 trillion by 2025, given the current pro-forma revenue number of $175 billion. If the company can operate effectively and deliver on margins of 5%, I see no reason why operating profits might not come in around $25-$50 billion by 2025. With a 30% tax rate, that translates into a 14-28 times GAAP multiple based on the 2025 numbers. This means that despite near retail dominance, the $500 billion valuation seems stretched as such multiples might only be achieved eight to 10 years from now.

If Amazon becomes an even more successful mixture of a retail power house, cloud service, and distribution company, company-wide margins might hit 10%. If that becomes a reality, which probably is Bezos' vision, operating earnings might hit $100 billion on a trillion sales base. That would result in after-tax earnings of $75 billion, which, at a generous 25 times multiple, yields $1.75 trillion valuation. This would indicate that shares could triple again in the coming decade if everything goes right. While that seems very impressive, a 300% return over a period of 10 years "only" works out to 15% per year.

As such, Amazon certainly has the potential for retail and grocery dominance in North America, and partially in other parts of the world as well. The trouble is that the valuation is reflecting continued great things to come in the future. While I applaud the move, expectations remain very high after a +30% run-up so far this year. If shares reverse, potentially on a further technology correction or if investors worry about associated capital spending plans, I will accumulate on sizable dips.

Disclosure: I am/we are long AMZN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.