The big news out of the US on Friday was Amazon’s offer to buy fresh food retailer Whole Foods Market Inc [NYSE:WFM] for US$13.7 billion.
At the same time, rival Walmart [NYSE:WMT] announced the purchase of online clothing retailer Bonobos for US$310 million. It marks Walmart’s fifth ecommerce purchase this year.
So here we have both behemoth retailers moving in on each other’s turf.
What is going on?
The move from Amazon is clearly the bigger deal. It signifies an admission that fresh food retailing is not a business that you can crack with a purely online presence.
It’s been trying since 2007 with its Amazon Fresh service, and hasn’t exactly made inroads. Put simply, it is very difficult to compete in a market like fresh food without economies of scale. And the online presence just didn’t do it for Amazon.
So it’s gone and bought a company with a physical network of around 400 stores. Whole Foods has around 1.2% of the US$800 billion US grocery market, compared to Walmart’s more than 25%. There is a sizeable difference between the two.
But it’s Amazon’s fearsome reputation for price competition that saw its share price rise and Walmart’s shares fall on the news.
Maybe that’s just a knee-jerk reaction. After all, this marks a tangible shift in Amazon’s strategy. For years it has avoided building a physical network because of ever rising rental costs. Instead, it built virtual stores that got cheaper to run because of falling technology costs…and the benefits of scale.
By the way, readers of Cycles, Trends and Forecasts would no doubt agree with Amazon’s rising rental cost view. It’s just the way economics works. Or, put more precisely, land economics.
That is, the fruits of economic expansion capitalise into land prices. So where Amazon is cutting the cost of doing business, the ‘gains’ made from this utilisation of technology translate into rising land values.
Because falling costs are passed on to consumers, which reduces their cost of living. This allows excess funds to go toward debt servicing and/or bidding higher prices to secure land.
Land is limited. Capital and labour have no such constraints. So land values rise within the context of a cycle. And as Phil Anderson’s, Cycle’s Trends and Forecasts points out, the next cycle isn’t due to bust for a number of years.
You can check out Phil’s work and the real estate clock, here.
Getting back to Amazon and Whole Foods, what happens from here?
Well, expect more competition in food retailing. It will take years to play out, but now you have the world’s best online retailer combining all its skills in that space to attack the incumbents.
This will have long term implications for Australia’s cosy duopoly of Coles and Woolworths.
I’m not sure how exactly. One of the benefits of being an incumbent is that you have the infrastructure already in place. Coles and Woolworths already have the best sites locked up.
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If Amazon were to emulate their move in the US here, it will probably be on second tier player like Metcash [ASX:MTS]. Metcash is basically a distributor of food and liquor to the IGA network, while it also supplies the Mitre 10 hardware chain.
It’s good a good distribution network too. Metcash’s supply chain is considered to be first class. It’s the sort of footprint that Amazon would take years to emulate.
Buying it would be cheaper than building it. Which is what the Whole Foods purchase was about. Whole Foods has been struggling lately. The shift to price competition has hurt their business model over the past few years. Whole Foods is a premium food/premium price retailer. That’s not exactly a high growth business in a world where wages growth is very low.
Check out its share price over the past six years…
After peaking at nearly US$65 a share in 2013, the stock went into a long decline. Earlier this year, the price traded around US$28 per share. That’s a fall of nearly 60%.
Did Amazon get a bargain then?
The market thinks so. It’s not often a company’s stock price rises on news of a takeover, but Amazon’s share price shot up on the news.
Still, Amazon needs to do some work. Based on the offer price of US$42 per share, Whole Foods trades at nearly 31 times 2018 forecast profit. Put another way, Amazon is getting the business on an earnings yield of just 3.2%.
So they need to boost earnings considerably to make the acquisition work.
Can they do it?
As I said, the market thinks so. But the risks are increasing for Amazon shareholders. The stock trades on 87 times forecast 2018 earnings. The premium is due to its proven ability to upend the traditional retail business model.
But now it’s heading back into the traditional retailing space. That means earnings relative to the capital it employs should decline.
And that means the share price will find it increasingly harder to sustain such high multiples. As you can see in the chart below, Amazon has had a tremendous run over the past six years. The correction that started last week may just be another pullback in this long bull market.
But the chart is worth keeping an eye on. A characteristic of major tops is increasing volatility as ‘distribution’ takes place. This is where long term holders ‘distribute’ stock to late comers and weak hands.
It’s too early to tell if distribution is taking place right now. But if the price continues to swing wildly, without falling too much or making convincing new highs, take that as a warning sign.