June 19, 2017

Stocks finished the week on a positive note according to the leading averages, but bond yields continued to drift lower and the high flying leadership names continued to show weakness.

But all this was overshadowed by the announcement on Friday that Amazon was going to purchase Whole Foods for over $13 billion in cash.  Amazon, the world’s largest Internet retailer by far, had dipped its toes in the water in terms of conventional bricks and mortar retailing before by opening a few bookstores and a few delivery outposts for food.  But this deal obviously changes the entire picture.  Whole Foods, with almost 500 stores concentrating on healthy and organic food, at first blush would seem like an unlikely fit for Amazon.  Many have renamed the chain “Whole Paycheck” for obvious reasons.  Amazon is known for high variety, quick delivery, and low prices.  Whole Foods has limited selection, has only dabbled with delivery and struggles to compete with new start food chains that undercut its prices.

While the stock market reacted strongly on Friday boosting the price of Amazon and slashing prices for the stocks of every food-related retailer from Kroger# to Costco, don’t expect Amazon to come in with a wrecking ball and suddenly transform Whole Foods into an organic version of Wal-Mart.  Yes, to be sure, it will streamline costs that many have said were bloated anyway.  And it, no doubt, will pass those savings onto customers in the form of more competitive prices.  But organic and natural foods cost more to begin with.

Amazon’s core is all about great logistics.  Those logistics help it to drive volume which is the real secret to lowering unit costs.  With that said, the beauty of the Internet is that Amazon is not bound by four walls.  A box, by its very nature, has capacity constraints.  It can only hold so much inventory and so many customers.  But if one looks at the store not just as a point of sale venue but as a distribution center, the notion of Amazon becoming not just the world’s largest purveyor of goods but the largest purveyor of goods and services begins to come into focus.

The holy grail of food delivery to date has been the last mile.  Internet companies like Instacart and GrubHub have become substantial businesses built entirely on the idea of delivering food-related products to buyers in a timely fashion.  But these companies don’t control the originating products.  The ability to standardize, which is a key to logistical success, is almost impossible.  What one can see looking ahead, is a company that sells food both online and in stores, and a company that sells prepared foods in store and for home delivery.  One can order online for delivery at a prescribed time or for pickup.  Prepared foods can be done in store or at a consolidating offsite location.

But make no mistake.  This venture is no guaranteed success, despite Friday’s stock market reaction.  Jeff Bezos, Amazon’s CEO, has stated often that one doesn’t succeed without taking chances.  While I noted that solving the last mile of the delivery chain is key to success in a venture such as this, there are no assurances that Amazon can solve it.  We have lived in a world of home delivery for food for a very long time.  Pizza may be the simplest form; one item with a short preparation time to be delivered locally.  But even there, pizzas often arrived cold.  When times are busy (e.g. football Sundays) waits can be annoying.  Amazon Prime members know they can count on their package being there within 48 hours whether it be a dog day in August or Christmas Eve.

Thus, what one should expect is:

  1. Quick steps to drive down costs within the Whole Foods organization that will make the company more price competitive with other food chains. This doesn’t mean you will buy organic milk in Whole Foods for less than a regular quart of milk in Wal-Mart.  But it does mean that Whole Foods’ prices will become more competitive.
  2. A lot of experimentation with delivery, pre-ordering and pickup. Amazon never moves slowly, but it may take some time to find an optimal solution.  Look for Amazon to try to control the entire distribution channel itself from food preparation to delivery.  Consistency can only be accomplished that way.
  3. Delivery can be both products and fully prepared meals.

As we noted at the start, if Amazon can deliver meals in a satisfying standardized fashion, it opens the gates for a variety of delivered services.  Amazon’s total addressable market expands greatly.  That’s the opportunity.  But the hurdles everyone else has faced over the years remain.  The Internet can help in the process immensely.  No busy signal calling in an order.  No miscommunications.  Pictures, well done, can show exactly what a particular dish will look like.  Push e-mails and ads can highlight daily or seasonal specials.  Those interested can receive daily menus or notifications.  If anyone can overcome the barriers, it would be Amazon.

Was the market right to savage stocks of every other retailer who sells any kind of food?  The answer to that may vary.  Today, home delivery via the Internet accounts for a very tiny percentage of food sales.  People want to squeeze the melons and see the piece of fish they are going to buy.  The Internet robs us of a sense of smell or touch.  But, in time, trust and consistency can overcome these shortcomings.  If Amazon can deliver a consistent satisfying product, it will develop a feeling of security.  But one must also remember that no one buys a candy bar at the CVS checkout counter based on price.  There are some stores whose primary attribute is convenience.  Amazon won’t overcome that.  There are some where low price is most important.  The Whole Foods shopper and the Wal-Mart shopper aren’t the same people.  Costco sells large quantities for big families at low prices.  Again, it is hard to see how Amazon disrupts that business model.  As investors have time to reflect, some of the carnage of Friday is likely to be reversed.

In summary, this merger can be a grand success that changes how we buy food or it could be a dream that can’t be forged into reality.  Most likely, it will end up somewhere in the middle.  In a nuanced way, it will add an alternative channel to fulfill the way we want to eat.  But most of us will still either eat out in a restaurant or prepare family meals in a traditional manner.  To be sure there is an opportunity for those who want to eat at home but don’t want to take the time to prepare the meal.  Any incremental dollars Amazon gains will come out of someone else’s pocket.  But don’t lose perspective.  Whole Foods does about $4 billion in annual sales.  That is a tiny drop in the bucket of total food sales in the U.S.  Even if Amazon can triple that over time, it would still be a small fraction.

One final point to consider.  Donald Trump is no great fan of Jeff Bezos.  Mr. Bezos owns The Washington Post.  Mr. Trump considers The Washington Post one of the leading purveyors of fake news.  Whether this merger is challenged should be up to the Justice Department or the FTC, but don’t be surprised if Trump offers his two cents before all is said and done.  He has never been shy when it comes to people he doesn’t care for.

Today Phylicia Rashad is 69.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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