The Life Lessons of Whole Foods

If you follow mergers and acquisitions in the North American public markets, you may be aware that a very active sector at the moment is, of all things, grocery stores. This group, which has an average quarterly net profit margin of less than 1% after income taxes, is generating fervid interest among both private-equity firmsand larger corporations in the industry, which are busily studying the SEC filings of their smaller peers.

What's driving the interest?
Part of the growth in merger activity is common sense: Grocery stores are among the first beneficiaries of higher incomes in an improving economy. A less apparent reason is what I call the "Life Lessons of Whole Foods (WFM)." The grocery industry has finally understood from observation what Whole Foods Markets grasped from day one. I sum it up as follows:

People of various income levels will pay more for foods with some or all of the following characteristics: fresh, free of preservatives, free of hydrogenated fats, locally sourced, socially informed, organic, attractively presented, prepared in-store. 

Image: Chelsea Gomez, under Creative Commons license.

What are essentially lifestyle choices for consumers translate into margin for grocery chains. That's why Wal-Mart has intensified its push into organic foods in recent years. Profits from choice-based foods were also a propelling rationale behind Kroger's (KR -0.04%) recently announced acquisition of southern regional chain Harris Teeter. That company is tiny in comparison with Kroger, but Kroger management has stated that it is seeking to learn from Harris Teeter's expertise in higher-margin items such as fresh produce and prepared foods.

We should see continued activity in grocery sector mergers in the near future. Let's review some takeover candidates that may be attracting interest from private and/or public buyers.

Arden Group: small chain, impressive stats
Read through the Arden Group's (NASDAQ: ARDNA) key ratios, and you may be reminded of Whole Foods or its smaller competitor The Fresh Market. The California-based company operates the tiny, 16-location Gelson's Supermarkets. The Arden Group enjoys Whole Foods-like quarterly gross margins of 38.3% and net profit margins of 5.2%. Its return on equity is 22.2%.

The company is currently exploring options for a sale. That, plus the market's recognition of its earnings potential, has pushed the stock's trailing-12-month P/E ratio over 21%. Gelson's locations are upscale and handsomely appointed, and they present an attractive starting point for a larger chain that may want to build on the concept in the southern California market.

Attractive price-to-book value
Weis Markets (WMK 0.84%) operates 165 stores in Pennsylvania and surrounding states. The company turns over $2.7 billion a year and is similar to slightly larger North Carolina-based Ingles Markets (IMKTA -0.23%), which operates 204 stores in surrounding states and posts $3.7 billion of annual revenue. Both companies are regional grocers, with footprints in smaller towns and cities.

A striking similarity between the two, from a valuation perspective, is their low price-to-book value compared with other grocery chains. That's of interest to financial buyers -- acquirers who are more prone to run purchased stores "as is" for a financial return, as opposed to strategic buyers, who look for synergies and may combine the acquired stores under the parent brand, or make major changes to the target's business model, in the interest of creating long-term value.

Financial buyers may have an interest in companies such as Weis and Ingles, in which incremental margin improvements -- say, an upgrading of produce items, or expansion of natural-foods offerings -- can be introduced without major infrastructure investments. Take a look at how attractive Weis and Ingles are on a price-to-book value basis versus peers large and small:

 Data source: YCharts.

The relatively diminutive size of Weis and Ingles, coupled with their regional footholds and low price-to-book ratios, very much increases their attractiveness to larger chains, in my opinion. Like Arden, both companies have seen their stocks take flight in 2013 as merger activity picks up. However, Ingles' quarterly earnings from last week included an unexpected charge to earnings, as the company incurred penalties to refinance long-term debt at favorable rates. As a result, the stock retracted more than 10%.

Consistency and spark
For a final idea in grocery mergers and acquisitions, let's flip the perspective and discuss an attractive purchaser of smaller chains.

If you just viewed Kroger on the basis of its financials, you would find it to be, despite its huge size, a prototypical American grocery stock, in that its most recent quarterly net income came in at 1.6% of sales -- decent for the sector, but hardly eye-popping. The company builds value through brute strength, recording more than $97 billion in sales in a year, and netting $1.5 billion in earnings. And Kroger does this with consistent top-line enhancement: It's posted 38 straight quarters of same-store sales increases.

Kroger's acquisition of Harris Teeter will add about $4.5 billion to top-line sales. While the acquisition won't make a significant immediate impact on Kroger's earnings, investors appreciate what the smaller company can teach its acquirer and are encouraged that Kroger is trying to enhance its organic growth through acquisitions. Kroger's stock is up 51% year to date, but the company still looks attractively valued: Its trailing-12-month P/E ratio is 13.4, and its price-to-earnings growth ratio stands at 0.073 -- implying that the stock may still have some space to climb.

Keep your eyes on this sector
The "Life Lessons of Whole Foods" will eventually increase the profit of the entire grocery sector, as chains that cater to the middle and lower spectrum of the market try to align their offerings with consumers' lifestyle preferences. Major outfits with balance-sheet strength won't hesitate to shorten their learning curve by snapping up smaller, more profitable chains, or, as an alternative strategy, they will purchase relatively undervalued corporations and introduce incremental margin improvements. If you enjoy predicting future tie-ups, there are plenty of possible future combinations to research.