In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Fool.com contributor Adam Levine-Weinberg dive into that deal before turning their attention to another major one rumored in the department store space. Nordstrom (NYSE:JWN) stock has seen significant gains since news broke that members of the Nordstrom family may be looking to take the department store chain private.
A full transcript follows the video.
This video was recorded on June 20, 2017.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I’m your host, Vincent Shen, and it’s Tuesday, June 20th. In the past few weeks, we’ve spent a lot of time talking about retail mergers and acquisitions within the industry, deal rumors. Well, the consumer-retail world is not letting up, and today we will be discussing two big stories — first, Amazon’s approximately $14 billion buyout of Whole Foods Market; and second, reports that members of the Nordstrom family are looking into options for taking their namesake company private. Joining me in studio is senior Fool.com contributor, Adam Levine-Weinberg. Thanks for coming into Fool HQ today!
Adam Levine-Weinberg: Thanks for having me!
Shen: Are you excited about all these deals that are coming up in our world?
Levine-Weinberg: Yeah, it’s a very exciting time for the consumer goods space.
Shen: Yeah, the consolidation, the struggles that a lot of the retailers are seeing, it definitely gives us a lot of good material to cover on the show, good topics to cover on the show. I think it’s fair to say, in this case, for this episode, that both the target companies that we are about to discuss have been facing headwinds within their industries, and they’re going to continue to fight an uphill battle going forward, and that will probably be an overarching theme for the show. Let’s start our discussion with the more recent and official announcement, and that’s with the Whole Foods deal. The news broke last Friday before market opened that Amazon would be acquiring Whole Foods.
A brief rundown of the most important terms behind the deal: Amazon will be paying $42 per share, which is a 27% premium to Whole Foods’ last closing price. This is an all-cash deal valued at about $13.7 billion, including Whole Foods’ net debt. John Mackey will be staying on as CEO. As a reminder to our listeners, John Mackey serves on the board here at The Motley Fool. Otherwise, the Whole Foods brand will remain intact. The headquarters will remain intact in Texas. The deal is expected to close in the latter half of the year, barring any hiccups, as we’ll talk about. Amazon, the stock has seen a nice bump with the deal announcement, and there’s a lot of investors and I think the media as well speaking to the big opportunity that this presents for the company. What do you think is driving the decision here for Amazon to want to make such a big purchase?
Levine-Weinberg: Amazon has been trying to get into the grocery market for quite some time. Obviously, Amazon is now well over $100 billion in annual revenue. As you get bigger, one of the main ways they’ve expanded is by gradually moving into new categories, getting a foothold, and then getting really big in that category. It wasn’t really that long ago, 15 years, Amazon was really just books and maybe some movies and music, and then they moved into electronics and became really big there, then they moved into fashion, they moved into food somewhat. But right now, in food, they are still not a really big player. In a few markets, they have their AmazonFresh service, which does home delivery, but it’s more expensive than Prime, you have to pay about $300 a year to subscribe. It’s very convenient, it’s not especially cheap. It’s really for people who want the convenience and are willing to pay, and it’s only in a few markets.
Shen: Yeah, more urban areas, denser populations where that kind of service is more feasible.
Levine-Weinberg: Yeah, and not even every urban market. I think, over time, they could continue to roll that out, and maybe Whole Foods will help them with that, maybe we can get into that a little bit later. They also have their Prime Pantry service, which is shipping things through their normal fulfillment network. That, however, can only do non-perishable goods. That’s an important segment of the market, but it can’t get the entire market. And obviously, things that aren’t available for same day delivery, you’re not going to be able to capture as much of the market, because people decide on a particular day that they need an item, they want to do a cooking project, and if you can’t get it to them right away, then they’re going to end up going out to their local grocery store. So it’s definitely an area where Amazon has a lot of potential. The grocery market is humongous, it’s close to $1 trillion just in the U.S. So this is a big place where Amazon could continue to grow and get the next $100 billion of revenue. So the question is how does it do that. The Whole Foods acquisition is definitely a big piece of creating a foundation for further growth.
Shen: You talked about some of their more online-focused efforts, but Amazon also has had experiments that have made headlines in the past year or so, in terms of some actual physical bookstores, and the experimental store that I think it’s still available only to Amazon employees, where there’s no cashiers, there’s no checkout lines, it’s all done with the technology that they’ve invented in terms of tracking the goods that you place in your basket. And now, I guess, here comes the grand experiment if they’re able to close this deal, applying some of the innovative thinking and the resources, significant resources that you mentioned that Amazon has, to the Whole Foods idea. Keep in mind, for Whole Foods stock, it shed about 50% since hitting its all-time high in late 2013. It’s lagged the market for several years now. So this is probably a bit of an unexpected surprise for shareholders, but at $42 per share, Amazon is paying about 31 times trailing earnings for the company. You have, ultimately, if you really boil it down, you’ve had a struggling company, weak results recently, but a very strong brand. What do you think about the deal that Amazon is getting?
Levine-Weinberg: I think it’s certainly paying a pretty high earnings multiple. But I think it actually makes sense for Amazon in that it does pry this foothold, where now they have hundreds of stores, it’ll still be under the Whole Foods brand but under that corporate umbrella. And there’s a number of ways that they can get this into the Amazon ecosystem and create a lot more value than they’re getting just from being stand-alone Whole Foods stores. Just a few of the things that you can think of, how could this help Amazon, for one thing, Whole Foods has a pretty highly regarded private brand, the 365 brand, which it sells in its stores and in the new 365 Market stores that Whole Foods has opened, which are targeted toward more price sensitive consumers. So you could easily see Amazon taking those items, saying, “You know what? We’re going to make them available on Amazon.com.” Huge increase in distribution and market penetration potentially. That’s one way to merge the Whole Foods brand and Amazon’s e-commerce business. Other things that you could see happening here, certainly you could put Amazon lockers in Whole Foods stores. If you want a way to drive more traffic into the store to increase sales at Whole Foods, and also provide better ways for people to pick up items, that’s a great way to do it.
It also might make it more feasible for Amazon to get into grocery pickup options, have some stuff shipped directly from Amazon to a locker in a Whole Foods. And the fresh items are kept in the Whole Foods refrigerated sections. There’s just a huge number of options. You could have free grocery delivery from Whole Foods for Prime members, you could have discounted prices at Whole Foods, a blanket discount for Prime members. There’s a lot of things that Amazon could do with Whole Foods. And really, there’s a story in the Wall Street Journal very recently talking about just how quickly this deal came together, and as a result, basically, it was in six weeks from when they first met with Amazon to when they finalized the deal. So Amazon hasn’t really figured out its strategy for Whole Foods, other than it sees a lot of opportunity, and is willing to make the investment necessary to capture that opportunity. So no firm plans from Amazon on what’s going to happen, but you can see there’s a lot of options for how Amazon can monetize Whole Foods. The fact that it’s paying a bit of a generous multiple is not that big of a deal. For Amazon, capital is very cheap right now. They can raise debt at a very low price. They have an extremely long time horizon, as most investors understand.
Shen: Sure. That’s a great glimpse, I think, into what the ultimate combination could look like, in terms of the changes and how Amazon will leverage this new asset. But we’ve put a little bit of a caveat on some of our statements about whether this deal closes, if the deal ultimately happens. That comes about because, for the past couple trading days, Whole Foods stock has actually topped the $42 per share offer price. As of a few minutes before the show when we got in the studio, it was trading around $43 per share. I think this is coming from some reports, also some speculation now of potential rival bids coming from competing grocery players like Kroger or Wal-Mart. The idea here is, for a Kroger, for example, taking over Whole Foods, it’s going to be a very good strategic fit. They’re in the same business, just some of the cost savings that you can expect from bringing their supply chains together, and things along those lines, probably hundreds of millions of dollars in savings, and also part of that is strategic in that you prevent Amazon from having hundreds of stores across the country to disrupt the industry with. That could be incentive enough, this competing play. How much potential do you think there is for a bidding war to happen, and that $42 per share that Amazon currently has on offer potentially going up?
Levine-Weinberg: Yeah, I think it’s possible, and I think that Kroger is the company more than any other that seems like a possible candidate to try to make a rival offer. Kroger is just humongous. They have more than $100 billion in annual sales. So they’re not much smaller than Amazon, in fact, in terms of sales. The main difference is that while both companies have pretty low profit margins, Amazon is growing, and there’s huge long-term opportunities for margin expansion. Kroger understands the grocery business is always going to be low margin. Kroger’s stock has just been crushed in the past week. They released a bad earnings report just the day before this Amazon-Whole Foods announcement came out. Then, with the Amazon Whole Foods deal news, Kroger stock ended up down about 30% in the span of two days.
Shen: You got a double whammy.
Levine-Weinberg: Right. So, that shows what investors see the threat being. If the threat is really that large, that raises the question, maybe Kroger should be willing to make a deal here. One of the problems is obviously, the purchase price is already pretty high, and now Kroger stock is trading at such a discounted valuation that unless you can raise enough debt to do a completely cash deal, you’re going to be selling stock at a discounted price to make a deal happen, which is potentially risky, or even if it’s not as risky for the company as letting Whole Foods go to Amazon, it’s something that the shareholders for Whole Foods might not want. They might prefer the certainty of an all-cash deal, as opposed to a partial or complete stock deal where you don’t know what you’re getting because you don’t know whether Kroger stock is going to go up or down. I think Amazon would probably raise its bid if it had to because of the value of getting that Whole Foods into its ecosystem. It certainly can afford to pay more, whereas I don’t know what Kroger’s capacity would really be to pay a hefty multiple. But I could definitely see them getting into the bidding war, because adding Whole Foods would allow a lot of cost savings, because you would get that purchasing power that Kroger already has. That said, the main benefit would actually be to prevent new competition from Amazon. The risk, of course, is that if Whole Foods isn’t available, that Amazon will go it alone or buy somebody else, and you will only have delayed Amazon’s growth into the grocery category by a year or something like that.
Shen: Yeah. This is a very clear indication from Amazon as to how serious they are taking this opportunity in the grocery industry. When it comes down to it, I think that’s a tough company to try to go head to head with in terms of resources and the partnership, or the fit, that Whole Foods sees in Amazon, these long-term opportunities. It’s definitely very attractive.
Levine-Weinberg: Yeah. If you look at pretty much any company that’s tried to compete with Amazon, in most cases, the results have not been very pretty.
Shen: Turning our attention now to Nordstrom. Another strong premium brand like Whole Foods, kind of the cream of the crop for the department store industry. A quick history lesson that I think is important to these latest developments. Nordstrom was founded over 100 years ago by John Nordstrom in Seattle. The Nordstrom family has been involved heavily in the business since inception. Three Nordstrom brothers ran the business for something like forty years. As of today, the family owns about a 30% stake in the company, and a group of family members, including several presidents of the company currently, have been considering their options to take the company private. You follow department stores and Nordstrom very closely, and we talked about headwinds for the industry and updates a few weeks ago. Can you give us some context, quickly, on the state of the business, and why the Nordstrom family is looking to take such drastic action right now?
Levine-Weinberg: Yeah. For several years now, Nordstrom has seen its profits depressing. It’s been a combination of two things. To some extent, it’s been increasing competition for department stores both in the department store industry itself, but also and perhaps more importantly, from off-price retailers and from Amazon.com, to be frank, and some other online retailers, as well. As a result, you’ve had lower profit margins, even though Nordstrom sales have actually continued to expand at a pretty healthy rate. At the same time, Nordstrom has also been investing pretty heavily in its business, both in order to protect it and build a foundation for long-term growth, and also for specific shorter-term growth initiatives. So as a result of that, it’s hard to tease out exactly how much of its profit decline relates to this increased competition aspect, and how much of it relates to the growth investments that it’s made which are going to pay off, hopefully, at least, in the next two to three years.
So as a result, you’ve seen the stock really collapse. It hit an all-time high above $80, and that was just back in early 2015. Since then, it’s been pretty much all downhill. The stock, just before the family announced that it was interested in this going private transaction, the stock was trading around $40, so that was down a little over 50% from the all-time high. So clearly, that shows that investors have lost their patience with Nordstrom and aren’t really convinced that the company has these great growth opportunities that management seems to see. That raises the possibility of, if it’s not getting a proper valuation as a public company, then maybe it would make more sense to be private. Since the founding family already owns 31% of the business, if they can buy the rest of it, that will allow them to invest in the company and also to ride out the current uncertainty for the next several years, keep with their plan and see what happens over the next five years, and then potentially go public again a number of years down the road, at which point maybe the storm will have passed and the company will get a higher valuation from the public market.
Shen: And at which point, they’ve had the opportunity to let some of those investments they’ve made play out, and see how that works out for the company. In our previous discussions about department stores, we’ve touched on the fact that, you can look at Macy’s, Kohl’s, some of the other competitors for Nordstrom, they are hurting even more so. The fact that, though there have been some weakness in the comps, for example, at the company, it is not doing nearly as poorly as a lot of other players in the industry. Speaking to some of our other analysts here, and you’ve mentioned this as well, the fact that Nordstrom gets lumped in with the overall weakness of the department store industry. Nordstrom stock, you mentioned it was down from its highs, since this news broke that some members of the Nordstrom family are looking into their options for taking the company private, the stock is up almost 20%, and the market cap is at almost $8 billion now. Considering the premium that would be required to close a deal, the financial hurdle for the Nordstrom family is pretty tall. What can we expect in order for a deal to happen? Is there going to be a lot of debt necessary? Are they looking at deal partners? What’s the situation here?
Levine-Weinberg: Yeah. A few more details have come out over the past couple weeks about what the Nordstrom family is thinking about. They have started a search for a private equity partner to do this deal with them. The goal was to find another private equity company that would put in somewhere from $1 to $2 billion of equity into the deal, and the rest of it would be debt. So what you’re looking at is, since the Nordstrom family already owns 31% of the company, depending on the premium, you’re looking at maybe $6 to $7 billion cash that they need to come up with to buy the rest of the company. That means that after the private equity contribution, you would need about $5 billion of debt. The good news is that Nordstrom has an A-level credit rating, so it’s well into investment-grade now. Now, it would get downgraded quite a bit, probably into junk territory, if you put another $5 billion of debt on top of that. But when you look at what interest rates are these days, the company can certainly afford to make the interest payments that you would have from another $5 billion of debt, especially when you consider that they might eliminate the dividends they’ve been paying, which has been costing them over $200 million a year. That would almost be enough to pay for the cost of that $5 billion of debt they would need.
I think the company can certainly afford it right now. The risk is, if business takes turns for the worse, then these deals that seem like they’re fine from a financial perspective turn into disasters, where all of the sudden you’re saddled with debt and you don’t have the flexibility that you need to make whatever changes, or just to ride out a retail slump. So there’s definitely a risk in that right now, retailers haven’t been doing very well for the past few years, but the economy as a whole has been growing. So when the next recession comes around, being a private company, there’s definitely some risk that if comp sales fall by 12% or something like that like they did during the recession, do you still have the flexibility to make your debt payments and not find yourself going into bankruptcy because of a short-term decline in the market? Whereas if you have an A-credit rating going into a recession, you can feel pretty confident that you can ride out any potential weakness.
Shen: Yeah. I think it’s important for investors to keep in mind, as well, you mentioned at the beginning of our discussion about Nordstrom, some of the context for the weakness in terms of increased competition. And there’s also some longer term challenges that the whole retail and apparel industry is facing, in terms of reduced consumer spending in that category of products, in terms of, a lot of people will point to surveys among younger consumers in terms of what their priorities are for their spending, and what their view is for their apparel purchases, in terms of Nordstrom, obviously more upscale brand, that has helped them in the past, but now if they run into an issue of a generation of shoppers not being as concerned with the high-end brands or, in general, just being more price sensitive in terms of where their spending money goes, that being a very long term challenge for the company. To wrap up our discussion here, I’d like to talk about, if the Nordstrom family is able to successfully make this deal happen, and the story essentially ends for shareholders, what will the priorities then going forward be for the management team, once they’re free from Wall Street’s more short-sighted view, in terms of quarterly results. What do you think some of the opportunities are beyond that?
Levine-Weinberg: There’s basically two theories about what the Nordstrom family wants here. The first theory is, what the family really wants to do is make the business great and continue to invest heavily. As a result, they need to be private in order to have the flexibility to not have to make their numbers every quarter, to make these really long-term bets, invest a lot of money, maybe that means renovating stores, in some cases building new stores. A lot of it would be creating new online tools, a better mobile site, different ways that you could build up the company’s e-commerce capabilities and figure out new experiences to bring into its stores to drive a rebound in store traffic. The advantage of that is if you could return the company to the faster growth trajectory, recently it’s been low single digits but if you get it back to high single digits where it was a few years ago, the company would potentially be worth a lot more. The downside is that it’s not clear that anything the company could do would really get people going back to malls. It’s just that the consumer shopping trends have gotten so far against malls right now that until you have a big shake out in that mall sector, where a lot of the lower performing malls close entirely, it’s not clear that you’re going to be able to get more malls. There’s too many malls competing for the amount of traffic that exists, so getting more people into a particular store is a really tough hurdle right now. The other issue is, if you invest all this money, then in a downturn, where are you going to come up with more capital? You’ve already taken on more debt, that’s going to increase your interest expense. And while getting out of the limelight does give you some flexibility, you still have to pay the bills, so it only gives you a certain amount of flexibility to invest more heavily.
The other second theory on what they’re doing is, they’re just trying to buy the business cheap, and it’s that they have a long-term perspective that the company is worth a lot more than what it’s trading for right now. And if they can buy the whole thing for say, $50 to $55 a share, they’re going to do that and wait for these investments they’ve made to pay off. To give some examples, they’ve made a big move into Canada. As of three years ago, they didn’t have any stores in Canada. They now have five. They’re opening a sixth this fall. Then, they’re going to start opening several Nordstrom Rack off price stores in Canada beginning next year. Up until now, they’ve been losing money in Canada, because these stores are very new, people are still getting acquainted with the Nordstrom brand, and they’ve had lots of pre-open expenses as they hire staff in advance before they open stores. Once you get open for a couple of years, then you can start making some money. So those stores that are right now losing money, hopefully in two or three years they become quite profitable for Nordstrom. They’re also opening a big flagship store in Manhattan. They don’t have any stores in New York City right now, so that’s a really big opportunity for them. They’re opening a smaller men’s store in the spring next year, and then the really big store is going to be a full line store on 57th Street in Manhattan. That opens hopefully in the fall of 2019, assuming there aren’t any further construction delays. That could be a store that generates $300 million or something of annual revenue, which is more than 2% of the company’s sales from last year, so it’s a really significant development. In the past few years, that’s been just cost and no revenue. So once that store opens, if it’s as successful as the company expects, that could be a significant driver of revenue, earnings, cash flow going forward.
Some other things they’ve been doing — expanding the Nordstrom Rack, building out their e-commerce capabilities. All of these things have lots of long-term potential. They just haven’t really contributed yet to the bottom line in the way that the company expects for the long-term. So the management team may just be thinking, “We’re going to take on this debt, buy the rest of the company, wait five years, continue with our current plans but not increase our current investment, just stay with our current plan. And in five years, the company will be making higher revenue, earnings, cash flow. And once investors see that the business is stable, maybe we can sell it for a higher multiple than what we bought it for and make a lot of money in the process.” So, I think there’s two different perspectives on what the Nordstrom family could be doing. But I don’t see the company getting really aggressive on investment. It’s too risky to take on a lot of debt, and then also further reduce your cash flow by ramping up your capex at the same time. I think the company’s made the investments that it needs, for the most part. They just want the flexibility to continue with the current rates, rather than having to focus just on making a lot of money right now to satisfy Wall Street.
Shen: Yeah, just trying to buy itself some time. I think it’s important to note that besides some of the doom and gloom that we’ve talked about a lot for department stores, that Nordstrom itself does have its bright spots, a lot of the things that you just mentioned, such as the continued strength of the Nordstrom Rack stores, its growing digital business. My last question for you, you are a Nordstrom shareholder.
Levine-Weinberg: I am.
Shen: Very quickly, what is your take? Are you bullish? Are you happy about this? What’s your feeling?
Levine-Weinberg: I think the Nordstrom family sees the company sort of the same way that I see it. I think the company is very undervalued. If you look at a very simple P/E ratio, you would think, this isn’t much of a deal. Nordstrom’s earnings forecast for this year is for EPS between $2.75 to $3.00. So right now, the stock is trading for around $47 — that’s almost 16 times the high end of its EPS guidance range. If you think about a deal premium, you’re looking at maybe 20 to 25 times earnings. So that seems like a really generous offer. I think most shareholders, frankly, would be delighted to get that. Personally, I would rather stick around for another five years with the family. If the rest of the shareholders were to vote for a private deal, I wouldn’t have that option.
I think that Wall Street is underestimating Nordstrom’s resilience. I also think that in the next five years, and possibly sooner, you’re going to have a shake out in the department store sector, because they’re just are too many retailers right now competing for the customer traffic that exists. One really recent development that may not come to anything, however still very interesting, is that a real estate-focused investment management firm called Land & Buildings recently took a stake in Hudson’s Bay, which owns the Saks Fifth Avenue and Lord & Taylor chains. They propose that, since the real estate of those chains is so valuable, why not just shut down the companies entirely, or shut down some of the stores and sell off the real estate, rather than continuing to operate as department stores. If something like that were to happen, you’d have a really sharp decrease in competition, and that could be really good for Nordstrom’s business, obviously, because they could certainly take over a lot of those customers, since they’re serving pretty similar markets.
Shen: Yeah, assuming that they can make it through the turmoil, that kind of shakeout would be a big boon for them. That’s all the time we have for today, thanks again for coming in today, Adam.
Levine-Weinberg: Yeah, thanks for having me here.
Shen: As a reminder, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don’t buy or sell anything based solely on what you hear during the program. Thanks, Fools, for listening, and Fool on!