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Wild Oats A Good Play: Deal, Or No Deal

Posted: Jul 09, 2007 11:46 AM by Eugene Bukoveczky

Tickers in this Article: WMT, SWY, WFMI, OATS

When organic food retailer Whole Foods Market (Nasdaq:WFMI) moved to acquire rival Wild Oats Markets (Nasdaq:OATS) last February with a tender offer worth $18.50 per share, the roughly 18% premium this price represented appeared well worth paying. Whole Foods CEO John Mackey had a list of good reasons for the premium, little did he know his list could cause the deal to backfire entirely.

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In a confidential memo to the Whole Foods board at the time, Mackey outlined his rationale for making the offer. Among the usual arguments of better geographic synergies, improved comps and positive earnings benefits, there was a surprisingly frank justification which Mackey may now wish he'd worded differently - "elimination of a competitor". It now looks like this phrase could have prompted the Federal Trade Commission (FTC) to launch an injunction stopping the takeover.

FTC Calls Deal Anti-Competitive
A phrase such as "elimination of a competitor" tends to get the attention of regulators whose very job it is to stop these anti-competitive moves. Loss of competition leads to higher prices, reduced quality and less choice for consumers.

And, according to the FTC, that's exactly what will happened if the Whole Foods acquisition of Wild Oats goes through. (To learn more, see Antitrust Defined.)

The FTC argues the specialized nature of premium and organic supermarkets differentiates these markets sufficiently from standard food stores. In such a narrowly defined competitive arena, there is a good argument to be made that a Whole Foods/Wild Oats combination could be anti-competitive.

Each constitutes a large national chain, fielding hundreds of stores. When combined, the company could control about one-quarter of the marketplace. The rest of the competition consists mostly of small, local operators who lack the clout to be any sort of competitive threat to a combined entity.

Whole Foods Disagrees
In its initial rebuttal, Whole Foods made the point that the natural- and organic-foods business has broadened to the point where it now includes an increasing number of traditional food retailers such as Safeway (NYSE:SWY) and Wal-Mart (NYSE:WMT). Whole Foods' same store sales experienced a significant slowdown which coincided with the entry of these big traditional retailers into the natural foods game. The company may have a case should it elect to pursue a court challenge to the FTC injunction.

Out-of-court Settlement Likely
While going to court is a possibility, the preferred route for both parties would be to go for some sort of negotiated out-of-court settlement. If Whole Foods opts for such an approach, it's likely it would have to sell-off some of its or Wild Oats' stores where the two entities share a market. The trick to making this approach work is doing just enough pruning to satisfy the FTC without jeopardizing the fundamental business rationale of acquiring Wild Oats. Skipping court would save on legal bills. Also there is no guarantee the company would win a court case.

'Risk-Arb' Play Worth Taking
With all this uncertainty, it's not surprising that Wild Oats stock has backed away considerably from the $18.50 offering price. Now at $16.80, a just over 10% risk-arbitrage premium (the difference between the current share price and the offer price) is available for investors willing to bet that the deal eventually goes through. (For more on risk-arb plays, see Trading The Odds With Arbitrage.)

While 10% constitutes the total upside on the trade, should the deal fall through, my sense is the downside will be limited to about $1 per share, or about 5%. Prior to the offer being announced, Wild Oats shares were trading roughly a dollar below where they are now, and sported a forward multiple of 15-times next year's consensus earnings $1 per share; a multiple roughly on par with what Safeway shares are currently offering.

Odds In Your Favor
All this suggests to me that the fundamentals would keep the Wild Oats shares from going into a free-fall should the Whole Foods deal fall though. Moreover, there's always the possibility that another bidder could make its own bid for Wild Oats. Given these odds, I'd be inclined to take a position in Wild Oats at this juncture and take the 10% premium now on offer.

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By Eugene Bukoveczky

Eugene Bukoveczky is a freelance writer and investment researcher. He holds a CFA designation and has spent several decades working in the investment business in places like Toronto, New York, London and Dubai. He currently resides in Nova Scotia, where, when not writing, he devotes his time to chopping wood, growing his own vegetables, riding his bike to the store, and thinking about other ways to reduce his carbon footprint.

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