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The Battle For Whole Foods Isn’t Over

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Every grocery retailer in the United States, and perhaps even Europe, has undoubtedly called emergency board meetings for this weekend. Amazon’s attempted merger with Whole Foods is a watershed event that will have far-ranging ramifications.

Ripe for Disruption

Over the past year, we’ve been spending inordinate amounts of time understanding retail that is both ripe for and immune to disruption. Better late than never! Whole Foods has cleverly innovated on revenue “mix,” structurally taking non-grocery categories like restaurant-quality meals and taproom beer and wine bars into the grocery experience. As we showed in our original research on Whole Foods from just a few months ago (now free on our public Research page), prices at “Whole Paycheck,” aren’t actually higher than the mainstream dinosaurs, their margins are higher because they have a structurally better mix that’s less susceptible to e-commerce, as 67% of revenue is fresh and prepped foods.

Since our March purchase of WFM, we have gone a lot further in picking apart the unit-level economics of online grocery delivery and still maintain that in today’s fragmented grocery market, unit-level economics of delivering most household’s baskets to their doorstep doesn’t work. At currently low levels of online grocery penetration, the break-even basket size for an American grocer is $185 vs. the actual average basket size of $41 today. At that price point, less than 2-3% of shopper’s current baskets are potentially disruptable online from a cost-competitiveness perspective.

Exhibit 1: Unit-Level Economics for Grocery Delivery in the Tri-State Area

 grocery delivery

This Changes Everything

All of that changes with Amazon’s entry into the market. The most important driver of better delivery economics is actually market share, not penetration. Similar to other technology models, online grocery delivery is a winner-take-all market. Think of the delivery van. A Mercedes Sprinter (the world’s least profit-making model) can hold about 40 loads of groceries (assuming a basket size of 20 items). If the leader in the industry is already in your neighborhood or delivering on your block, the incremental cost to your delivery is pretty close to zero. But in a fragmented market, you have delivery vans criss-crossing the city at different times of day to meet consumer demand at specific time slots. It’s the opposite of “scale,” that the retail industry has for so long thrived on.

But there’s one player in the retail industry that already has massive online scale (43% in 2016 and still rising). Of course we all know who this is, yet Jeff Bezos has in the past been unable to “crack,” the grocery industry, as Amazon’s mind share for people who are looking for dinner is at a virtual zero percent penetration. Whole Foods and its very high relevance, where customers’ #1 perception of the company is “fresh,” and “high quality,” completely fixes this lack of mind share.

Even at today’s low online penetration in the United States of <5% of revenue (10% of households order at least once a month), we believe Amazon’s current market share of 43% of the e-commerce market would make every basket above $63 in-play for e-commerce given the model becomes a cheaper mechanism of total delivery at that point. This doesn’t even consider the obvious add-on benefits to the consumer of being able to automate or replicate past purchases, as well as Amazon’s ability to sell so many further add-ons to the delivery.

Exhibit 2: Unit-Level Economics for Grocery Delivery in the Tri-State Area

Whole Foods

Thanks to a giant installation of new grocery square footage over the last decade, grocers are precariously close to the brink. Many of them couldn’t withstand even a 2% same-store-sales deceleration with a concurrent 1% shrinkage of gross margins. The ramifications to Amazon being able to deliver well over 50% of the baskets in the industry, if penetration were to rise to the UK’s current level of online grocery sales, really cannot be understated for such a weakened base of competitors. At current economics, we believe over ? of the industry’s baskets are at risk. That’s the day after the deal closes and Amazon Prime customers all of a sudden have access to subsidized and automated grocery delivery. Consumers, say hello to your extra hour a week. Retailers, hunker down, this is about to get real.

 It’s Not Over Yet

As a result of the wide-ranging ramifications Amazon’s scale brings to the current hyper-competitive grocery market, we don’t believe the Amazon cash offer of $42 per share will be the final price for shares of Whole Foods.

The desperate dinosaurs, if they have any wits left, should stop at nothing to let this transaction go through. With the highest quality brand in the industry able to expand its market reach from just 1.5% today to nearly 100%, and the delivery economics to Amazon becoming competitive with well over 50% of the industry’s transactions, this transformational merger is the beginning of the end for the grocer near you.

We think the ramifications go even further: to Target, Walmart and other “do everything” retailers that have low inventory turnover and high margins (see our related article from last month on retail ripe for disruption). Then of course, Amazon has been battling consumer-packaged goods companies who are clinging onto their margins in order to mostly pay dividends to their robotic shareholders. They are officially on notice, as Whole Foods’ 365 brand will very clearly erode the market share of legacy brands.

If you’d like to see a demonstration of how quickly this will filter into the industry, check out Professor Scott Galloway’s recent youtube on the declining importance of brands in the Amazon age.

 Who’s Next

There is one other e-commerce solution, the only one in the world that we know of, that has been able to prove not only positive returns on capital even with a fragmented market share, but ROIC >50%. That’s Ocado’s current model for the UK. The company can deliver its current small sliver of the online grocery market in the UK at rates of return over 50%.

In an ironic twist of events, your author was about to buy shares of Ocado this morning when the AMZN-WFM news broke and was wondering why the stock was plummeting so fast. It took us a couple hours, but when we finally regained our composure, we took advantage of the irrational sell-off in Ocado and started a “starter” 4% position in the company today (we also started a 6% TripAdvisor position today). We think because the desperate dinosaurs need to have some “strategic” answer to this watershed tie-up in the industry, Ocado’s profitable and highly efficient platform could be just the right solution for a retailer fighting for survival.

Of course, Walmart, Kroger or even Alberston’s-Safeway, whose IPO now looks unlikely to ever happen, would best try and go hostile on the Amazon bid and enter in their own bid for Whole Foods – who clearly didn’t shop themselves around to the dinosaurs. In the worst case scenario, they would just force Amazon to pay a higher entry ticket into the hyper-competitive industry. In the best case scenario, the industry buys themselves a few quarters or years until the eventual denouement comes to pass. We’ll be holding onto our WFM and OCDO LN shares until then.

Good luck at the emergency board meetings, everyone.

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