Amazon's Midas Touch Hits Whole Foods

| About: Amazon.com, Inc. (AMZN)
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Summary

Amazon has so much momentum right now that the market loves anything it does.

Amazon's acquisition of Whole Foods is nice, but I do not think the grocery world is ending.

Amazon could have opened 431 distribution centers if that's what it was looking for.

I remain bullish on Amazon, but I also think Costco's sell-off was extreme.

I cannot remember the last time I saw such consensus love and praise over an acquisition. Whole Foods' (NASDAQ:WFM) sale to Amazon (NASDAQ:AMZN) reminds me of when Valeant's (NYSE:VRX) Mike Pearson had the Midas touch, turning every deal into a higher share price. While I am actually quite bullish on Amazon overall, and am currently a shareholder, I believe the reaction to today's deal is incredibly optimistic and reflects investor confidence in Amazon rather the strategic brilliance. I do not believe the deal will be terrible for Amazon shareholders, but I also do not think the transformational commentary about the deal is appropriate. Amazon decided to enter the bricks and mortar grocery business. Perhaps Amazon will try to expand grocery delivery, but ultimately, I think investors are reading far too much into the deal.

Delivery Nodes Or Maybe Nada

Source: Twitter

I do not know Dennis Berman, but I wanted to highlight this tweet as the perfect example of peak overreaction. Several people I follow on Twitter retweeted the message, and I think the takeaway is quite obvious: Amazon will turn Whole Foods into mini distribution centers that serve affluent customers.

I have to challenge the logic of this statement. Currently, Whole Foods stores are optimized to sell and warehouse groceries. Perhaps Amazon will review every KSU and work to add in additional high volume items that are ordered from Amazon in a given zip code, but I think refitting the store would be not only expensive, but it also might end up damaging the existing store experience. One can argue that Whole Foods isn't performing that well in its current state, but I simply do not see the value in turning Whole Foods into Amazon stores.

Furthermore, why do I need to get my Amazon orders from Whole Foods? If you live in a market like New York, Chicago, or San Francisco, then a high percentage of your Amazon Prime orders probably come within a day or two anyways. I would argue that Amazon can (and already has) built an amazing distribution footprint already at a much lower cost than acquiring a company with real earnings.

Some companies like to watch an industry burn

I have seen many obituaries written for the grocery industry in the last twelve hours. Kroger (NYSE:KR), Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), and Target (NYSE:TGT) should close shop now rather than be subjected to the horror as the new non-profit Whole Foods destroys the industry.

Without question, I agree that margins in the grocery space are likely to decline. This is not only the result of Amazon's entry into the business, but it also is the result of Aldi and Lidl entering the US market. Kroger reduced guidance before the Amazon deal was even announced, and there is little doubt in my mind that competitors see this business as a 1%-2% operating margin business at best.

That said Amazon could have bought Kroger, which boasts about 10x as much in sales ($115 billion) as Whole Foods and a 3% operating margin. Instead, Amazon opted for the company with a paltry $15 billion in sales (in a $800 billion industry) with a 5.4% operating margin. Perhaps Amazon doesn't want to conquer the grocery industry or even compete against the likes of Kroger and Costco. While we are not aware of the company's rationale, I believe Amazon saw Whole Foods as a strong brand that it could purchase at a relatively decent price of ~25x earnings that has strong customer overlap with Prime. Perhaps Amazon can juice same-store sales a bit by adding its own delivery service that comes at no additional cost for Prime customers.

Further, the grocery business is the anti-marketplace. While Amazon currently limits its investment in working capital by utilizing third party sellers and acting as the logistics arm, the grocery business requires significant amounts of investment in working capital. Perhaps Amazon can slightly reduce working capital at existing stores by improving turnover, but overall, I do not think this is the classic type of business that Amazon wants to compete in.

Maybe the world isn't ending

Bottom line, if Amazon was looking to destroy an industry and compete strictly on turns, it could have purchased Kroger or even Target. I am not convinced Amazon is using Whole Foods to conquer the world. I think Jeff Bezos made an interesting investment in a struggling company that has historically shared Amazon's customer-centric focus and has a loyal following. I have no views on Kroger, Target or Wal-Mart, but I did take the opportunity to add to my Costco position on the news.

When it comes to Amazon, I remain a shareholder, though, admittedly, not for its entry into the grocery business.

Disclosure: I am/we are long AMZN, COST.

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.