Whole Foods M&A Rumors: Reality Check, Weekend Food For Thought (WFM, KKR, KR, SWY, TFM)

If you have ever seen a private equity wish list if companies, Whole Foods Market, Inc. (NASDAQ: WFM) would be on it.  The stores are sleek, the products are at a premium, and its customers seem to be somewhat immune to the woes of the rest of the world.  The stores also generate far better profit margins than traditional grocers with the paltry 1% to 2%.  So, this week brought up rumors and ‘reports’ that Whole Foods could be a private equity takeover target.

We do want to quantify that a single firm or a private equity group can buy almost anything if it can get financing for it.  The valuations don’t always make sense on the surface.  The problem is that Whole Foods trades at such a premium today that most private equity firms with more than horse-sense would instantly determine that acquiring this trophy company would come at too high of a price.

For a private equity buyer to own a company, the goal is to ultimately resell the company at a much higher price down the road.  And at the time the deal is closed, a common move is to leverage the company up with debt and then to pay out a bulk of the cash on the books as a dividend to the buyers to instantly recoup 10% to 30% of the investment.  Even if it takes a decade to completely exit the transaction, at least the returns up front and the return of capital along the way can justify the exercise.

It isn’t like private equity investors are exactly eager to make 2.1% in 10-year Treasury notes and it isn’t exactly as if they have made stellar returns in the stock market over the last decade under Warren Buffett’s buy and hold forever strategy.

It was the Daily Mail out of the U.K. that first floated the rumor. To say that we are skeptical of a British media outlet scooping this one, particularly the Daily Mail, would be an understatement.  It noted that the premium and organic grocer could be under the watchful eyes of Kohlberg Kravis Roberts & Co. (NYSE: KKR) and Bain for somewhere around $90.00 per share.  Shares are currently around $59.00 and the 52-week trading range is $34.04 to $68.00.  The market cap today is about $10.4 billion

Thomson Reuters has estimates for Whole Foods’ fiscal September 2011 of $1.92 EPS and $10.12 billion in sales and estimates for fiscal September 2012 of $2.25 and $11.52 billion in sales.  Whole Foods trades at just over 30-times expected earnings and trades at close to 1-times expected revenues.  If you count Whole Foods as a grocery store, it is just too expensive to buy for a private equity firm even at today’s prices.  If you throw up a magical 50% premium to that $90.00 level, then KKR and Bain’s rumored price would be at about 45 year’s worth of earnings and about 1.5-times revenues.

The problem is when you start comparing Whole Foods to The Kroger Co. (NYSE: KR), a more traditional grocery store.  Ditto for Safeway Inc. (NYSE: SWY).  Kroger has started carrying higher-margin organic and premium products as well, often the same exact products as you find at Whole Foods for what is often 25% cheaper. Kroger trades at 11.7-times this year’s expected earnings and trades at only 0.15-times expected revenues with a market cap nearing $14 billion.  Safeway trades at about 10.2-times this year’s expected earnings and trades at only 0.14-times expected revenues with a $6.1 billion market cap.

Perhaps the more appropriate comparison is The Fresh Market, Inc. (NASDAQ: TFM), an upscale grocer that has recently come public over the last year. As of June 2, 2011, it operated 101 stores in 20 states of the southeast, midwest, mid-atlantic, and northeast. With a market cap of nearly $1.6 billion, it trades at 29-times this year’s expected earnings and almost 1.4-times this year’s expected sales.

Whole Foods has 309 stores today with about 11.7 million square feet.  It has recently signed eight new leases averaging 30,400 square feet in size which are scheduled to open in fiscal year 2012 and beyond.  The company listed out to 2015 as 16 tendered and 61 “total leases signed.”  The total new markets is listed as 12 out to 21015.  The market value for what you get today on a per store and per square foot is about $33.6 million per store and about $889.00 per square foot.  That is before a single penny of premium is considered in a buyout.

Our take is that you do not value Whole Foods as a grocery store, but rather as a retailer of luxury goods and healthier lifestyles.  Any private equity buyer understands this.  It is not about food and beer and wine.  It is about status and knowing that the quality is better than what Joe Six-Pack is getting.  While the company trades at a massive premium, we do not expect that the full value has been realized out of this great game-changing grocer.  The company has a limited amount of long-term debt and more than $650 million in liquidity.  It could easily be leveraged up if it chose to do so.

For a private equity buyer to step up, the growth plans would have to be ratcheted higher and higher.  There are too many mispriced “value companies” that can be acquired for 10-times to 12-times earnings where 20% or 30% of the investment can be immediately recouped by private equity firms without adding on so much leverage.  Also, a $10 billion, well $15 billion at the premium suggested, is not a simple feat for a private equity firm.  In short, this is just a leveraged buyout in theory.

Whole Foods shares peaked at nearly $80.00 on a split-adjusted basis back in 2005.  Leonard Green & Partners, L.P. owns almost 10% of the company and it is up significantly in its investment. Our take is that for a buyer to step up and buy Whole Foods, they should have done it a year or two ago.  A buyout of this size and magnitude when the economy is obviously softening (or much worse) is just too much for us to swallow today.  Anything is possible when it comes to vanity and private equity.  If a deal is announced, we’d expect that KKR, Bain, and whoever else is in the deal will be criticized for overpaying for a great company too late in the cycle.

If a private equity buyer does emerge, we have one suggestion (or plea): please invest in paper grocery bags that have stronger handles so that the bags don’t tear apart before the groceries can be put in the refrigerator.

JON C. OGG