Technology

What's Amazon's Plan for Whole Foods?

INTRODUCTION

It’s clear that Amazon’s $13.7b acquisition of Whole Foods will result in lower prices at the notoriously expensive grocer. What’s less clear is how Amazon will accomplish this. Most expect them to bring-to-bear their formidable supply chain and delivery know-how, driving prices lower by revolutionizing how groceries are shipped and distributed. While these are surely some of Amazon’s long-term goals, this presupposes that Amazon has already solved the unique challenges of storing and shipping groceries. The reality is Amazon does not yet have the core competencies required to operate a grocery supply chain. These they will learn from Whole Foods. 

But if improvements to the supply chain or logistics are still a ways off, then the question remains: how will Amazon reduce prices? We posit that by automating in-store operations via technology (e.g., self-checkout) and pushing more private label products, Amazon will drive down expenses by billions of dollars. They will then pass these savings right back to the customer in the form of lower prices and better value for Prime members. 

THE GROCERY CHALLENGE

Grocery is the holy grail of retail—nearly every individual must buy groceries on a regular basis, and what does get purchased is often the same from week to week (e.g., meat, eggs, milk, bread). At $650b, annual US grocery sales are 6x Amazon’s revenue, yet only 2% of those sales are done online. So grocery presents a massive opportunity for Amazon, but despite the company’s operational efficiency and extensive distribution network, they have not been successful in this space. Why? 

Look no further than the unique challenges of selling groceries. Amazon may have mastered shipping uniform, non-perishable, and scannable items like books and electronics, but shipping goods that spoil, have inconsistent availability and fluctuating costs, require refrigeration, and varying quality of individual units, is a significantly more difficult challenge. Had Amazon already solved this, they wouldn't have needed Whole Foods in the first place. 

WHAT IS AMAZON’S STRATEGY?

As Amazon experiments with logistics and distribution, their near-term strategy is likely to focus on three areas: improve in-store operations via technology and automation; introduce more private label goods like AmazonBasics and 365; and increase the value of Prime. 

1) In-store Operations 

In January, Amazon revealed AmazonGo, which is a suite of technologies (e.g., cameras and sensors) that enable customers to walk into a store, grab what they want, and walk out—all without needing to wait in line or see a cashier. By automatically detecting what a customer took off the shelf, Amazon can bill their account, monitor in-store inventory levels, and reduce “shrink” (i.e., theft). We expect AmazonGo technology to be pushed out across Whole Foods’s 465 stores. 

If we assume half of Whole Foods’s 100k employees are cashiers—and that their total hourly cost to the company (including wages, benefits, perks, etc.) is $25/hour—then Whole Foods likely spends around $2.5b/yr on this expense—13% of total sales. 

2) Private Label Goods 

No longer seen as cheap, low-quality knockoffs, private label goods are now sought after by savvy customers because of their attractive value proposition: same quality, lower price. Brands like Kirkland, Trader Joe’s, 365, and AmazonBasics, are going toe-to-toe with expensive name brand alternatives; and in many cases they’re winning. And it’s not just customers who benefit. By selling private label goods, companies earn higher margins, gain product exclusivity, and have greater control over packaging and distribution. Since Amazon and Whole Foods have been independently selling more low-priced, high-margin private label goods, we expect the acquisition to accelerate this trend. 

By improving in-store operations and selling more private label goods, Amazon stands to increase the profitability at Whole Foods. But rather than keep the profit, Amazon has other plans…

3) More Value for Prime Users

We expect Amazon to “give back” any profits to customers through lower prices and increased value for Prime members. To understand why, look no further than the company that serves as Prime’s inspiration: Costco.

Costco sells products “at cost”, meaning if it costs them $1 to supply customers 1lb of turkey, then that’s the same price they charge those customers. While this virtually guarantees Costco can offer the lowest prices, it also seemingly guarantees they’ll never make money. But there’s a catch—to get Costco’s low prices, customers must pay $60/year to be a “member”. It’s a unique but brilliant business model; customers win because they receive more than $60 worth of savings each year, and Costco also wins because there’s no incremental cost to provide a membership, so all membership fees fall directly to their bottom line.

This is the same model that Amazon Prime means to replicate. Since the company doesn’t need to make money directly off the goods it sells, it can keep prices lower than its competitors. The low prices drive more memberships, which increases sales, which in turn gives the company more leverage to get even lower prices from its suppliers. Rather than keep that margin, the company gives it right back to the members through lower prices, thus driving more memberships and restarting the virtuous cycle.

Because of the acquisition, Amazon will have a number of new opportunities to increase Prime’s value, such as: free grocery delivery, member-only sales/pricing, exclusive brands, online ordering/pickup, and easy re-ordering. And by increasing Prime’s value, Amazon attracts more Prime members, which increases sales, which in turn gives the company more leverage with suppliers, which drives prices lower, which….well you get the point. 

CONCLUSION

While predictions of drone-delivered swiss chard may make for good headlines, the future success of Whole Foods does not depend upon it—nor any other single technology for that matter. What it will depend on is whether or not Amazon can create value for customers through low prices, great selection, and convenience. Over the next few years, we think it is far more likely for Amazon to achieve these goals through slightly less exciting—though no less impactful—methods like self checkout technology and selling more private label goods. Both changes will substantially reduce costs in the near-term, which Amazon will use to accelerate the virtuous cycle of AmazonPrime. 

Tesla (TSLA)

“I honestly don’t really care about business all that much. It’s not really my first motivation.”

 - Elon Musk

Today, Tesla represents the future of transportation. This is for good reason: the company is led by the brilliant inventor Elon Musk; it creates fantastic products; and it has cheap access to the large amounts of capital necessary to build cars. It’s hard to argue that another company is better positioned to make self-driving electric cars a reality.

This—however—does not make Tesla a good investment. The premise of investing is not betting on whether a company’s product is good or not, or if the founder is right about what the future holds; it’s simply about buying a business for less than it’s worth. And even if Musk does fulfill his loftiest promises, investors wouldn’t stand to gain much, because Tesla’s current value has become wholly detached from economic reality. It trades at 70% of GM’s value, despite selling 187x fewer cars and not generating a cent of profit—a level which is simply unsustainable. Yet most alarming are Tesla’s myriad of red flags: poor corporate governance, quixotic acquisitions, and a financial structure best described as a house of cards—to name a few. I’d argue, therefore, that Tesla is clearly a stronger short candidate than long. But investors have become so enamored of the company’s narrative and promises for the future that they are ignoring these risks with reckless abandon.   

To illustrate, imagine that you have the opportunity to invest in “Tesla Pizzeria”—a local pizza place with the following characteristics:

IT HAS GREAT GROWTH PROSPECTS

…BUT THE BUSINESS BURNS CASH

COMPETITION IS HEATING UP

The pizza market is brutally competitive and dominated by industry giants. For every pizza pie sold by Tesla Pizzeria, the largest competitor sells 200. Companies like Pizza Hut, Dominoes, and Papa Johns have taken notice of Tesla Pizzeria's innovative products, and have signaled their intentions to make similar pizzas. And while Tesla Pizzeria has a similar paper valuation to its competitors, it severely lags behind them in both profit and experience. In fact, every competitor has been selling pizza globally for 50+ years, whereas Tesla Pizzeria has only been selling for eight years, all mostly in one market

Since Tesla Pizzeria publishes all of their recipes and techniques for free, it won't take long for competitors to start making pizzas in the same fashion. To make matters worse, enormous companies in adjacent markets—like McDonalds and Starbucks—think they can make really good pizza too, and are poised to introduce their own products in the next few years. There are even well-capitalized global upstarts gunning for a "slice" of the market. And then there are the companies set on shifting consumer preference to pizza alternatives.

IT SUFFERS FROM POOR CORPORATE GOVERNANCE

AND NOW IT’S BUYING ANOTHER MONEY-LOSING BUSINESS… 

The owners of Tesla Pizzeria have decided buy a tomato farm which lost $192 dollars for every $100 of tomatoes they sold last year. Alarmingly, many of them also happen to own the tomato farm (or are related to someone who does). And it's run by two of the manager's cousins. The sale—which is for a 35% premiumwill net the manager of Tesla Pizzeria and his relatives ~$700m, despite the farm's deteriorating business model. In order to avoid insolvency, the farm recently raised $345m in “tax equity”—whatever that is; and some are even suggesting Tesla Pizzeria is "bailing out" the tomato farm so that its owners don’t lose their shirts. Thank goodness for the synergies!

BUILT ATOP A FINANCIAL HOUSE OF CARDS

The business is financed with a convoluted web of stock sales, private investments, warrants, convertible bonds, and exotic debt. And by taking out personal loans against his ownership stakes in his various companies, the manager is exposing the owners to significant risk

So, is this a pizzeria you would want to own?

CONCLUSION

Investing isn’t about predicting the future or buying the company that will have the greatest impact on society; instead, it’s simply buying a business for less than it’s worth. And with a market value of ~ $35B, Tesla shareholders are almost assuredly paying more than the company is worth—even if Musk is right about the future. But if he’s wrong, the dubious acquisition, poor corporate governance, and risky capital structure ensure the losses be swift and steep. So whether or not Musk is right about what the the future holds, there’s only one smart move for investors to make: hope and pray he pulls it off, but to short Tesla.