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Retail Ripe for and Resistant to Disruption

A favorite cocktail party question we had a few years ago was, “which business do you think will get amazoned next?” At the time it seemed slightly novel. Now, it seems like the norm. In fact, your GreenWood Researchers recently overheard two grandmothers from Long Island saying there was no need to be entrepreneurial anymore, “because Amazon is just going to destroy your business.” In some respects, this is equivalent to the taxi driver investing in tech stocks in the late 1990s, but in other respects, it’s a sign that retail disruption has gained critical mass.

As the Economist magazine this weekend highlighted in a Special Report, “The total amount of capital, both debt and equity, supporting American retailing (excluding Amazon) now exceeds $2.5trn.” This means that the seismic shifts underway in the retailing landscape will be creating significant opportunities – both on the long and the short side.

Having avoided JC Penney, but missed Coach, we’ve long been attracted like gnats to a flame to the value-drivers of retail. An industry that has always been influenced by long-term trends, with significant operating leverage and large addressable markets, retail should be an industry where investors dedicate some time to, and not just to studying the mighty merits of Amazon.

We think right now is a particularly terrific time to be looking at the retail industry, as the valuations between businesses in secular decline and those with durable competitive advantages are surprisingly narrow. This creates opportunities on both the short and the long side, where contrarians like us can still find fairly differentiated views.

When we took our stake in Whole Foods Market (WFM) in early March, the name was still surprisingly controversial at its trough valuation of under 7x EBITDA. Even after an activist took a stake in the company, short interest has actually grown to a fresh high of 13.0%, and bearish sell-side recommendations still outnumber bullish ones by 1.5x. The consensus view is that Walmart, Kroger and many others are rolling out organic items and the prices in Whole Foods’s baskets are unsustainably high.

The organic rollout across the low-priced and commoditized retailers in the country is mostly in the rearview mirror – that competitive advantage is basically gone. What is not gone is the structurally higher product mix shoppers demand from Whole Foods, as produce is significantly higher-turning and higher-margin than non-perishables, and prepared foods (19% of WFM’s mix) have structurally higher margins than produce and other perishables. Two thirds of WFM’s sales are fresh products, while its peers have two thirds of their sales in the zero-margin category of non-perishables.

Whole Foods has a quality assurance promise that no other grocer can match. Because the cheapest eggs, dairy and meats are at a minimum free-range and cage-free, as consumers continue to care more about the quality of the food they put into their bodies, this “quality assurance,” will keep them coming back to Whole Foods. Locally-sourced and sustainable foods also carry pricing power, as customers are on average willing to pay 14.5% more for locally-sourced products. This doesn’t actually mean Whole Foods’ baskets are priced unsustainably higher than peers. If the shopper compares organic apples to organic apples, the typical basket actually rings up around the same price as competitors like Albertson’s, Kroger and Publix. The key difference is that Whole Foods doesn’t carry factory-farmed meat and dairy products, while its competitors do. That creates a perception of a large pricing gap – a gap the company is working to eliminate by plugging regional vendors into its national distribution network, in exchange for pricing concessions that will get passed along to its customers.

As the company transitions more of its square footage to food halls and bars, the footprint will continue to evolve to a structurally higher margin mix of business. No other retailer aside from small specialty grocers like Eataly is innovating on mix. Yet, with the large looming bankruptcies in the retail sector and vacancies which are set to rise to possibly ⅓ of the current retail network, opening up a physical store has never been cheaper and more contrarian. Consumers will not only continue to want in-person experiences, but will place a premium on differentiated experiences the more their social lives become electronicized. With retail property owners desperate for traffic, Eataly was recently given an entire $20 million store in lease-hold improvements for free as the World Trade Center knew it would drive traffic and create value for the neighboring retail. Nearly all innovation of the past three decades in retailing has happened by lowering distribution costs. Yet, there are certain areas where online sales make little sense.

Because of the inefficient nature of individualized distribution, where much of the variable costs are tied to the volume of the products shipped, the retailers most vulnerable to online disruption are those which have high margins and light-weight products. Books, music and movies were some of the earliest products disrupted, as these retailers had very high margins – leaving plenty of room for amazon to profitably cut prices and still bear a reasonably high cost of variable distribution.

Book vendors also had very low inventory turnover, and a fairly sizable property footprint. This required much higher capital costs to carry this inventory than did other retailers like Walmart, Costco and later Amazon. Using these examples, the simplest rule of thumb to identify businesses most ripe for online disruption would be to map out retailers on the basis of inventory turnover and gross margins, as we’ve done in exhibit 1.

Exhibit 1: The Zone of Disruption

As groceries are particularly heavy items (the average shopping bag weighs 15 pounds and would be north of $20 per bag for Amazon to deliver), have extremely high inventory turnover, and also have a very efficient distribution network, they are one of the least likely industries to be disrupted by e-commerce, as the Economist article also points out.

Exhibit 2: Amazon’s Distribution Costs for Groceries @ Current Economic Model

Source: Our Presentation at ValuEspaña 2017

Even with the heavier and costlier economics of individualized distribution, we still believe select grocery demand will eventually go online, particularly for non-perishables that are easily automated. Additionally, the convenience factor alone has been attractive to wealthier consumers, many of which are Whole Foods shoppers. In fact, areas where the company has partnered with Instacart for delivery in as little as one hour, e-commerce penetration at Whole Foods is already hitting the high single-digits.

Of course, inventory turnover and gross margins are just the start of the search for businesses vulnerable to obselesence and e-commerce. The overhead of stores is also a key consideration. The higher the overhead, which aside from occupancy costs is largely tied to the number of employees at a particular store, the easier it will be to take costs out and pass these savings along to consumers.

Exhibit 3: Per Square Foot Economics of Groceries

Exhibit 3 is what excites us so much about the Whole Foods opportunity going forward. Because the company’s sales mix is structurally skewed to higher-margin product categories, and its sales per square foot are the highest of any public peer (only Trader Joe’s and Eataly are higher, from our research), as the company automates multiple functions and re-allocates these employees to its new food halls and bars, the company has a substantial opportunity to cut SG&A and, at the same time, continue innovating on the customer experiences and shifting its revenue to a higher-margin mix.

Even after the shares have run up in the last couple of months, the stock remains controversial and we are eager for bears to reiterate their short thesis on the company. Over the next year and a half, the company will be buying back as much as 15% of the company – best to do it under controversial conditions with loud bears around. Yet, while we don’t want them to go away, the bear thesis that that Whole Foods is under attack from a competitive industry is not new, and in fact has largely played out over the past few years. Online threats are not only over-stated but are largely irrelevant.

In one of our favorite books on business, Conscious Capitalism, WFM CEO John Mackey discusses his view that competition forces businesses to continuously innovate and stay a few steps ahead of their peers. In a recent Charlie Rose interview, which we highly recommend, Jeff Bezos also talks about the importance of staying a year or two ahead of the competition.

We think the recent competitive encroachment on Whole Foods’ turf has led to very important cost and product mix innovation at Whole Foods. The company has used the period of deflation well, and now that deflation is ebbing, we think the best days for Whole Foods lie very clearly ahead.

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This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

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This Post Has 7 Comments

  1. ” We think the recent competitive encroachment on Whole Foods’ turf has led to very important cost and product mix innovation at Whole Foods. ”

    And what part of this new WFM approach can’t be copied later on by “dinosaurs” like CostCo and Wallmart (or even more efficient and creative deep pocket competitors), to render this new WFM approach moot ? In other words, what part of WFM’s approach is a moat ? I think WFM has no moat anywhere, and therefore is open to further disruption, since it’s ROIC is still relatively high and thus attracting unending competition. That being said, you are clearly a very smart person, and I truly loved this blog entry, I learned something again…..

    1. Thanks for the opportunity to clarify!
      First, the company has signed exclusive supply arrangements with many of its vendors – so if you like a particular grass-fed steak, or a particular hummus, etc etc, you will increasingly only be able to find it at WFM. Because they treat their suppliers very well, they are the first call for any food brand that is seeking distribution.
      Second, “dinosaurs” only have 2% of sales going to deli/prepared food, compared to WFM’s 19%. Trying to change that customer behavior and getting people to think of Costco as a place to go get dinner (the average American decides between 3pm-5pm what they’ll have for dinner) for that evening will be a very tough re-branding task for the legacy stores. Or look at a Kroger – clearly they have increased space dedicated to prepared foods, but without very high turnover, the food isn’t as fresh and you don’t have the positive-feedback-loops WFM has from heavy traffic, high sales per foot, high inventory turnover, which in turn, ensures freshness.
      Third, seeing people have a beer and eat-in at a grocery was quite foreign to us before Eataly, but now food halls are becoming a norm. Sure, legacy stores often have a fast-food store within the store to try and capture some of this demand, but again, if you are coming for a “foodie” experience, you’re not going to a Walmart. Because nearly half of American shoppers describe themselves as foodies or aspirational foodies, the total addressable market for differentiated vendors is quite high.
      Don’t get us wrong, we don’t think WFM has permanent barriers to entry, as zero retailers do, but we believe investors have underestimated its actual competitive strengths and are ignoring the footprint changes that are taking place as we speak with increasing square footage to food halls and bars. Eventually that will be banal, and there will need to be more innovation to offset more competitive encroachment. But customers going to Walmart to have a glass of wine and a meal? Even our imaginations can’t stretch that far…

      1. ” But customers going to Walmart to have a glass of wine and a meal? Even our imaginations can’t stretch that far… ”

        Yeah, if you want to do that, you go to a decent restaurant with a nice terrace to chill out, not a WFM or a Walmart box with a large parking lot. What I was trying to convey, is that stressed out working janes and joes will not drive specially around to collect premium fresh food, if they can order it from home and pick it up quickly (already prepackaged and paid for) on their way back home from work, or get it all delivered at a small premium directly at home in one hour, as is shown in underneath posted link. One stop quality food shopping and internet delivery are the future, and competitors can and will be eating at the WFM edges at all times. I repeat that you are a very intelligent person, and want to thank you for the nice profits I made with your EXOR and Bolloré advise, but on WFM i really have a hard time sharing your long term optimism, unless you take a look at the current land value on which the 1200 WFM stores are sitting, like McDonalds is now viewed (McDonalds is basically a huge real estate corporation selling cheap commoditized hamburgers through franchisees, franchisees paying McDonalds Corp a small fee on each hamburger sold and a large lease fee on each square feet of rented real estate land, on which their shop outlet is built). I now live in Europe, where quality food supply and tasting experiences are for us a simple basic daily occurrence found in any decent supermarket that wants to stay in business (it is brand independent), since junk food is only a small part of our daily diets, unless you happen to be brainwashed by the constant advertising for it (I don’t watch TV). I suspect the USA is now going the Europe way too, by giving it’s shoppers better quality food at any supermarket that cares about retaining it’s clientele. Diabetes explosion rates probably being one of the reasons for this US better food craving cultural evolution. That is why I bought some Novo Nordisk shares, the competition there is far lower (basically Eli Lilly and Sanofi) , and global “customers” are growing in numbers and are for life, since there is no cure yet for diabetes … Cynical? yes. Welcome to Wall Street.

  2. here’s a very very interesting summary article (pro and contra) concerning WFM.

    A small quote from a dead astronomer : “If you ever start taking things too seriously, just remember that we are talking monkeys on an organic spaceship flying through the universe”

    Good Luck, Steve. I won’t post anything anymore concerning WFM,

    The future will show what happens.

    Hopes it pans out for your investment.

    There are many of them out there, you simply have to pick the ones fitting your tastes…

    I prefer the sticky ones, where people open their wallet without thinking, because their neurons have been deactivated by the product attraction, and they can’t get enough of it, whatever the fee for that product at the end of the day.

  3. Awesome job, guys! Don’t know if you are happy with the price, but I’m sure you’ve made a nice return.

    1. Thanks so much! We would have preferred a long-term triple, but I suppose we’re happier than Kroger shareholders today!

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