GrubHub Merger Logical Bridge To Food Delivery Consolidation

Press reports this week indicating that online food delivery operation GrubHub (GRUB) was exploring strategic alternatives, including a possible sale or merger, jump-started the stock but now the company is refuting the sale process part of the equation. Regardless of which route they prefer, this sector is in dire need of a structural realignment and I suspect we will see that transpire this year.

For the food delivery companies, the business model is just really, really difficult. There is no way that a restaurant and a third party delivery service can both make reasonably good margins if I want a burger, fries, and shake delivered to my house in an hour or less. GRUB does a lot of business in high density urban areas like New York, where delivery routes are more efficient than in the suburbs, but still the company barely makes any money. EBITDA per order between 2014 and 2018 averaged anywhere from $1.01 to $1.18 depending on the year. Imagine the volume you must do to build that into anything worthwhile. No wonder investors have soured on the stock:

It’s just as bad for consumers trying to navigate the ordering process with so many competitors popping up to embrace this horrible business model. Here in Seattle, my wife and I have food delivered relatively frequently and in a big city like this we have DoorDash, GrubHub, Postmates, and Uber Eats to choose from (we had Bite Squad at one point too, before they were absorbed by Waitr and left our local market). It is a huge pain to scroll through 4 apps to figure out what restaurant you want, the fee structures between them differ, and places switch from one service to another all the time. There just isn’t room for more than 1 or 2 players in this space, assuming they can figure out how to make it work financially.

So what should GrubHub do now, as the first mover and only pure play public company that is getting pounded by the newer entrants? David Faber on CNBC this morning nailed the answer to this question; they should merge with Uber Eats.

Uber is bleeding cash but the ride sharing business is actually profitable in mature markets, whereas the food delivery business is losing a few bucks on every order. If you merge Uber Eats into GrubHub you have a stronger, clear #1 player in the space that remains a public company and can try and figure this business out. It would probably force further consolidation (why not have Postmates and DoorDash merge instead of both pursue an IPO?) which benefits everyone.

And it does something else (which for those of us who recently bottom-fished Uber because it looks like a cheap stock would be wonderful) by ridding Uber of the cash-sucking food delivery division. Uber shareholders would get stock in the newly formed GrubHub/Uber Eats company and Uber stock itself would likely rise materially as they easily push up their profitability timetable by a year or more. It just makes sense to separate these two business models, as one is likely to be very profitable at scale (ride sharing) and one is far more uncertain (food delivery).

Uber stock has already rallied from the sub-$28 price I jumped in, so maybe I am getting a little greedy, but a deal like this probably sends the stock into the 40’s and perhaps to the IPO price of $45. And it just makes sense from a business and financial perspective. Hopefully the executives and bankers were watching CNBC this morning and realize how great of an idea Mr. Faber shared on the air.

While Publicly Traded Plant-Based Meat Alternative Companies Are New, The Products Are Not

First, there was cannabis seller Tilray (TLRY), which saw its stock price peak at $300 per share just a few months after a mid-2018 IPO that priced at $17. A buying frenzy among individual/retail investors resulted in a more than 17-fold surge, but as it usually the case, sanity returned. Today TLRY can be purchased in the 40’s.

This chart does not show the intra-day high of $300 but it did indeed peak at that price

With the cannabis craze now passed, as well as that of bitcoin, which stole the show in 2017, we have another round of exuberance with Beyond Meat (BYND), the plant-based meat alternative seller which priced its IPO at $25 last month and this week topped $200 per share.

While I lacked helpful fundamental insights into TLRY, outside of the always important valuation discussion, the “alt-meat” sector is something I know a little about because my wife is a vegetarian and we typically have very little in the way of actual meat products in our house. As a result, over the last decade or so we have tried most of the products out there. Some impress, others do not.

What I find perhaps most interesting about the last month is that because BYND is the first pure play plant-based meat alternative company to go public, those who follow the financial markets (but don’t eat the products), seem to think that this market is brand new and that BYND (and fellow upstart Impossible Foods) are the first two companies to launch plant-based meat products. If there was indeed some sort of first-mover advantage, and the market for these items was brand new and growing like crazy, I guess one could justify paying a huge valuation for BYND. Though I think the current $10 billion equity value is beyond rich for even such a scenario.

The problem with that viewpoint is that plant-based burgers, ground beef, and chicken nugget alternatives are not new. Brands like Morningstar Farms, Quorn, Lightlife, Gardenburger, Boca, Field Roast, and Gardein have been at this game for a long time. In fact, market leader Morningstar Farms (owned by Kellogg), with annual sales estimated at $750 million, was started all the way back in 1975!

I suspect that people are noticing them more today because both Beyond and Impossible have been aggressively marketing their products and have succeeded in getting them on restaurant menus over the last couple of years (the legacy brands have typically focused on grocery store distribution). Sure, there are more vegetarians and vegans today than there were 20 or 30 years ago, but it would be a mistake for investors to assume that a couple of new companies are going to dominate the market and have no competition.

The market size is also an interesting topic, because in 2017 only 3% of Americans identified as vegan or vegetarian. If 5 companies battle each other for maybe ultimately 5% of the meat market in the U.S., it might be hard for investors to justify anywhere near a $10 billion market value for BYND, let alone a handful of players combined.

Some people are saying that meat eaters will eventually become big customers, but I doubt that will be true. Surely there will be some, as I enjoy many of the items with my wife (even though I do eat meat, poultry, and fish at restaurants), but I don’t think specific situations like ours will be all that common, even five years from now.

So while these products are real, in many cases quite tasty, and the businesses are growing, the stock valuations are clearly out of whack. There is no way BYND is worth $10 billion when Kellogg’s equity is valued at $19 billion and Conagra (the owner of Gardein) is worth $14 billion. Those companies have total annual revenue of $13 billion and $10 billion, respectively, while Beyond is projected to book sales of $300 million in 2020.

Much like cryptocurrencies and cannabis, many investors seem to be overestimating the alt-meat market opportunity (through insane stock market valuations). This is not to say there won’t be winners and profits won’t be made, but in a rush to want to own shares of what could be the “next big thing” valuation gets thrown out the window in favor of momentum and excitement. That typically does not end well. After all, the saying “buy low, sell high” was never shortly replaced by “buy high, sell higher” mainly because that strategy rarely works over the long term. Tilray speculators learned that and I suspect BYND bulls will as well.

Lastly, if you are curious and want to try some of the legacy alt-meat products (and compare them with BYND to see if they really have a better mouse trap), here are our favorites:

Coca Cola Bottling Shares Surge 130% After Name Change: Could FinTech Be To Blame?

Hat tip to Upslope Capital for bringing this to people’s attention. It appears that do-it-yourself investors relying on tech platforms to invest need to be even more careful than some may have previously thought. Sure, having a computer decide your asset allocation could be problematic long term, but it turns out that even someone trying to buy Coca Cola stock might get into trouble if they don’t do their homework.

Whereas Coca Cola trades under the symbol KO, their largest bottler/distributor trades under the symbol COKE. The latter used to be called “Coca Cola Bottling Co Consolidated,” which made it easier to understand which stock was which (given that the “real” Coke did not trade under “COKE”). Then in January the bottler changed the company name to “Coca Cola Consolidated” and dropped the “Bottling” completely.

So what happened? COKE shares almost immediately surged more than 130%:

So much for being just a boring bottler of soft drinks… COKE shares rally from under $130 to a peak of $413 in just four months after a questionable name change.

What could possibly have prompted such a huge move in this once boring stock? Well, one theory was floated by Upslope Capital; the name change itself!

If you read through their report (linked to above at the outset), you will notice that users of the popular Robinhood investing app have gobbled up COKE stock this year, likely due to the fact that searches for “Coca Cola” bring up the name of the bottling company with the stock symbol COKE. If you were a young, amateur investor, you probably would not think twice about putting in a buy order thinking you were getting shares in the mega cap global beverage giant that counts Warren Buffett as an investor and sports a total market value of more than $200 billion (70 times bigger than the bottling company!). And then you would wind up with an investment in the far smaller bottling company. And worse, your fellow investors would be doing the same, helping to push the stock up more than 100% in a matter of months!

While the air has come out of the balloon in recent days, COKE is probably still overvalued at $316 per share. I suspect sometime over the next year the stock trade back to $200 or $250 and plenty of investors will wonder exactly how they lost so much money on such a dominant company’s stock.

While technology surely will play a role in evolving the investment process for many, the idea that hiring a human being to assist you with your savings and investment objectives is unlikely to become outdated for the majority of folks, for reasons exactly like this one. Sometimes the computers are going to be value-destructive, not value-additive as intended.

Full Disclosure: At the time of writing, I am short shares of COKE, but positions may change at any time.

Not Enough U.S. Cash Burning IPOs for You? Here Comes China’s Luckin Coffee

Just as U.S. investors are trying to make sense of the Uber (UBER) and Lyft (LYFT) IPOs, both disastrous for those buying at the offer prices, on Friday we will get a U.S. listing of Chinese-operated, Cayman Island-incorporated coffee upstart Luckin Coffee. How much should investors pay for this so-called Starbucks of China (even though its business model is not copying the Seattle-based giant)? Quite frankly, who the heck knows? If that is not a sign that one should pass for now, I don’t know what is.

Below is a summary of Luckin’s financials from the IPO prospectus, though keep in mind its operating history is short (having gone from zero to 2,370 stores between October 2017 and March 2019).

This income statement reads like a Silicon Valley cloud-computing start-up, not a Chinese bricks and mortar coffee chain

As you can see, Luckin’s stores are run at a loss, with Q1 2019 sales of $71 million dwarfed by direct store operating costs of $83 million and another $25 million of marketing expense.

Investors should not exactly be enamored with Luckin’s growth rate. After all, selling coffee at a loss is an easy way to rack up sales and there is no way that the company has a detailed, refined, and proven unit expansion plan in place given that they are opening these money-losing locations as fast as humanly possible (an average of more than 4 new stores a day since they launched 18 months ago!).

None of this says anything about the long-term odds of success for Luckin Coffee. They could very well become China’s largest coffee seller and make money doing it. There is simply no way to know at this point, so investors are left deciding whether they want to take a gamble or not. Many will given that the company will list on a U.S. exchange this week, but with no sound financial model to back up the prices being paid for the shares, there is really no fundamental case to be made for buying the stock.

All one can do is estimate what they think margins could ultimately be based on the business model, assume long-term success, and calculate an imputed price-to-sales ratio worth paying today given certain growth assumptions. That is how Uber and Lyft are likely to be valued (assuming people care to value it at all), and the same idea applies to Luckin Coffee and whatever the next cash-burning IPO waiting in the wings happens to be.

Author’s note: To give you an example, assume that Uber can ultimately earn 20% EBITDA margins over the long-term and one can justify paying 15x EV/EBITDA given their potential growth outlook. That valuation equates to an EV/sales ratio of 3x, which based on 2020 revenue projections could yield a per-share fair value in the $30 ballpark (vs today’s quote of $40). And don’t even ask me to guess what Luckin Coffee’s margins could be.

Chipotle Valuation Surging to Dizzying Heights, Surpassing Amazon!

It should not be surprising that hiring a veteran restaurant executive to replace an inexperienced founder will have a material impact on the business and its stock. Chipotle Mexican Grill (CMG) is a classic example, as Steve Ells stepping aside for Brian Niccol (formerly of Taco Bell) has launched CMG’s shares into the stratosphere:

CMG’s customer traffic has rebounded (+2% in Q4 2018) after flat lining earlier in the year and material price increases (+4% in Q4 2018), which were sidestepped after the e coli incidents, have same store sales rising 6% and profits surging even faster. The current analyst consensus estimate has CMG earning $12 per share in 2019 on a mid single digit same store sales increase and 5% unit growth. Those figures would place CMG near the top of the sector.

As is often the case, the biggest issue is the magnitude of CMG’s recent stock gains. At more than $600 per share, CMG’s forward price-earnings ratio is a stunning 50x. Why a casual dining chain with 2,500 locations already should trade at such a valuation is hard to understand, unless one believes they are going to steal a lot of market share going forward from here. Many folks believe that will happen, but I am less excited.

To give readers a sense as to how nutty this CMG valuation appears to be, let’s compare it to Amazon (AMZN). I know AMZN is not a dining stock, but I find it to be an interesting comparison because they are both loved consumer brand stocks right now. Not only that, I would venture to guess that an investor poll would conclude that Amazon’s business is better than Chipotle’s and is likely to grow revenue and profits faster over the coming decade. And yet, today we can invest in Amazon at a cheaper valuation:

Looking at 2018 reported financial results, CMG trades at 31x EV/EBITDA, versus 28x for Amazon. I used EV/EBITDA to account for balance sheet items as well, but on a P/E basis the numbers are also similar: 50x for CMG and 59x for AMZN.

For those who are intrigued by Chipotle stock, I would simply point out that Amazon has long been a loved growth stock for which investors are often willing to pay sky-high valuations for. Today an argument can be made that CMG is more expensive and you would have a hard time finding people who expect CMG’s business to outperform AMZN in coming years.

If that’s true, either CMG is overvalued quite a bit, or AMZN is relatively cheap, or both. I would bet that AMZN outperforms from here. For those who like paired trades, being short CMG against an AMZN long looks interesting.

Biglari Holdings: Severely Mispriced Yet Again

I have not written about Biglari Holdings (BH) on this site since late 2014, but that does not mean the company has fallen off of my radar. While BH was once a prime long-term buy and hold candidate, it has become obvious over the years that the controlling shareholder and CEO, Sardar Biglari, not only prefers running an unconventional public company, but often does so at the detriment to its shareholders.

For those unfamiliar, the bulk of BH’s assets (and value) come from a 100% ownership of Steak N Shake and a large stake in two hedge funds run by Mr. Biglari, which are mostly comprised of shares in BH and Cracker Barrel (CBRL). The stock is volatile, sometimes trading quite low and other times approximating fair value for an unfocused conglomerate with little investor recourse.

Given a few too many unconventional moves (buying BH shares on the open market via the hedge funds and holding them for investment, as opposed to buying them at the corporate level and retiring the shares), I have largely been interested in BH in recent years as a trading vehicle — not a long-term investment — buying when the stock is clearly mispriced and selling when it approaches a more reasonable level.

Such an opportunity has once again presented itself after a late April move that resulted in shares of BH being divided into dual classes of stock; A shares and B shares, the former allowing Mr. Biglari to maintain control of the company, with the latter having no voting rights and serving as potential M&A currency.

Prior to the dual class issuance, BH stock was trading around $420 per share. Upon issuance of the new class A shares, the B shares should have fallen in price by roughly one-third according to the exchange ratio, which would have put them in the $280 range. And for a few days that ratio seemed to hold, but then a free fall began. Today BH “class B” fetches around $200 per share (I am focused on the non voting stock because the voting rights are meaningless considering that the CEO controls more than 50% of the votes).

So just how mispriced is this $200 piece of paper? Well, the total equity value at current prices is roughly $630 million. If we ignore the operating businesses (more than $800 million of annual revenue and by my guess, maybe $25M-$30M of EBITDA this year), BH shareholders own (indirectly via ownership of hedge fund LP interests) nearly 4.4 million shares of Cracker Barrel and nearly 1.3 million class B equivalent shares of Biglari Holdings. Since both are publicly traded, we can quickly assign a value to each, which cumulatively comes out to more than $950 million, or $305 per BH class B share. And yet BH class B’s trade for just $200 apiece. As you can see, something is off here.

Now, there are reasons why BH will unlikely ever trade for “full price” based on its assets. After all, many investors would immediately balk at a public stock that owns some companies outright, minority stakes in others through hedge funds, and chooses to buy up but not retire its own shares in the open market. There are other issues too, such as a large unrealized gain on the Cracker Barrel shares, which were acquired for less than $50 each (current price $160), and over $200 million of Steak N Shake debt outstanding.

Still, even if the negatives surrounding BH would result in the operating businesses being valued closer to zero than a more typical $25-$50 per class B share (which I believe they would fetch with a different owner), BH remains mispriced. If we exclude the BH shares owned by the company itself, the equity is valued at about $370 million. To put that into perspective, the Cracker Barrel stake alone is worth $700 million at the current market price, so maybe $600 million net of tax.

At a certain price it is hard to argue against taking a long position in a company that often sees its share price get out of tune with reality due to its unusual composition and low float (due to being small to begin with and having a majority owner). Count me as one who does not think the B shares should trade materially below the $300 level. The recent dual class restructuring has given the small investor a profit-making opportunity.

Full Disclosure: Long shares of BH class B at the time of writing, but positions may change at any time

Somehow Food Companies Are No Longer Viewed as Stable, Defensive, Attractive Investments

For decades the consumer staples sector was viewed by investors as a stable and predictable cash flow generator with above-average dividend yields and below-average volatility. In particular, food companies like Kraft and Pepsi fit the bill, with brands that stood the test of time.

Lately, however, investor sentiment has shifted. While brand names continue to have loyal followers, younger consumers often prefer private label foods that come with lower prices and quality that is close enough to the branded alternative that they are more than adequate. I understand this view completely, as my family buys many store brand products from Safeway, Target, and Whole Foods.

So while the gap between store brands and global brands narrows, should food and beverage as a category be seen as no longer stable, predictable, and defensive? By the looks of the stock charts, as the tech sector powers the current bull market ever-higher, you would think that food is no longer a consumer staple. I say that because both private label and national brands are getting pummeled on Wall Street. I am baffled as to how that can be happening at the same time.

Should Kraft trade at 16x EBITDA these days? Probably not, given that they are set to cede market share over time. But there are other consumer brands that have fallen to levels that are truly cheap (as opposed to trading at a premium that may no longer be warranted).

One I like is J.M. Smucker (SJM), which has fallen from $140 to $100 over the last nine months or so. SJM owns brands such as Jif, Smucker’s, Crisco, Wesson, Folgers, Pillsbury, Hungry Jack, Milk Bone, and Kibbles ‘n Bits. While these brands will likely not grow market share in the future, they should continue to be cash cows for the company over the long-term. In the meantime, SJM has the scale and experience to launch brand extensions and new products that can resonate more with younger shoppers (examples being all natural, organic jam from Smucker’s or Natural Balance pet food). Today SJM shares trade for 15x normalized free cash flow (which I estimate to be $7 per share) and carry a dividend yield of over 3%. They look underpriced to me.

Perhaps more interesting is the fact that the world’s leading supplier of private label foods, Treehouse Foods (THS), has had one of the ugliest sell-offs lately that you will ever see from a multi-billion dollar a year category leader:

Treehouse counts each of the 50 largest food retailers as customers, with the top 10 accounting for more than half of the company’s $6 billion in annual revenue. If you want to place an investment bet on private label foods increasing market share over the coming 5-10 years, THS is your stock. Needless to say, it has been quite a headache in recent months (I have been building positions in the name throughout 2017).

Treehouse’s valuation makes J.M. Smucker look like nothing worth mentioning. Even after missing their own internal financial projections for most of 2017, I estimate that THS should book between $250 and $300 million of free cash flow this year. The current market value of the company is only $2.45 billion, which makes for a sub-10x free cash flow multiple. And that is for the largest private label food company out there. For comparion, over the last 10 years, THS shares have fetched an average of 16x free cash flow, which seems quite reasonable.

So we are in a weird moment in time where restaurant stocks are getting crushed (due to rising labor costs, a proliferation of home delivery services, and excess unit expansion in recent years), brand name food stocks are losing their once-premium valuations (due to private label encroachment), and the big private label supplier has seen its share price more than cut in half (due to management missteps after a large acquisition). Simply put, how can this all be rational at the same time?

Well, I am making a bet that things normalize over the longer term. I think it is fair to say that large, global food and beverage brands should no longer trade at premiums to the S&P 500, but I think any material discount is unwarranted as well. Dining out will continue to book huge sales figures overall, but profit margins are likely to permanently  compress, so valuation models need to factor in that likely reality. And as private label foods stand to gain market share over time, I cannot help but think Treehouse will fix their operational issues, grow free cash flow per share over the long-term, and once again fetch a more normal valuation (15-20x seems appropriate to me).

None of these outcomes will garner the attention from investors that an Amazon, Tesla, or a Netflix will, but if you care about valuation when investing your capital, we are talking about large multi-billion businesses that are here to stay and will generate fairly consistent profits for decades to come.

Full Disclosure: Long SJM and THS at the time of writing, but positions may change at any time

Restaurant Bubble? Shake Shack Has Two Locations at One Mall

Once seen as a very strong industry riding the secular trend of Americans moving away from cooking at home, the restaurant sector is starting to feel growing pains. With U.S. population growth slowing and immigration becoming more difficult, same-store traffic declines are backing restaurant companies into a corner. The choice is simple: continue to open new units faster than your customer base is growing spending on food, or admit to investors that the growth they have come to expect is over.

High-flying fast casual burger chain Shake Shack (SHAK) has made the decision that, despite dozens of burger places popping up everywhere across the country, the name of the game remains growth. In fact, despite having fewer than 85 locations in the U.S. as of June 30th, the company now has two units open at the bustling King of Prussia mall outside Philadelphia.

Some bulls on the company will likely reference the Starbucks phenomenon whereby that chain purposely opens locations near each other in order to reduce the size of waiting lines during busy peak times. But this is different. Shake Shack has told its investors that it sees room for 450 locations in the U.S. alone. If your ultimate goal is to build 9 locations in every state, it probably does not make a lot of sense to have two in the same mall.

The bigger point has large implications for the industry. As more and more big box anchor stores close their mall locations (Sears, JC Penney, Macy’s, etc), landlords are trying to fill the spaces fast. And with so many bricks and mortar retailers struggling to compete in the e-commerce world, restaurants are an easy way to fill space.

It should not be hard to see the problem with this plan in the long run. With minimal population growth and declining mall traffic, over time there will be less of a need for restaurants at these locations, not more. And yet the industry continues to grow seats far faster than consumer spending. We are seeing the result already; less traffic per location, and thus less revenue and falling profits.

Shake Shack might be able to get away with overbuilding for a while, mainly because the chain started in New York and is brand new to most consumers as they expand across the country. But five years from now we are likely to look back and see that it was silly to have two Shake Shacks at King of Prussia (assuming mall trends continue in a similar trajectory).

As a long-time investor in the restaurant space, the current landscape is challenging. On one hand, Wall Street is giving many companies (not Shake Shack) meager valuations due to falling customer traffic. On the other hand, if the industry continues to build new locations for the sake of growth (and not due to demand exceeding supply), it will make it hard for any chain to post impressive financial returns.

How should investors approach these dynamics? Well, it looks like the franchising route might be the best way to limit downside risk. While lower sales will impact royalty streams for the franchisor, fixed cost deleveraging will impact the bottom line far more severely, and that will sting the franchisee first and foremost.

Shake Shack management would argue otherwise. In fact, during their latest conference call they bragged about having a second unit at King of Prussia mall. Essentially, they argue that it was a wise move as long as they sell more burgers cumulatively with a second location. After all, if the demand is there, why not book the sales?

However, this assumes that the demand will be steady and/or rising over time. Once Shake Shack loses its “newness” and more competing chains invade their turf targeting the same customers, we could very well see demand for their burgers fall considerably. Enough that two locations make little sense.

Full Disclosure: No position in Shake Shack, but positions may change at any time

The Door Is Open For Somebody To Swoop In And Steal Whole Foods Market

It has been nearly three months since I wondered in writing whether anybody would step up and buy Whole Foods Market¬†and a lot has happened since then. By now most people know that Amazon is in the driver’s seat with their $42 per share all-cash offer having been accepted by the WFM board of directors last month.

My assessment of the situation back in April was hit and miss. My estimate of fair value for the stock proved to be spot-on (“low 40’s”) but I dramatically underestimated Amazon’s interest in making a large acquisition. I pegged the odds of a deal at 40%, with the most likely buyers being a private equity firm or another grocery chain. Amazon must really like the idea of a Whole Foods combination, given that I do not believe it has ever offered $1 billion for another company, let alone the $13 billion Whole Foods will cost.

Today Whole Foods released its merger documents in preparation for the shareholder vote and the tidbits we learned were quite interesting. Specifically, four private equity firms and two grocery competitors reached out to the company, in addition to Amazon’s interest. Perhaps not surprisingly, Whole Foods focused on a deal with Amazon and never actually opened up the bidding to other interested parties. I suspect this is mainly because the company’s founder and CEO wants to keep his job and Jeff Bezos will let him.

In terms of where this deal heads from here, it was also noteworthy that Amazon’s initial offer was $41 per share and when Whole Foods countered at $45 Bezos and Co. made a best and final offer of $42. This is interesting because not only were they not really interested in increasing their bid, they also insisted that WFM keep quiet about the negotiations. Amazon even insisted on multiple occasions that they would walk away immediately if the deal was leaked or if other buyers were allowed to join the bidding.

Such a negotiating strategy clearly worked, but it does open up the possibility that a last minute competing bid could emerge. Imagine you are at a private equity firm, or another grocery chain who would be interested in partnering with PE to help fund a bid. Assuming you liked the idea of grabbing Whole Foods, the main reason not to would be the fact that Amazon has deep pockets and would likely be able to prevail most easily in a bidding war. But after reading the details of how this deal came about, it appears that Amazon might not be willing to raise their bid above $42 per share. In that case, as little as $43 or $44 might steal WFM away. You can bet that Jana Partners, the hedge fund whose 8% stake fueled the most recent takeover talk in the first place, would support taking the best offer possible.

Whole Foods stock closed today right at $42.00 per share, so there does not appear to be a high degree of confidence that another bid is coming. That may be true, but all it takes is one interested party who decided to take a shot at it. It could be a very quick turn of events (and relatively easy) if a single bid over $42 prompted Amazon to walk. I won’t bother placing odds on this happening given that I didn’t think Amazon would bid in the first place, but I don’t think it is a stretch to say that the details we learned today could sway another party who has been pondering making a higher offer. After all, they were never really allowed to bid in the first place.

Full Disclosure: Long shares of Amazon and Whole Foods Market at the time of writing, but positions may change at any time.

Will Anybody Step Up And Buy Whole Foods Market?

Activist hedge fund Jana Partners has amassed an 8% stake in Whole Foods Market (WFM) and is urging them to work harder harnessing strategies to maximize operational efficiencies and also test the waters in terms of possible takeover interest. I have been a fan of the company for a long time, and of the stock ever since it cratered into the 30’s several years back. The original investment thesis hinged on long-term square footage growth (8-10% annually) but the company has now decided to slow new location development. As a result, we are now left with more of a cash cow business with minimal growth (same store sales have been falling 2-3% for over a year).

The stock recently traded in the high 20’s (too low for even a slower growth outlook) and Jana seems to have timed their purchases very well during February, March, and April at prices of between $28 and $32 each. Even without a buyout I believe WFM stock would be fairly valued in the low 40’s (far lower than I would have said when they had a stated objective of reaching 1,200 stores (versus less than 500 today). Wall Street does not agree, as even with the Jana-related bump the stock fetches $34 per share.

The easiest way for WFM to realize a more fair price would be to find a buyer, but the company would be a big target ($11 billion market value at current prices). As a shareholder, I would not be thrilled with anything less than a $13.5 billion acquisition price. But who would acquire WFM?

The press reports that Amazon contemplated an offer last year seems odd. They simply prefer to build businesses internally. With no track record of large M&A deals, the odds that Jeff Bezos would all of the sudden offer eleven figures for WFM seems remote.

The second possibility would be a strategic buyer, as in one of WFM’s grocery store competitors such as Kroger or Albertson’s. One could make the argument either way on this line of thinking. The traditional stores have been successful recently copying the WFM product offering, which has resulted in negative comps for the organic pioneer, so they really don’t need to buy WFM. On the other hand, one less competitor means less pricing pressure industry-wide, which could be attractive in such a cut throat market like grocery retailing. I could understand both sides of the coin very easily.

The last option in my view would be a private equity buyer. This makes the most sense from a financial point of view, as PE could use debt to fund much of the acquisition cost without endangering the company (WFM’s balance sheet is pristine). Other grocery store chains have far more leverage which limits their ability to borrow more money. I suspect banks would allow a near-term leverage ratio of up to 5x for a Whole Foods leveraged buyout, which would equate to roughly $6 billion of debt financing and $7 billion of equity capital (assuming a purchase price of $13 billion).

The biggest hurdle for private equity is that $7 billion equity requirement. That is a very large deal for one company to take on alone. More likely a consortium of PE firms could get together and pitch in $2-3 billion each. I have no doubt that many firms are taking a look at this type of option.

All in all, a buyout of WFM is possible, but not probable, in my view. The price tag would be high in absolute terms and there is enough concern about the company’s competitive position that pulling the trigger on a deal might be tough for most of the parties that do in fact kick the tires. If I were setting the odds, I would say there is a 60% chance WFM stays public, a 25% chance private equity makes a play, a 15% chance another chain bulks up its store base, and a <1% chance Amazon is serious about a deal.

Full Disclosure: Long shares of Whole Foods Market and Amazon at the time of writing, but positions may change at any time