In our first class as part of the Nicholas Center Class of 2019, we are building a full valuation model from scratch to analyze Amazon’s $13.7 billion acquisition of Whole Foods, Inc. In our analysis, we are utilizing all of the primary valuation techniques including a discounted cash flow analysis, a comparable companies analysis, a precedent transaction analysis and a leveraged buyout (“LBO”) analysis. At first blush, we expected that a bid from a private equity firm would be an important source of competition against Amazon’s offer. We know that private equity firms are able to raise a significant amount of debt at attractive rates in today’s low interest rate environment, we know from Whole Food’s proxy statement that 4 private equity firms expressed interest in pursuing an LBO of Whole Foods, and we know that private equity firms have a history of investing in the supermarket space (e.g., Apollo’s acquisition of Fresh Market).
But ultimately, Amazon faced no real competition in its bid. Why not?
Background on Our Analysis
We utilized publicly available information in Whole Food’s proxy statement to build our LBO model. We went through all the steps together in class and had a review session to make sure everyone understood the concepts. The first step was to calculate the purchase price of the LBO – we derived equity value from a given share price (e.g., $42.00 per share was Amazon’s offer) multiplied by the fully diluted shares outstanding. Then we added the net debt to get an enterprise value of $13.7 billion. We then calculated the sources and uses required in the transaction and made assumptions about the type and amount of debt financing available to the private equity firm. We then built our income statement, cash flow statement and debt paydown schedule. Finally, we calculated the internal rate of return (“IRR”) available to a potential private equity investor in the transaction.
Our LBO model suggests that a private equity firm would generate an IRR of approximately 20% at $42.00 per share, using the projections Whole Food’s management gave to Amazon. However, if we utilize Wall Street analyst estimates (which were considerably lower than the management projections), the IRR falls to approximately 10% at $42.00 per share.
Why Couldn’t Private Equity Compete with Amazon?
Evercore, Whole Food’s financial advisor, told the Board of Directors that private equity firms couldn’t compete with Amazon’s offer (see page 29 of the Whole Food’s proxy statement). We agree, and we understand that strategic buyers like Amazon, who have synergies in an acquisition scenario, can generally pay more for a business than a private equity firm that is looking to generate IRRs in the 15-25% range.
The key reasons why private equity couldn’t compete here include:
- The size of the equity check – over $7 billion by our calculations. That is a staggering amount for a private equity firm to put into any one deal and generating a decent return on that large of an equity check is challenging.
- Whole Food’s doesn’t have a great cash flow profile. It spends a lot in capital expenditures (e.g., developing new locations) and therefore, the free cash flow conversion is pretty low. Only ~40% of the debt in an LBO scenario was paid down after 6 years in our model.
- EBITDA in 2017 was actually declining. Amazon could look past the results for a year or two, but that is more challenging for a private equity firm with a 4 to 5 year investment horizon.
If Whole Foods had a better cash flow profile and could be purchased at a lower valuation multiple (Amazon’s purchase was at ~11x forward EBITDA), then private equity would have been better positioned.
Overall, this was an interesting situation to analyze, and our LBO model helped us to understand one aspect of how this deal worked. Stay tuned for more analysis of the Amazon / Whole Foods deal.