December 2008

In early November I published excerpts from a piece I was doing regarding the future of private equity and how it will adapt in this current market. You can now download the published article here.


wholeI’ve had a love hate relationship with Whole Foods Markets, Inc.  I love what they provide for me, but I hate the crowds and the customer experience.   In my household we refer to it as “Whole Paycheck”.   I was lucky, in a sense, when I lived in New York, the first Whole Foods  went in just a few blocks from my apartment, providing a working guy an oasis of healthy food options, that stood in marked contrast to everything I could procure within a 10 block radius of my doorstep.   I moved to Seattle and, thankfully, Whole Foods was just a few exits up the freeway, and I was able to conveniently procure my produce, protein and staples that served as the basis of our healthy lifestyle.

I first learned about Whole Foods when I was a traveling management consultant at Price Waterhouse (pre-merger with Coopers & Lybrand).   Back in the early days of Fast Company (circa 1996), the magazine featured an article on the company (article here) calling it the future of democratic capitalism — decentralized team based work environment, financial transparency, and consensus hiring.  At the time, I thought it was interesting model (multi-functional teams were all the rage in the reeingeering world), completely counter cultural within the grocery industry, but I was fairly out of tune with the natural foods movement at the time.

As I graduated from consulting to investment banking, my proximity to Whole Foods became closer,  and not only as a consumer.   Perry Odak, who was a Gordian Group, LLC (my previous employer) relationship, from the Ben & Jerry’s deal, had been brought in to turnaround Wild Oats Markets, Inc., the second largest organic market chain in the country.  While we were never engaged, to my knowledge, we were routinely bouncing ideas off of Perry and providing him valuation insights.  It was clear that an M&A exit was in their future.  I spent more time understanding the industry and business model and walking the isles of Whole Foods.  By then I was pretty much living in the prepared foods section.

While Whole Foods enjoyed a healthy run, driven by expansion of the store footprint, accelerating consumer sentiment around natural and organic foods, and the strong economic environment, the run began to lose steam in late 2006.   With the stock trading at $65/share in November 2006, the company announced results which included a projected slowing of their growth rate.   Comps were off, margin compression was evident, and square footage ramp was below expectations.  The era of 20%+ annual growth for Whole Foods had sunseted many believed.  Applying more conservation price-to-earnings assumptions yielded implied stock prices nearly 50% the prevailing share price.  By January, the stock was trading at $43/share, or better than expected according to analysts.

In February 2007, the inevitable happened, Whole Foods offered to purchase Wild Oats via a tender offer for would turn out to be approximately $752 million ($586 million if you net out the stores sold to Smart & Final post close).  If you can’t build it any more, than buy it.  Given Wild Oats historical operating challenges and Whole Foods  execution acumen, it was thought that considerable value enhancement could and would occur.  Whole Foods has a strong track record of turning around under performing natural foods retailers, and  it appeared there were significant opportunity for both overhead cost savings and store-level productivity gains to be had at Wild Oats owned stores.   The analyst community believed the merger will be a significant earnings driver for Whole Foods over the next several years.

A funny thing happened on the way to the alter however — the Federal Trade Commission  (FTC) filed a lawsuit to block the proposed acquisition, taking a very narrow view of the antitrust market, given that nearly every grocery store now sells organic and natural products.  This had negative implications for the stock, as uncertainty now was a compounding factor on top of eroding performance in the core business caused by cannibalization, competition and price reductions.   At the very least management would be distracted and integration delayed.

Whole Foods did not sit on its hands and wait for the FTC to mess with its future.  Instead they took their case to court and received a preliminary injunction against the FTC, setting the stage for an imminent closing.  In the background, it came to light that Whole Foods CEO John Mackey had been posting negative comments  under an anagram of his wife’s name (Rahodeb, when unscrambled would be Deborah) about Wild Oats and glowing comments about his own organization on the Yahoo! Finance message board for seven years, referring to himself in the third person.  Additionally emails from Whole Foods executives expressing their disdain for Wild Oats and their desires to “crush them at any cost” came to light.   That notwithstanding, on August 27, 2007 the deal was finalized and the merger effected.

Case closed? Not so fast.

After closing the deal with Wild Oats, Whole Foods stock price continued to erode.  Earnings misses followed by failed integration milestones blurred in to an economic crisis where consumers were trading down and, ultimately, suspension of the dividend.   Facing both a confidence crisis and a liquidity crunch, Whole Foods took a $425 million investment from Leonard Green & Partners (LGP) through their Green Equity Partners Fund.   While very successful, LGP is not known for paying peak market multiples.

Then things started to get very strange…

On July 29th,  a three-judge panel ruled that a district court judge had erred when he refused to grant an FTC request for an injunction to block the merger of Whole Foods and Wild Oats.  On November 21st, Whole Foods lost a decision to have that ruling reviewed by a larger panel of judges.   Despite the fact that most Wild Oats stores have been closed or absorbed, the FTC is now moving to have the merger invalidated.  A hearing on the merger is scheduled for February 2009.  Whole Foods has launched a new suit, claiming their right to due process has been violated.

In an effort to make a compelling case that Whole Foods is not a monopoly they have subpoenaed the records of 93 competitors in the natural food space (note: the number quoted in the popular press is 96, but in a recent court motion, the number was stated as 93).  Their inquiry focuses on 29 markets in what is terms are the “premium organic retailing space”.   Parties were given until November 4th, 2008 to respond. Financial records, weekly sales figures, marketing plans, store opening schedule, inventory reports, and more.  Most of these entities are in fact private, making these records proprietary.  Amazingly, 50 of 93 entities have complied in whole or in part without a peep.  The squeaky wheel in the machine is New Seasons Markets, a nine store chain of natural markets located in Portland, Oregon.

New Seasons CEO Brian Rhoter naturally took issue with the subpoena and is taking his case to court.  In his blog Rhoter points out not only the burden complying with the order is having on his business financially, but also, aptly,  that the FTC motion does not, in his mind, provide for adequate protection of its information or remedies upon breach.  Basically, Rhoter is saying we don’t have a dog in this fight, so why are we unnecessarily being burdened and our business information being put at risk.   The fact that Whole Foods had fronted the argument that none of their employees would see the data, and then went to court to get it sent to their Austin headquarters, raises eyebrows.

While I feel for New Seasons and side with Rhoter on this issue, my sense is that Whole Foods will prevail in court.   Antitrust does not work without competitive information and Whole Foods is following the common protocol, at least at a high level.  What boggles my mind is that others being impacted by this legal morass are not lining up behind Rhoter, at least in an attempt to greatly narrow the scope.   And what of the 42 odd companies (sans New Seasons) who have made no production in this case?  What action is Whole Foods going to take against them?  It is possible if New Seasons would have quietly ignored the subpoena that they might be better off in the short run.  After all I don’t think Whole Foods has the necessary runway to successful compel “groupo 42” to produce and then internalize that response and incorporate it by February.

I can’t also help but let my mind wander, to the actions of Mackey and the emails of key employees that painted a win at all costs culture within the corporate center, and wonder if secretly Whole Foods is loving this part of the process.  Essentially this is antitrust as a business strategy.  I’m not saying that anything Whole Foods is not above board or that they have any intention of misusing anyone’s information, but the reality is you can’t see this information and then wipe the slate clean of it when making decisions.  Sure, pursuant to the protective order, key executives would never see this data but there are a cadre of individuals who will and invariably there will be data leakage, there always is.  Further, this case is central to the future of Whole Foods, its executives and board have to be exposed to  some of the information in order to make decisions on legal strategy.  Even if data reaches them in summary form, or at a high level, it is information they would otherwise not  have had access to in absence of this case.  This only leads me to be more sympathetic to Rhoter, as it points to a lack or organization among independent organic retailers.  If only they had known they would need their own lobby.

The last great example of a company that used antitrust as a business strategy was Gemstar-TV Guide International.   The fate of that entity and its executives was not so favorable.  That said, I value Whole Foods role in the market and I hope it prevails in its case against the FTC.  A break-up of the company would do more harm than good.   Organic food retail is a highly competitive market place once you consider how much of the product can be obtained in  mainstream supermarkets and club warehouses.  However, I wish Whole Foods approach to business was more indicative of its role as senior statesmen for the industry and consistent with what we might view as its mission.


sambaAssuming you read my blog with some regularity, and did not simply tune in read a post or two (wishful thinking I know), you will recall I recently, maybe slightly sardonically, predicted the demise of institutional beverage investing in the near term.  My thesis was the cost of garnering a threshold level of revenues required too much capital to meet target internal rate of return hurdles for venture investors.  Put more simply, the category has become too crowded driving marketing spend and elaborate costly packaging that made the business unattractive as an investment.

I stand by those comments.  However, two of my fine readers (and maybe my only two) were nice enough to point out that two beverage deals were announced in the  past 10 days.  Adina For Life announced the close of a $10.4 million financing led by Sherbrooke Capital.  Two days later, Sambazon announced an undisclosed amount of investment from a group led by Verlinvest S.A. (rumored to be $17.5 million, which included Bradmer Foods, also an investor in Adina, and RSF Social Finance, according to Dow Jones).

Eat crow? Not so.  Why not?

Because both of  these deals were well underway when I wrote my predictive post .  In the case of Adina for Life, this is actually the closing of a round raised in April 2008 led by Sherbrooke Capital, but left open for additional investors which turned out to be Pacific Community Ventures and Good Capital.  As for Sambazon, as a category leader in the better for you fruit beverage category, it was just a matter of picking a partner (though they did take their time).  Verlinvest is a perfect investor for them given their mission and extended time horizon.  It was never an “if” with Sambazon, but rather a “when”, “with whom” and “at what price”.

So why did these companies attract investment in these difficult climes, for companies in general, let alone the crowded beverage space?

First, Adina and Sambazon are playing on a number of hot company trends, namely sustainability, fair trade and natural and healthy.   In short, these are mission based organizations that adhere to a strict set of core values that they place ahead of financial success.   While they still strive to earn a profit, they not enact policies that erode their value system.  Based on what I know of each (more Sambazon, less Adina, thought they seem quite similar in their devotion to the mission) they did not come up these outlooks as a result of convenience, but rather fundamental belief.   Mission based organizations achieve an authenticity which attracts die hard customers, who will often times go to great lengths to purchase the product irrespective of the price.  Often times these organization are referred to as “triple bottom line”.  Financial success comes as a result of the core values.

For many years, I enjoyed a Sambazon acai smoothie to kick off my morning, much the way that someone might enjoy a Starbucks Frappachino (whatever that is, honestly I don’t even know).  As a result of this continuous consumption pattern these companies enjoy nice growth trajectories.  In combination with their core missions, they are able to attract a certain shade of capital.  While I have not seen a summary level statistic, capital flows into health and wellness funds from both traditional limited partners and family offices have been rather robust the past 3 years.  These funds tend to focus on investing in companies whose mission they support.  The companies in turn get capital that is symbiotic with their purpose and often times is structurally more attractive than traditional consumer venture funding.  Funds like Sherbrooke, Good and Verlinvest are well known within the category along with Inventages, Physic Ventures, Prolog Ventures, Greenmont Capital, DBL Capital, TBL Capital, I could go on, and on.

Second, both companies have solid management teams and boards.  In the case of Adina, while Margatte Wade-Marchand was the inspirational founder of the company, given that the core foundation of the beverage line came from her native land, Senegal, Greg Steltenpohl runs the show as CEO.  For those of you who are not familiar with George, he founded Odwalla, one of the alternative beverage founding fathers, so to speak.   While he was not there at exit, his credentials are, for the most part, beyond reproach.

As for Sambazon, while Ryan and Jeremy Black and Ed Nichols might not be a roster of “been there done that” executives, they are clearly a smart trio of entrepreneurs and come from strong leadership and team traditions.   Their strategy of controlling the source of a highly valued and scare resource is brilliant, while at the same time cultivating their mission.  Further, the Sambazon board is stacked — Steve Demos (Silk brand soy milk), John Elstrott (esteemed academic and Director at Whole Foods Markets) and Gary Hirshberg (Chairman, President, CE-Yo, Stonyfield Farms).

Third, and finally, Adina and Sambazon are more than just drink companies, they are emerging lifestyle brands.  In Senegalese (the native country from which the brands inspiration came), the word Adina means “life, in its holistic and spiritual dimension”.  No mention of making great beverages.  The company’s mission is to “create the magical experience of connecting people beyond borders by providing healthy, exotic and delicious beverages, original music and lifestyle products infused by the spirit of world cultures”.  Again, beverages is just one leg of the stool.  You can get international music information and free singles via the Adina website.

Sambazon uses acai as a vehicle to promote sustainable agriculture.  You often here people say Sambazon is a lifestyle, a sustainable lifestyle (the picture at the outset of this blog is Cameron Faist, Sambazon Event Coordinator).  Their beverages are a means of spreading that message and doing good for the people of the Amazon rain forest.  Samabazon has its own “team” (dubbed the “Sambazon Family”) of sponsored athletes, artists and musicians who are product users, by more importantly advocates of the mission and core values.  You can find Sambazon catering the athletes lounge at the X-Games or at any of the major music festivals.  People are attracted to the product because of the vibe it creates.

Do I expect more beverage companies to get institutional funding — yes, but they need to be special companies — like Adina or Sambazon.  Companies that mean more than great tasting beverages.  Companies that tap in to broader social themes which will enable them to be viewed as more than just drink companies.


As the holidays approach my travel schedule will heat up and the deal closing calendar is crowded.  Hopefully I will get more content up by year end but I expect posting velocity to slow until the new year.

beans2I hope all of you enjoyed the recent holiday.  I know I did, even if my waistline did not.  In the interest of Thanksgiving, and the positive spirit in brings out in all of us,  I wanted to hold off on this post, because there is not a lot of good news within.  Long short, further barriers to rightsizing transaction velocity continue to emerge my friends.  I don’t have to continue to wax on about the challenges in the private transaction markets, but after reviewing the proposed changes to accounting and reporting standards in mergers and acquisitions brought to you by the Financial and Accounting Standards Board, I can say we have achieved an even further state of gloom.  The implications, discussed below, are going to create a significant drag for acquirers post January 1, 2009.  I expect these new policies are going to create further frictions to getting deals done at attractive valuations.

Before we get into the captivating nuances of FAS 141(R) and FAS 160, let me make one positive note, albeit it a fleeting one.  At this time, it does not appear the Obama regime is in a rush to change capital gains treatment.  While it remains my belief that the Democratic regime recently elected into office will raise capital gains on households that meet the $250,000 income threshold, Team Obama appears to have recognized that raising taxes on anyone is generally not good policy when trying to steer a large ship out of an economic crisis.  One small victory for tax-kind.

Now on to the rest of our story…

So like all good stories, this on has a protagonist, the Financial Accounting Standards Board, better known as FASB.  FASB is responsible for developing the Generally Accepted Accounting Standards, or GAAP, the basis of public company accounting.   FASB sets the standards for GAAP within public companies and private equity firms then “force” these down upon the private sector.  FASB has two red headed step children, so to speak, FAS 141(R) and FAS 160, which governed GAAP related to business combinations and non controlling interests in consolidated financial statements, respectively.  Until January 1, 2009, the twins were reasonably well behaved, limiting the impact of transactions on near term earnings per share and allowing for structure deals consideration to be amortized.  However, in 2009 the twins are moving towards the concept of “fair value”, in a effort to achieve greater balance sheet transparency.  Good for accounting, bad for acqusitions. Here are some of the key changes that should impact M&A.

>  Valuation of Equity Consideration: Previously equity consideration was valued at the time of announcement.  Subsequent fluctuations did not impact the purchase price for accounting purposes.  However, new for 2009 (I feel like I am narrating a car commercial) the purchase price will be based on the stock price at close.   This change, becomes meaningful when the value of the equity consideration appreciates materially from announcement to close as it will result in additional goodwill being recognized by the acquirer.  Goodwill is bad in the M&A world, in general, and more so in this case.  As a result, expect to see more purchase price caps, which are disadvantageous for sellers, who are bearing a majority of the prurchase price risk fluctuation.

> Transaction and Restructuring Costs:  Under the old regime, transaction costs were recognized as part of the purchase price and amortized like goodwill and restructuring costs were recognized as a liability as of the date of acquisition.  In both cases, they were considered part of the deal price — you inherited these as a cost of M&A.  Warts, but not tumors.  Going forward these items will be unbundled, and recognized separately from the transaction.  This means they will be expensed as incurred.   This will push down earnings in the post transaction period as a result of expensing what had previously been goodwill (double bad).  You should also expect to see more detailed explanations of fees and restructuring expense justifications.  Expect public floggings as a result.  The concept of “immediately accretive’ will be banished from the acquisition vocabulary, which is again bad for sellers.

> Contingent Consideration: Historically earnouts were accounted for at the time of realization.  As a result, you did not have to take the accounting hit, unless you actually had to pay the freight (recognized  as additional goodwill in the deal).  In the brave new accounting world, all contingent consideration must be recognized at fair value as of the date of the acquisition.  This will increase goodwill at the time of close.  This creates several conundrums, not the least of which is how to value earnouts at the time of close.  More importantly, the associated liability for contingent consideration recognized, but not yet paid, will fluctuate as the earnout is, well, earned.  Earnings will be more volatile as a result.  Net net, in a world where earnouts are necessary to bridge gaps in valuation, FASB is slapping the hands for those who utilize them as deal structuring mechanisms.  Bad bad FASB.  Bankers who get their kicks deriving complex consideration structures will be banished, rightfully, to the corner.

> Partial Acquisitions and Non Controlling Interests:  For deals involving partial acquisitions, where the buyer acquires a controlling interest (> 50%), the buyer must record all assets and liabilities at fair value on the date control is obtained.   There is no longer a ratable recognition based on percentage ownership.  In order words there will be full recognition of goodwill and more depreciation and amortization, which will have a greater impact on earnings than previously contemplated.  If asset values are impacted over time, it will also have a more significant impact on underlying earnings per share.   Additionally, an acquisition of a minority interest, where there is no change in control, will be treated like an equity transaction, which will impact the investors equity account based on consideration relative to fair value, which will fluctuate over time.  Net net, getting strategic investors to take a minority interest will be more of a headache due to the consolidation accounting that will come with the financial benefits of ownership.

All in the new accounting standards for mergers and acquisitions will influence deal negotiations and associated structures.  We expect to see valuations negatively impacted and buyers reluctant to let sellers earn in over time due to the fair value implications at close.  Net net, FASB has served the transaction community cold soup at a time where it really needs a warm hot meal.


(p.s. that picture at the top of this post is an unhappy bean counter)