17 May July 2017 – Amazon Foods
The announcement in June that Amazon is buying Whole Foods Market was not eye-opening from a financial standpoint. The $13.7 billion deal would only be the 10 th largest deal that closed last year, which does not include twelve other deals that were announced but have not closed. Nine larger acquisitions have already been announced this year. The acquisition is, however, much more significant from a symbolic standpoint. Large technology companies are moving fast and disrupting, or in some cases destroying, old business models.
Apple, Alphabet (the parent company of Google), Microsoft, Amazon, and Facebook are the largest public companies in the United States. Collectively these five companies hold over $500 billion in cash and securities, providing ample dry powder for future forays into new business lines.
Amazon has not shared any thoughts regarding the strategic rationale for the Whole Foods purchase. The deal came together very quickly, with the agreement reached only 6 weeks after the first meeting. Despite this quick tie-up, I think Amazon has many potential strategies in mind in regards to Whole Foods and looks forward to experimenting with different ideas. The deal signals the importance of physical space in an omni-channel retail strategy for some product categories. Amazon will likely use Whole Foods as both distribution centers for deliveries and pick up locations for Amazon purchases. Amazon has made significant inroads into some product categories such as books and consumer electronics without a physical presence, however food and beverage is a different animal with only 2% of sales through the internet. Amazon has hinted at a need for a physical presence in this space with the Amazon Go and Amazon Fresh Pickup concepts in testing. Beyond these more obvious strategic reasons, the primary reason for the purchase may be about data.
According to an article in The Wall Street Journal , a Morgan Stanley survey found that 62% of Whole Foods customers are members of Amazon’s Prime service. Amazon has troves of data about online shopping, but limited data on how consumers shop in stores. The company could use this new data to improve product offerings, expand private labels, and increase cross-selling opportunities, to name just a few of the possibilities where their experimentation may lead.
One characteristic that unites Apple, Alphabet, Microsoft, Amazon, and Facebook is the insatiable need to acquire more data. A recent article in The Economist aptly described Amazon as a platform company that benefits from “network effects” – the more people buy from them, the better they get. I think this description can be applied to all five tech behemoths. These companies use data to both improve their core product offering and expand into new adjacency. These adjacency, or “moon shots” as Alphabet calls them, are full of amazing research and potential. Apple and Alphabet are working on self-driving cars. Apple, Alphabet, Facebook, and Amazon are all working on original content in video. Amazon and Facebook are working on drones. Alphabet is working on internet-bearing balloons and energy-harvesting kites, and the list goes on and on. One category that all five companies focus on is artificial intelligence, a field in which data helps drive better outcomes.
The potential implications of the power held, and more importantly future potential, of these five companies are deep enough to write a book, but for the sake of this newsletter I will focus on stock selection. Now I must add a disclaimer. I rarely write about individual companies because there are strict restrictions on writing anything that could be considered a recommendation. So in an effort to be crystal clear, I’m not recommending that anyone purchase or sell any of these stocks. I simply want to share some thoughts around the stocks, particularly in the areas of valuation and risk management.
Stock returns, particularly in the short run, are dependent upon how companies perform, not in a vacuum, but against expectations. One way to measure investors’ expectations is the valuation multiples placed on the stocks, the most common being the price to earnings ratio. This ratio is simply the price of the stock divided by the earnings per share which shows how much investors are willing to pay for each $1 of earnings. Starting with Amazon, the stock trades at 148x 2017 expected earnings. This compares to the market as a whole (represented as the S&P 500) trading at 18x expected 2017 earnings. Embedded in Amazon’s high valuation multiple is the expectation of high future revenue and earnings growth. Last year Amazon had $136 billion in sales. According to Credit Suisse, no company with greater than $100 billion in sales has grown greater than 15% for 10 years straight. Amazon crossed this threshold in 2015. Can they keep it up until 2025? Current expectations are for sales to grow about 20% per year for the next few years. At the same time Amazon is expected to reduce capital expenditures causing earnings to grow about 40% to 50% per year. Amazon is without a doubt a great company. Whether it will be a great stock depends to some extent on its ability to exceed these lofty expectations.
As another frame of reference the P/E multiples on the other four stocks discussed are 16x, 23x, 27x, and 31x for Apple, Microsoft, Alphabet, and Facebook respectively. All are great companies in which their stock valuations contain different levels of embedded expectations. Investors can make or lose money in any of these companies based in part on whether they live up to expectations.
Lastly, from an investment standpoint, idea generation can come from inspecting concepts where these five companies are succeeding or experimenting. What other companies will benefit from the adoption of self-driving cars? What about the expansion of omni-channel retailing? Artificial intelligence? Investors may also be able to identify areas of the market to avoid if these technology companies continue to flourish. What business models are likely to be challenged by these companies in the future? What brands lose value in an Amazon-dominated world?
The success and power of Apple, Alphabet, Microsoft, Amazon, and Facebook is expanding as these companies harvest significant volumes of data while at the same time reinvesting cash generated from their core business lines into new opportunities. Investors are faced with the challenge of weighing the risk vs. reward in these 5 behemoths, and also presented the opportunity to uncover other investment ideas tied to the successes of these companies branching into new categories.
Tom Searson, CFA