The Acquisition Heard ‘Round the Industry

What will happen to Whole Foods now that it owns the second largest natural products retailer?

ByAdam Ismail

The acquisition of Wild Oats by its main competitor, Whole Foods Market, seemed like a landmark deal that would have space-changing implications. Immediately critics came out of the woodwork, saying it was either a bad deal financially or that it would harm competition in the natural and organic space. Let’s find out what the real implications of the deal are.

Industry Trends

In some respects, Whole Foods has become a victim of its own success. The company has grown rapidly, maintaining a sales growth rate of nearly 20% annually. However, there are two ways to grow retail chains—add more stores and/or make the stores you have more productive. The key concern for Whole Foods in-vestors of late is the drop in same-store sales growth, which has fallen by almost half in the past year—from 13% to 7%.

When you are a company with $5.8 billion in revenues and double-digit productivity growth, you attract a lot of interest from your slower-growing rivals. Last year Wal-Mart an­nounced that it was going to make natural and organic a major push that would likely make it the largest retailer of such products in the world. In addition, most other mainstream grocery retailers in the U.S. have already launched their own lines of private label natural and organic products. Further, consider the flood of natural and organic versions of mainstream brands.

For years Whole Foods and Wild Oats have served as a destination for consumers seeking natural and organic foods, with the only alternative being the smaller natural foods stores that don’t offer the same variety. Many patrons, however, do not exclusively shop at the two chains, opting instead to get many of their groceries at traditional retailers. A more empirical analysis is really needed to determine the exact reasons why Whole Foods same store sales have fallen, but it is not far-fetched to suggest that these forays into natural and organic foods by traditional grocery retailers has had some impact.

Value Creation

So if you are in Whole Foods’ shoes, and you are looking to create value for your shareholders, an acquisition of Wild Oats seems like a very attractive option. Aside from the obvious 20% boost in revenues you would gain from the acquisition, Wild Oats stores have not been nearly as productive. Wild Oats stores typically sell about $450 dollars of goods per square foot, while Whole Foods stores sales sit north of $900 per square foot. Some of that difference is due to the locations of their stores, but much of it is a result of the shelf management and expertise of Whole Foods.

So an acquisition of Wild Oats, at the right price, could offer Whole Foods both avenues of growth—increasing the number of stores and increasing the productivity of stores they already operate. The Wall Street Journal recently reported that the worry amongst investors is that the stock market may be counting on too much value creation. In fact, one analyst claims the current price of Whole Foods shares is already accounting for them being able to get all of the Wild Oats stores up to the productivity of other Whole Foods stores. Only time will tell if Whole Foods can achieve such growth and extract other significant synergies out of the deal that will help it regain its high growth trajectory.

Competition

A second complicating factor in this deal is whether or not it will stifle competition and lead to higher prices of natural and organic foods. Traditionally, the Federal Trade Commission (FTC) is the watchdog of such issues, and one of the measures it uses to determine whether or not an acquisition will harm competition extensively is to calculate the concentration of the industry. The calculation they use to determine this is called the Herfindahl-Hirschman Index (HHI)—HHI is calculated by multiplying the market shares of all companies in a sector by 100 (70% becomes 70), squaring each of those, and then adding them all together. In industries where the HHI calculation is above 1800 after the merger, the industry is considered highly concentrated and will inevitably get reviewed by the FTC.

The key, however, is how you define the industry. If you look at the entire retail environment of grocery stores, then obviously Whole Foods and Wild Oats are too small to worry anyone. As you narrow the definition of “industry,” though, the power of the two retailers becomes more interesting.

Table 1 (calculated from Nutrition Business Journal data) shows that for the FTC to stop this deal on anti-competition grounds, it would have to very narrowly define the industry in which they compete because even if you took the most narrow definition in the group below, the HHI would only be 1447, well under the limit of concern for the FTC.

While it looks likely the deal will get the “ok” from the FTC, the agency may require Whole Foods to divest some stores. This would only likely be the case in markets where Wild Oats and Whole Foods currently compete. De-pending on how narrowly you define a metropolitan area, the two companies currently have a presence in about 185 different markets in the U.S., and compete directly in about 20 of them. Most of those areas where they compete directly, however, are places where there is a plethora of other retail outlets where consumers can buy natural and organic products, like Colorado or Southern California.

Final Thoughts

So while competition does not look like it will be negatively impacted too much and there will be an opportunity for significant value creation as a result of the deal, Whole Foods is still going to have to come up with a strategy for maintaining its growth and continuing to fend off traditional grocery retailers. Wal-Mart is always mentioned as a threat to other retailers because of its size and buying power, which is an advantage that is difficult to compete against. On the other hand, Whole Foods is often considered a strong threat to traditional grocers, but its advantage has come from having a product offering other stores could not match. That advantage now is becoming harder to defend. The Wild Oats deal will likely help Whole Foods, but it will have to make significant adjustments to its strategy in order to defend its position in the future.NW