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

Originally published on June 16, 2017

Amazon (NASDAQ:AMZN) announced it was paying $13.7B to buy Whole Foods (WFM). 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 its 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 (PG), 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 it stocks less of the mass market goods and thus receives 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 is 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 its products lacked deal dollars and thus had to be priced higher. And its 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 in Amazon, you know it really figures out your needs and helps 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 Wal-Mart (WMT)) 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 at the 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 AMZN 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%! AMZN 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 Wal-Mart

For the last several years, Wal-Mart's general merchandise sales have been declining due to the Amazon Effect and growing online competitor sales. For the last three years, overall revenues have not grown at all. To maintain revenue, Wal-Mart has shifted increasingly to groceries - which account for well over half of all its revenues. By purchasing Whole Foods, Amazon takes direct aim at the only part of Wal-Mart's "core" business that it has not attacked.

Wal-Mart's net profit before taxes is ~4%. If Amazon can use Whole Foods to combine stores and online sales to take just 3% of Wal-Mart's grocery business away, it could remove from WMT ($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 Wal-Mart's pre-tax income by $7.25B, or ~35%.

The negative impact of declining store sales on the fixed costs of Wal-Mart is atrocious. Even small revenue drops mean cutting staff, cutting inventory, cutting store size and eventually closing stores. Look at how fast Sears (SHLD) 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 Wal-Mart's grocery sales, say over three 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 an e-commerce initiative.

But this is not so unlikely given Amazon's track record. Amazon has been growing at over 25%/year, adding between $20B and $25B of new revenues annually. In three years between 2013 and 2016, Amazon doubled its revenues. So it is not that unlikely to expect Amazon put 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.