Monday, October 29, 2007

Monday Morning Java

Analysis: The Futility of the FTC's New Appeal of the Whole Foods' Acquisition of Wild Oats Markets

Last week the U.S. Federal Trade Commission (FTC) filed an appeal with the U.S. Federal Court for the District of Columbia seeking to block the acquisition of Wild Oats Markets, Inc. by Whole Foods Market, Inc. even though Whole Foods is well on its way to merging the former supernatural retailing rival it acquired into its corporate culture and retail operations.

At the end of August, 2007, the U.S. Federal Court in Washington D.C. approved the merger despite an original objection filed by the FTC (which was dismissed by a federal judge) and an appeal after that, which the same judge also dismissed, ruling in Whole Foods' favor at the time, and paving the way for the acquisition/merger to go through.In their August appeal, asking for a temporary injunction against the merger, the FTC sighted anti-competitive arguments for not allowing Whole Foods to acquire Wild Oats. Essentially the FTC argued the merger/acquisition would result in a serious lack of competition in the supernatural grocery retailing sector by giving Whole Foods a monopoly over the selling of natural and organic grocery products in the category.

In its ruling, the United States District Court for the District of Columbia rejected this argument by the FTC. The court said that "premium natural and organic supermarkets (how the FTC refers to Whole Foods and Wild Oats) was not a relevant product market. A relevant market is one in which a hypothetical, multi-store monopolist , owning all stores in the category (and eliminating competition among them), would raise prices," the court stated in its ruling. Based on a number of economic studies it reviewed the court said a Whole Foods/Wild Oats' merged company would not meet its test of a monopolist, and as such it ruled against the FTC's August, 2007 pre-merger appeal and for Whole Foods. ( you can read the D.C. federal court's ruling here as well as testimony from FTC experts and Whole Foods and court experts here.)

However, almost two months after the federal court ruling in favor of Whole Foods, and over a month after the supernatural grocer first began integrating Wild Oats' operations and stores into the Whole Foods retailing system, the FTC is back with an unusual new appeal. The appeal is unusual in that the federal regulator very seldom, if ever, has filed a new appeal once the federal court has made a final ruling on an acquisition or merger, and once the acquiring company is well on its way to integrating the purchased company into its operations.

This time around the FTC is still arguing against the merger based on anti-trust grounds, saying the deal will stifle competition and raise prices. The FTC is sighting what it says its research demonstrates is a high estimated "diversion ratio" between Whole Foods banner stores and Wild Oats stores. In other words, when Wild Oats goes out of business, 50% of its customers automatically go to Whole Foods stores, the FTC says. This means a "diversion ratio" of half, which economists say is very high, if true. The FTC sights this argument as evidence of anti-competition, saying the 50% "diversion ratio" figure amounts to a monopoly in the supernatural retail grocery category. The commission also argues this "monopoly" will then result in Whole Foods eventually raising prices.

This argument was used by the FTC however (along with expert testimony) in its original appeal, so we're hard pressed to see why the commission thinks it will work with the court this time around, by merely giving it more weight and emphasis. Most anti-trust legal experts agree with us, saying it's highly unlikely the FTC will be successful with their new appeal.

Last Monday, when the FTC filed its latest case, it said a new appeal also is warranted in part because Whole Foods continues to operate many of the Wild Oats stores separately. We really aren't sure what significance the FTC puts in this fact.

First off, Whole Foods has only been integrating the Wild Oats stores into its retailing system for about a month. Some Wild Oats stores are being rebranded as Whole Foods stores, others are being closed, a number still have the Wild Oats banner, and some are even getting new names, like a former Wild Oats store in Boulder, Colorado (Wild Oats' former corporate headquarters), which Whole Foods has rebranded as Alfalfa's Market, a name the grocer obtained the rights to in the acquisition. (Alfalfa's was a popular Boulder-based chain of natural foods stores that Wild Oats acquired in the 1990's.)

Second, Whole Foods has told its stockholders it plans on changing most if not all of the Wild Oats banner stores remaining to the Whole Foods banner--and a few more to banners like Alfalfa's when it makes marketing sense. Public corporations aren't likely to tell their shareholders facts like this unless they mean it. There's no upside to doing so for Whole Foods. Lastly, even if Whole Foods keeps a number of stores under the Wild Oats banner, so what. Food retailers create and eliminate store banners/brands all the time. The Wild Oats brand is intellectual property Whole Foods acquired in the merger and we see nothing wrong with them using the name in any manner the grocer sees fit to do.

We don't understand how still having stores operating under the Wild Oats banner is evidence of anti-competitive behavior or "price raising," which are the FTC's chief arguments from an anti-trust perspective against the merger. Is the FTC saying Whole Foods' continuing to operate stores under the Wild Oats banner is part of a master plan by the grocer to acquire its rival but keep stores under its name because they believe they can control the category by having both? Doesn't make since. Wouldn't work if the grocer wanted it to.

Let's examine the logic (or lack thereof) of the FTC's argument. First, the FTC is saying Whole Foods already is a monopolist because of the merger. As such store names should hardly matter. Second, Most companies pay a premium in an acquisition because of the brand equity a company offers. In fact, seldom does an acquiring company eliminate the brands it obtains in a acquisition at all. Therefore, the FTC argument just doesn't make much sense. And it surely isn't the basis for an new appeal in our view. We asked for some elaboration from the FTC but they aren't commenting on the appeal; not even to the New York Times and Wall Street Journal, according to editors at both papers.

Whole Foods Market, Inc. has filed a motion, asking the D.C. appellate court to dismiss the FTC case as moot because the two companies (Whole Foods and Wild Oats) completed the merger transaction on August 28, 2007 after being given the green light from the federal court. The FTC is asking the appellate court for an expedited review. Most anti-trust lawyers are saying the appeal is considered a long shot. We agree.

We also think this dog is long dead and that the FTC should spend its time on more productive and important endeavors. The natural, organic and premium food and grocery industries are moving so fast, and are far too dynamic, for Whole Foods to gain a monopoly. There are far too many retail formats--with more coming online seemingly every month--to allow Whole Foods to stifle competition and raise retail prices on category products in any significant way.

Additionally, Whole Foods has an organized consumer opposition movement that refers to the grocer as "Whole Paycheck," among other negative epitaphs. Should the grocer raise its retail prices more than a couple percentage points at any one time, based on the natural increases in cost of goods, inflation and the like, it will find itself with an "anti Wal-Mart type" opposition movement, which is the last thing Whole Foods wants, especially post the Wild Oats acquisition. In other words we think the market as it is at present will be an strong enough check on Whole Foods' retail pricing behavior.

Does Whole Foods benefit having acquired Wild Oats? Yes. Does the grocer benefit to the extent it will allow it to be a monopolist? No. Whole Foods now owns the supernatural retailing category. We have no doubt of that. However, the point is that there are plenty of other retail formats--upscale national, regional and independent supermarket chains, mass merchandisers like Wal-Mart and Target, Trader Joe's and the many similar specialty grocers in the U.S., and more--where natural, organic and premium foods and grocery products can be purchased by consumers. Whole Foods may own the supernatural retailing category, but it doesn't own anywhere near the exclusivity in retail sales of products in these categories.

In fact, the supernatural retailing category is slowely blurring and going away. Why? Two reasons. First, the channel-blurring between natural foods supernatural stores, supermarkets, mass merchandisers, specialty grocers and others who sell natural and organic foods is making the supernatural category less relevant. In the past, when the only places a shopper could find natural and organic foods was at Whole Foods, Wild Oats or other natural foods stores, the category had meaning. Since that's no longer the case today--you can even buy a limited assortment of natural and organic foods at drug stores and traditional convenience stores--the entire concept of the supernatural category is being turned on its head and being rendered less meaningless and significant.

Second, the retail food industry is constantly evolving. New formats like Tesco's Fresh & Easy Neighborhood Markets (upscale, convenience-oriented grocery markets featuring fresh, prepared foods and natural, organic, basic and specialty groceries), Trader Joe's new larger stores with more fresh natural and organic foods, H.E.B's huge new 112,000 square-foot Cypress Market banner (which carries as many natural and organic groceries as a Whole Foods store), Safeway Stores Lifestyle format (which is evolving into a Whole Foods-like store but with basic groceries as well), and many others, are constantly redefining food retailing.

In an industry as fast moving as natural, organic and premium food marketing and retailing, there really isn't much time for a retailer like a Whole Foods to become a monopoly. The fact is, only a month or so after the merger, Whole Foods is already looking over its shoulder at the food retailers mentioned above, and many others. It's a dynamic industry. And the next hot format (or more likely format combinations) could change the retail landscape considerably.

Whole Foods also is considerably smaller than most supermarket and mass merchandising chains that sell natural, organic and premium foods. Safeway, Kroger and Supervalue, for example, are five to six times the size of Whole Foods in terms of gross sales and store count. H.E.B., Publix, Wegmans (and a number of others), all upscale grocery chains and major players in the natural and organic grocery retail space, are two to three times bigger than Whole Foods in terms of annual sales. And Wal-Mart, the world's largest retailer and a major player in natural and organic grocery sales, does over $300 billion in annual sales with stores located globally, compared to Whole Foods annual sales of about $6.5 billion.

As these huge, major food retailers (and numerous others) move more and more into natural and organic grocery retailing, as they're doing, it would be a big mistake to discount the notion that Whole Foods itself might become a takeover target. We don't think an acquisition offer or hostile attempt is on the radar screens of these mega-food retailers now or in the near future for a number of reasons. However, it's potential isn't lost on them (or not discussed behin closed doors). Nor is the potential of either a friendly or not so friendly acquisition lost on Whole Foods' management.

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