Amazon.com, Inc. (AMZN) Stock’s Whole Foods Buyout Is Strategically Smart

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Chris Lau

Updated Sun, Jun 25, 2017, 6:00 AM

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News that Amazon.com, Inc. (NASDAQ:AMZN) would buy Whole Foods Market, Inc. (NASDAQ:WFM) sent retail stocks, especially those reliant on selling food, sharply lower on June 9. Amazon.com will pay for the $42-per-share offer, which values to acquisition at about $13.7 billion, entirely in cash.

Amazon.com, Inc. (AMZN) Stock's Whole Foods Buyout a Seismic Event

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For the online retailer, adding bricks and mortar assets to its retail channel makes sense strategically for the company. The deal is more than Alexa technology making online grocery ordering the next big thing.

Market Caught Off-Guard

Market participants clearly did not expect the WFM stock acquisition. Target Corporation (NYSE:TGT) and The Kroger Co. (NYSE:KR) fell 5% and 9%, respectively, following the news. Amazon.com’s aggressive pricing strategy and effective online business model will add even more pressure on those companies.

Still, integrating Whole Foods with Amazon.com may have some challenges. The former incorporates management concepts that are vastly different than those used at Amazon.com. But if Amazon.com is successful in figuring out how to delivery groceries within its well-established model, then the 30% premium it is paying for Whole Foods is worth every penny.

Challenging Wal-Mart

Steady investments by Wal-Mart Stores Inc (NYSE:WMT) in building an online presence may have spurred CEO Jeff Bezos in making the deal.

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Walmart offers many convenient services that are not available from Amazon.com, including drive-by pickup. On its mobile app, customers may view a weekly store advertisement, pay via Walmart Pay and search for items at brick-and-mortar locations. Amazon.com does not have much of a brick and mortar presence. Owning Whole Foods Market would change its strategy of depending on sales solely through online channels.

The acquisition comes at a time when markets are growing more and more negative on retail businesses that depend on physical stores. Falling sales at Macy’s Inc (NYSE:M) or J C Penny Company Inc (NYSE:JCP) are indications that specific brands have trouble growing sales. A physical store presence is still a critical component for even online retailers like Amazon.com.

Amazon.com’s first priority for Whole Foods is figuring out how to improve profit margins. In the first quarter, Krogers reported a drop in FIFO operating profit. The company is adding hours to some of its service departments and increasing starting wages. Conversely, Amazon.com must boost productivity, sustain the positive shopping experience at Whole Foods and all without raising operating costs.

Amazon’s Core Business Is Healthy

Despite the attention investors are putting on the Whole Foods acquisition, the fact remains that the online retail site and AWS (Amazon web services) are still Amazon.com’s core businesses.

In the first quarter, AWS had a $14 billion run rate. It made seven price decreases, a move that drove revenue and operating income higher. It plans to invest more capital in AWS to support the growing demand in the quarters ahead. Capital expenditures grew 51%, due mainly to the addition of 26 fulfillment centers last year. Clearly, AMZN will offset higher CapEx needs due to the assets acquired from the Whole Foods Market deal.

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That is the back-end of AMZN’s business. On the conference call, when an analyst asked about grocery purchases, Amazon.com put Alexa in focus by saying “whether someone is ordering off their Alexa device or whether they’re going to their phone, or going to their computer, it all has the same effect for us.” (Source: SA Transcript).

Takeaway for AMZN Stock

After a brief blip in its share price, Amazon.com looks ready to resume its upward trend. Valuations would scare away value investors. At a PEG of nearly 5.5 times and a P/FCF of 36 times, the confidence the company will take away market share from traditional retailers will justify the share price.

Amazon’s next goal is proving to the market that it is capable of operating a grocery business at decent profit margins. But since it paid for the deal in cash, not stock, shareholders need not worry about getting diluted.

As of this writing, Chris Lau did not hold a position in any of the aforementioned securities. Chris Lau offers a Marketplace Research service: Value Stocks for DIY Investors.