The Acquisition Price Floor

acquisition price floor

The news shocked the markets…

Amazon (AMZN), in their bid to conquer yet another retail sector, made a massive move into the grocery space last Friday, agreeing to buy Whole Foods Market (WFM) for $13.7 billion, at $42/share. It was a 27% premium to the previous day’s closing price.

The reactions across the grocery industry showed investors were spooked as to what this move means for the future direction of grocery shopping. Costco (COST) tanked 7% on Friday alone, and continues to fall—down 12% in total since the announcement. Kroger (KR) fell 18% on Thursday based on poor earnings guidance, then fell another 9% after the Amazon news. Wal-Mart (WMT), Target (TGT), and Sprouts Farmers Market (SFM) all dropped hard on the news as well.

The retail pain was widespread, as the news also hit other companies outside the grocery space—including spice maker McCormick (MKC), General Mills (GIS) and packaged-food maker Conagra Brands (CAG). Investors are quickly reassessing what the future of retail will be in a world that is becoming increasingly driven by the moves of Amazon, and the Whole Foods acquisition implies Amazon is not hesitating in their quest to shake things up even more.

Amazon was already a threat to grocers, as their online-delivery service, and Amazon Fresh branded market share looked poised to grow; but a Whole Foods acquisition turns Amazon into an immediate and very dangerous threat for grocers everywhere. No longer will they “someday” move considerably into the grocery industry—they are there now with the Whole Foods purchase. Now we are left to wonder…where will their next move be?

An acquisition isn’t a done deal though. WFM is currently trading above the $42/share purchase price, because investors are betting on a bidding war among companies such as Costco, Kroger, Wal-Mart, or even Target—all of which do not want Amazon to gain the brand, customers, and supply chain of Whole Foods. This story isn’t over yet. The WFM buyout price could get higher, and we’ll see how it plays out—though remember Amazon can most likely win in a bidding war with any company who cares to challenge them.

Why are we talking about this today?

As longtime Investment Intel subscribers, and students of ours, know—Whole Foods is a company we have researched and analyzed over the years. It’s been a company we’ve invested in, and a company we’ve followed since about 2010. Not only are we both frequent customers of theirs, but we have respected the company/management since the beginning, and liked their stock when they traded lower as well.

A big part of our investment thesis (and risk management) on Whole Foods is what we call the “acquisition price floor”. In our many webinars and subscriber articles on the company, we’ve repeatedly said that competitors simply wouldn’t allow Whole Foods to drop below a certain threshold; they wouldn’t allow it because they would prefer to acquire the company on the cheap—gaining access to their assets, brand value, vendor relationships, retail footprint, and more. We see this type of floor very frequently among great companies with valuable qualities attached to their business, when their shares begin to lag.

Anytime WFM shares traded near this acquisition price floor, we believed competitors would make offers to buy the company—either bidding the shares up, or buying the company out altogether. Since management is responsible for acting in the best interest of the shareholders, they would have to entertain offers from outside companies, and be open to an acquisition if the price was right. This was our thesis anyway, and what we described as a floor in WFM price, where the stock was not likely to trade below for an extended period of time.

Of course, we didn’t know exactly what price that would be—but we suspected that a company would be willing to come in and buy up Whole Foods if their stock approached the $25/share level. Whole Foods assets, both tangible and intangible, as well as their strong and consistent cash flows, were well worth the $25/share price tag for a competitor to scoop up. On top of that, they had hardly any debt to get in the way of an outside company financing a buyout. This $25 price would have valued the company around $8 billion—a bargain considering the brand and respect Whole Foods has built up over their 37-year history in the organic food space.

This $25 share price was our “acquisition price floor”. We felt our risk would be properly managed if we paid the right price for WFM, theorizing that they would not stay below $25 for very long, if at all, before getting bought out for a significant premium.

It turned out to be conservative, but not by much. WFM traded just under $28 in September last year, but didn’t quite sink to the $25 floor. The shares were trading for $33 when Amazon announced their $42/share buyout. I think it had less to do with being too conservative on our part, and more to do with the fact that Amazon was willing to pay a higher price than many others—simply because they have the ability to do so, and the desire to expand quickly. Their ability to pay a higher price could force others to have to pay a higher price as well, if they decide to make more enticing offers to WFM in the ensuing weeks, or look to acquire other grocery brands.

 

Using the Acquisition Price Floor

The Whole Foods buyout is a picture-perfect example as to why we prefer to keep the focus on excellent companies—those who have strong and durable competitive advantages, and valuable qualities built into their business. Doing so gives us two distinct advantages which position us for above-average returns and significantly decreased risk.

First, these excellent companies with great, big, wide moats (Warren Buffett’s term for competitive advantage), have a higher degree of predictability, and are much more likely to continue to grow shareholder value for many years down the road. This is how we consistently gain above-average returns over the long-term—by investing the bulk of our portfolio in these types of companies.

When investing in a company, we don’t invest with the hope that they’re going to get bought out. That can provide a floor, or a quick return, but a buyout does not generate consistently high annualized returns over the years, like an ongoing, excellent business does. It is also never a guarantee.

A solid company with a profitable business model that will generate high amounts of cash for shareholders for the next 5-10+ years is the absolute best scenario you should be looking for when investing—and should be your first priority. Finding excellent companies with a strong competitive advantage is a great way to put the odds on your side that you have a company that will continue to produce for many years, and make big returns on your investment accounts.

Once you identify these types of companies, it simply becomes a matter of investing in them at the right price—an attractive price with a margin of safety, which can set you up for big returns with decreased risk.

Just think of a company like Home Depot (HD), Disney (DIS), Hershey (HSY), or McDonalds (MCD). Sure, a buyout 10 years ago would have been a nice, instant return for shareholders at the time—but these companies remaining in business is what provided their shareholders with enormous annualized returns over the long-term. Staying public and continuing to grow was a much better result, and should always be the preferred choice when dealing with cream-of-the-crop-type companies.

Some WFM shareholders are happy they get to cash out of the company at a profit (if they bought below $42), but many long-term shareholders probably don’t see the buyout as being great news. That’s because an excellent company will no longer produce for them. WFM will no longer pay dividends, and it won’t continue to compound in their account. Granted, Whole Foods has been struggling lately, and has been a drag on returns for shareholders more recently, but their long-term future was still bright, and the intangibles the company possessed were extremely valuable moving forward.

Since most of what we do in our investment training is concentrate on this first advantage, I’m going to take the rest of this post to talk about the second advantage of investing in great companies.

The second reason we like to keep the focus on excellent companies with durable moats and valuable intangibles/resources, beyond simply their ability to compound at high rates of return over the years, is because it’s a form of risk management; or a way to follow Warren Buffett’s rule #1—“never lose money”.

This is where the acquisition price floor comes in. Once we identify a special company, and can get them at the right price, we feel confident that a price floor exists not too far below our margin of safety price. This provides us with a safety buffer, or a threshold where it’s unlikely the price will fall much lower. This helps us immensely with limiting the downside risk associated with an investment.

As we’ve talked about with Whole Foods, and many other companies we analyze, special companies with valuable intangibles/resources and durable moats have this invisible floor in their price—an acquisition price floor—where well-funded competitors (such as Amazon and many others) would be happy to scoop them up.

Notice I’m not implying there is no risk; risk will always exist with investing, and we can never predict exactly how management will react—but the presence of a potential acquisition price floor can help us manage our risk, and greatly limit our potential for major losses. As Buffett repeatedly says, managing risk and avoiding losses is more important than anything. After all, it’s his very first rule of investing.

Again, we don’t make an investment hoping for a company to get acquired (we’d prefer scenario #1 above); but we know it’s a form of a fail-safe; a price floor where the stock is highly unlikely to break through before getting bought out. It’s just one way to manage risk.

Companies with a high likelihood of getting bought out when their shares are priced near historically low valuations contain one or more of the following qualities:

  • Valuable brand
  • Innovative technology
  • Solid base of customers (broad or niche)
  • Wide or strong footprint
  • Strong vendor relationships
  • Little to no debt
  • Other valuable qualities not reflected on their balance sheet

These are qualities which have tremendous value, yet don’t necessarily show up under their assets, or aren’t entirely factored into their growth rate. These qualities/resources are components of a company which competitors either want to acquire for themselves, or rid from the competitive landscape.

When a competitor acquires another company, they gain immediate access to these qualities for a cheaper price, and lower opportunity cost (in terms of time) than it would take for them to go out and develop it or build it on their own. This makes it worth the investment. Durable moats and various qualities of a business are extremely valuable—and they can take a tremendous amount of time and money to build.

Consider the case for Whole Foods. They’ve been around since 1980. They were the first mover into the organic/fresh foods space, and they have built up a network of 425 physical storefronts, a complex supply chain and distribution channel, invaluable vendor relationships, and a tremendously valuable/well-respected brand and customer loyalty. In the case of Amazon, they are acquiring 37 years of expertise, brand equity, infrastructure, relationships, and knowledge—immediately (unless a bidding war ensues and another company acquires WFM).

This was a large amount of value embedded into Whole Foods share price. Isn’t that worth a lot to competitors, or a company attempting to get into the grocery space? You bet it is. These valuable qualities and resources are what put an acquisition price floor in the stock price of WFM.

For instance, consider their brand equity. The value of the “Whole Foods Market” brand doesn’t show up on their balance sheet—it’s not listed as an asset; but we know it exists, and we know it carries tremendous worth to their business, or potential buyers. Their brand, by itself, was likely worth billions. Amazon understood this. In doing any type of research on Whole Foods, you could see that their brand was incredibly valuable, and they were able to maintain their core customers, while driving more customers into their stores—despite being referred to by many as the “whole paycheck” grocer. Their brand name and reputation allowed them to do this.

Similarly, the Walt Disney Company brand, and their characters from Mickey Mouse to Donald Duck aren’t factored into their assets—but it’s worth tens of billions to them or potential buyers. A competitor probably couldn’t build the Disney brand, or even come close to duplicating it, even if you gave them many billions of dollars to do so. And probably the most important aspect they could never duplicate, is the amount of time it takes to build a respected brand name. Therefore, Disney stock also carries with it an acquisition price floor where their share price could drop to a certain range, and other companies who have the ability to spend the money, would eagerly buy them up.

Those are just examples of how powerful and valuable a great brand can be, but special companies possess other valuable characteristics which are worth a lot, and which can put an acquisition price floor in their stock. Whole Foods possessed at least four of those special qualities listed above, which Amazon saw the value in, and which we believe has put a floor in their price for many years.

Subscribers of ours will recall how we valued WFM in the past. Even though it was hard to justify them as a value stock based on their decreased growth potential in a tough industry, and what the face value calculator was showing us—we knew odds were very high that they wouldn’t fall below $25/share or so, for very long. That’s because of those special qualities which put the price floor on their stock where a competitor would prefer to acquire them.

We couldn’t really factor these things into their growth rate; we couldn’t say their brand was worth x% growth, and their distribution channel was worth y% growth, etc. But we knew the value was there, and we knew these were qualities which many outside companies would love to have for themselves.

So, we valued WFM based on their strong and consistent cash flow, hoping to get the opportunity to acquire them around $26, and backing that up with their historically low enterprise multiple which investors were placing on them. On top of our valuation, we knew that if things continued to go poorly for Whole Foods, and their price continued to fall—there was a pretty good chance someone would buy them up. Our estimated acquisition price floor controlled the risk of a major loss.

However, we couldn’t pay just any price for them, in the hopes that someone would come in and save the day. That’s not handling risk very well. When WFM was at $50, we could’ve said, “look at all that value in Whole Foods; there’s an acquisition price floor on the stock. Somebody will buy the stock so we are safe at any price”. If we had done that at $50, we’d still be facing a loss—even after the acquisition. That would’ve been due to a lack of control on the purchase price, and the failure to purchase with a margin of safety built in.

No, we still needed to get them at the right price, study what those qualities of theirs could be worth to a competitor, then hope the company could turn things around and compound growth in our accounts for many years. If they couldn’t, we would have had to pay a low enough price that it wasn’t likely they could drop much lower before a buyer swooped in. We determined that desired buy price by using our free cash flow calculator.

We didn’t know that Jeff Bezos (Amazon’s CEO) would swoop in and offer to buy the company, we just estimated that chances were high some company would do it near our projected acquisition price floor, because of their multiple valuable qualities.

Similar value exists across countless other special companies in the stock market as well—not just Whole Foods or Disney. Go through the list above and run a company through it to see if you believe they have an acquisition price floor, and where that might exist. We’ve used similar forms of risk management by projecting an acquisition price floor on companies such as Coach (COH), Decker’s (DECK), Southwest Airlines (LUV), Boston Beer Company (SAM), OpenTable (bought out by Priceline), and many more excellent companies.

I want to stress one more time that an acquisition price floor is not why we invest, or what we are hoping for; but it’s a good form of risk management.

The best way to gain above-average returns is to first, keep the money you have (avoid major losses), and then to have a few major winners who can grow and compound your account values over time. Focusing on excellent companies with durable competitive advantages and valuable tangible/intangible qualities is one of the best ways to position yourself to check off each of those components.

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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