Special situation: Whole Foods (WFM) – “free options” anyone ?

A few days ago, Amazon famously announced to take over Whole Foods Market for 42 USD per share (representing a premium of around 27%).

Markets enthusiastically welcomed this move from Amazon, with the Amazon share jumping almost 4% or ~13 bn USD, which coincidently was almost equal to the deal amount.

Whole Foods itself was “under siege” from activist investor Jana which had built up a 9% stake in the company. Just 2 days before the takeover, Whole Foods CEO called Jana “greedy bastards” indicating that he was not happy having such a shareholder.

Selling out to Amazon seems to be a good deal for him, as Amazon allows successful subsidiaries like Zappos to run their business as they like it and Bezos has proven that he thinks very long-term.

However there are also some unhappy people about this deal. The first unhappy group are the other supermarkets:

While Whole Foods shares are surging because of the 27 percent premium being paid, other grocers are getting crushed. Kroger Co. was down as much as 17 percent, Supervalu Inc. dropped as much as 22 percent and Weis Markets Inc. slumped as much as 9.6 percent.

The stocks of the competitors haven’t recovered much since then because everyone assumes that Amazon clearly will disrupt food retailing next. So theroretically one could argue that it might make sense for Costco, Walmart or someone else to make life more difficult and offer a counter bid.

Another group of unhappy people were the other 6 bidders interested in the company. According to filed documents, Amazon threatened to kill the deal if Whole Foods would try to contact other interested parties.

So it is not really clear if the deal was the best deal for shareholders or if it was just the best deal for the CEO.

My assumptions at the current share price of 41,90 USD:

I think there is very little risk that the Amazon deal will fail. If no higher bid comes up, the deal will go through in the second half of 2017. If I would need to quantify this I would say max. 5% risk of non-completion. My own assumption for an “undisturbed” price would be rather ~34,50 USD/share.

However I do think that there is some likelihood for a better deal. It is hard to say how high the probability is, but with two groups of potentially interested parties (PE & competitors), I think the probability is not zero but rather maybe somewhere between 25-50%. For calculation purposes I use (25%+50%)/2 = 37,5%.

A “normal” take over premium in a competitive process should lead to a higher price. My “gut feeling” assumption in this case would be 5 USD more at 47 USD/share.

When the Amazon deal goes through I will get my 42 USD. The probability then is 100% -5%- 37,5%= 57,5% and I will earn 0,1 USD (before trading costs) in that case.

Update: As a reader pointed out, it would not be unrealistic to assume 1 dividend payments until the end of the year. This would add 0,18 USD or ~40 bps to the expected return and pay for the trading costs…..

So the expected profit based on my assumed probabilities could be calculated the following (based on 41,90):

=5%*(-7,40)+ 37,5%*(5,1) + 57,5%* 0,1 = 1,60 USD or ~ +3,8% for 6 months (or 7,7% annualized).

Alternatively I could invest my existing cash into a USD deposit which would pay my 1,5% annualized or ~0,75% in absolute terms. So on an annualized basis this is a spread of 700 bps which looks attractive to me compared to the risks I take (of course before trading costs etc.).

Looking at the recent price chart it is interesting to see that there seem to have been higher expectations for a higher bid in the beginning when the stock traded up to around 43,80 USD:

wfm gip

For some people this might look like “picking up the nickel in front of the steam roller”. For me it looks like an almost “free option” that someone comes along and puts in a higher bid. As long as I have cash (currently around 13% and still increasing), this is an attractive alternative.

Therefore I have initiated a 3% position at 41,90 USD per share. Again, as in the Actelion case, I fo not hedge the dollar, as I am still within my comfort zone with reagrd to USD exposure.

 

 

 

 

 

29 comments

  • From the press (that went fast):

    Amazon to close Whole Foods acq on Mon. 8/28, 2 months and a week after the deal was announced on 6/16. This news followed shortly after Whole Foods shareholders and the FTC approved the deal on 8/23. Wasting no time, Whole Foods will lower prices on a selection of best-selling grocery staples on Mon, including organic bananas/apples, responsibly-farmed salmon, organic eggs, and more. Notably, Amazon Prime will eventually become Whole Foods’ customer rewards program, providing members with special savings and in-store benefits, and Whole Foods’ private label products will be available through Amazon, AmazonFresh, Prime Pantry, and Prime Now.

  • Can you tell me the bloomberg ticker for Metro spin or otherwise. Thanks.

  • Hi memyselfandi007, what do you do with the antitrust regulation ? I’ve read on reuters that a senator wants a hearing on it. Thank you

  • Thanks for the posting. the annualized return seems attractive. From your posting I see that the reason you find this trade make sense for at least a couple reasons:

    1. good enough return for a short period of time.
    2. there may be a higher bid

    For 1), on the merger arbitrage side. Would you think this is too risky for a retail investor? I understand the probability of the deal going through could be high or even close to 100%, but if the deal doesn’t go through (for so many possible unexpected things could happen to stop this deal), the potential loss could be ~20% vs the capital gain of >1%. (I am excluding dividend consideration here because assuming it would be the same even if acquisition was not announced.)

    Joel Greenblatt describes this kind of trade as similar to selling insurance in the book “You can be a stock market Genius”. I would agree with him here that you need to make sufficient bets (diversification) to make it safe, just in case the deal doesn’t go through.

    A quite high probability event that would have impact on the annualized return would be the timeline when they will actually close the deal. It quite frequent that deals get delayed even though they get through eventually.

    For 2). would your decision be different if taking out the speculation of higher bid for WFM?

    I am interested on what you would think about couple thoughts i have:

    1. the “selling insurance” characteristic for this trade. If you are selling insurance policies, sufficient volume is needed to diversify the risk in case you have to pay out for a particular policy (take big loss in this case). Your position is about 3%, It seems diversified for any potential loss.
    2. how much of weight the hope that there’s a higher bid for WFM (the free option) has influenced your decision. I think this part is more speculative in nature. Where 1) is more value based.
    3. I am not sure how many companies that are similar to WFM out there. But let’s assume there a a few out there. Competitors of AMZN not necessarily need to bid on the same one to start a bidding war. they could target current competitors of WFM and build the empire. For the same reason, if the deal blew up, AMZN could go to someone else and make the offer? ( I am assuming WFM is not super unique here and I could be wrong).

    Thanks

    • Thanks for the comment. With regard to the risk I refer to my earlier post:

      https://valueandopportunity.com/2017/05/16/nickels-steam-rollers-and-other-bad-investment-heuristics/

      This is a game of large numbers, so you should do these kind of investment on a regular basis or not at all. I personally see the downside slightly less critical because there were 6 other potential buyers but you never know.

      Of course without the possibility of a higher bid, the current price would be not that interesting. I think I made my assumptions transparent and the “free option” is driving the case.

      Of course I could be totally wrong but then I will need to incorporate this into my future similar investments. There is no guarantee that this will work out.

      Betting on other food retailers as potential targets is in my case a very different risk/return proposition and not something I would do right now.

  • Some analyst has suggested that Costco should launch a counterbid:
    https://finance.yahoo.com/news/analyst-urges-costco-buy-whole-154925860.html

  • I follow the logic, but at the risk of being a value philosophy pedant, almost all the value in the trade sits in your 37.5% estimate of a chance of a higher offer, and this is a number you’ve picked out of thin air. That’s not to say it’s a bad trade, it’s just that the core of the logic is based on a finger in the air. Personally, I prefer the TPCA tender offer Carl Icanh is running right now – buying shares and tendering at $45 gives me an IRR of 30%+ which is enough to pay for the small chance the tender fails. In any case, thanks for the post and good luck with this one!

    • Yes, this is the point that you don’t know the probabilities beforehand. What oen shoudl do is of course to systematically track those cases and see how good the estimates are. The more critical assumptions in this case however is the 5% chance of failure. But this is clearly “part of the game”.

  • Thanks for this good idea. By the way, do you look at another industry also disrupted by Amazon, auto parts retailers – Autozone and O`Reilly? They are high-quality and cheap, though cheap for a reason.

    • hmm, Autozone has significantly negative equity. I would not call this “high quality”.

      • It’s all because AZO has buying tons of its own shares. AZO is a cannibal, defined by Munger. And you can look at the following numbers:

        Total FY2002-FY2016
        Operating Income 20.0B
        Net Income 11.6B
        OP Cash Flow 15.8B
        FCF 11.2B
        Amount in Buyback 14.7B

        Its outstanding shares decreased from 107M in FY2002 to 30M in FY2016, a 71% reduction!! It gross margin is 52%. Operating margin is 19.4%. You won’t see many retailers with this high margin. ROIC is 40%, ranging 25%-40%. Negative working capital. Consistently negative cash conversion cycle.

        It’s really a high-quality company. But going forward, maybe not that good because of Amazon…

  • Regarding WFM. For those who want some leverage or don’t wish to tie up capital you can purchase a November 42/45 call for around 20 cents or less.

  • I think WFM will pay at least one, maybe even two, dividends before the deal closes.

  • Interesting as always.
    Yet, factoring in the trading commissions & stock exchange fees, return becomes 3.5-3.6%, or ca. 7% annualised. It only seems good because of the (historically) very low risk-free returns. And 7% return is not brilliant for the (relatively large) risk intrinsic to an expensive market as now. My risk appetite is more geared towards emerging markets.

    • I don’t understand that argument. I don’t have market exposure with this position but event exposure. Using Emerging market (stocks) as a comparison in this case IMHO is comparing Apples with cucumbers. And again, my benchmark for this is cash.

    • I meant you are exposed to the volatility/uncertainty of the market, but probably you are right that is more accurate the term event exposure. Being cash the bmk, I personally prefer betting on EmergingMarkets small caps etfs, than the bet on WholeFoods. Thanks for your sharp comments though.

  • Where are you getting 1.5% on USD cash?

  • I’ve been looking at this and arrived at a similar conclusion…

  • Thanks a lot for the post. I’ve been following the SP of Whole Foods closely and also think this could be a good opportunity to earn some small $ w/o much downside. Whole Foods would have to pay Amazon a $400 million breakup fee what’s a heavy weight to lift for the new bidder. But anyway, could a bidding war be won against the cash machine Amazon? I think no. But the party could be disturbed a little bit which undermines your thesis of an increasing offer.

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