June 20, 2017

Alexa, can I afford it?

by Breakingviews.

Wal-Mart’s market capitalization dropped 5 percent, losing $11 billion, after Amazon.com unveiled its $14 billion deal to buy Whole Foods Market on Friday. Meanwhile, Whole Foods shares closed on Friday nearly 2 percent above the agreed price, implying some investors think a rival bid could emerge. But even for Wal-Mart, that would be a stretch.

Whole Foods’ filing suggests it wasn’t shopped around. Amazon only became serious in late April when the company’s team signed confidentiality agreements. That means some shareholders, notably Jana Partners, an activist owner of an 8 percent stake, could be receptive to a higher price. A grocery-industry buyer like Wal-Mart could also cut costs, helping to justify paying more than the 27 percent premium Amazon is offering.Then there’s the defensive value. If investors were right to sell off grocery-chain stocks across the board in the United States and Europe on news of Amazon’s plunge into the sector, it could be worth keeping Jeff Bezos’ online giant away from Whole Foods.

Wal-Mart is one of few candidates. Its $230 billion market value dwarfs listed U.S. grocers, including Target, Kroger and Sprouts Farmers Market, as well as private Albertsons. Its balance-sheet cash could in theory finance nearly half the acquisition and, with total debt currently at about 1.5 times EBITDA, it could borrow more.

Adding an upscale brand might help Wal-Mart attract new customers and boost its grocery business. Yet that would be a change of direction. Its recent strategy has been to improve its e-commerce offering, including with Friday’s deal to buy men’s clothing e-tailer Bonobos.

Financially, too, topping Bezos’ offer would be tough. Assume Wal-Mart is able to cut Whole Foods’ operating costs by a generous 3 percent, or about $450 million a year. Taxed at 35 percent and capitalized on a multiple of 10, those savings are worth just under $3 billion today, roughly the same as Amazon’s premium. Wal-Mart would be irrational to pay more, especially since it would also have to cover a $400 million break fee.

This math applies to any interloper. Likewise, even hefty cost cuts won’t make Whole Foods’ EBITDA expand enough for the after-tax return on an acquisition to exceed the 8.6 percent weighted-average cost of capital Morningstar attaches to the company. Whatever clicks-to-bricks magic Bezos has in mind, his advisers have done the trick of making his deal hard to beat.


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