Judge Weighs Pricing in Whole Foods' FTC Case

ELLIOT ZWIEBACH and MARK HAMSTRA

WASHINGTON — A federal court judge here will try to peer into the future to see what the world would be like for consumers without Wild Oats.

In last week's packed, two-day antitrust hearing concerning the chain's proposed acquisition by Austin, Texas-based Whole Foods Markets, Judge Paul L. Friedman heard testimony from economists representing each side of the case in which the Federal Trade Commission is seeking to block the merger.

“What the judge has to do is predictive,” said Chris Mac-Avoy, a partner in the Washington office of Howery LLP who attended the hearing. “He is trying to predict what would happen if the merger went through, and he is trying to predict specifically what would happen to prices.”

MacAvoy said most of the testimony presented was related to the pricing issue — that is, whether Whole Foods would raise its prices in the 25 markets where it currently competes or is expected to soon compete with Wild Oats. The economist for the chains, David Sheffman, used a “critical loss analysis” argument in which he sought to show that raising prices at Whole Foods could result in a loss of business to other competitors, such as Safeway, MacAvoy explained.

By contrast, the economist for the FTC, Kevin Murphy, presented pricing evidence about the way the two chains have responded to each other as head-to-head competitors in various markets where they operate near each other.

“Based on this pricing activity that we've seen in the past, when Wild Oats goes away as an independent entity, will there be room to raise prices?” Mac-Avoy said. “The question is, which of the two experts has the more reliable predictive tools.”

MacAvoy said the hearing was so crowded that attendees filled an overflow courtroom where sound was piped in and some were standing outside in the hall.

Friedman is expected to issue a decision by “mid-August,” Whole Foods said last week. In February, Whole Foods had offered $18.50 per share, or nearly $700 million including assumption of debt, to acquire its smaller rival, considered the No. 2 player in the natural/organic space. In June, the FTC filed to block the merger on antitrust grounds, claiming that the two chains compete in a “premium natural and organic” niche that is distinct from other retailers who sell such foods.

The FTC included in its presentation many of the comments made in email messages and online postings by John Mackey, chairman and chief executive officer, Whole Foods, in which he spoke of “eliminating nasty price wars” and reducing competition through the acquisition. Although MacAvoy said such evidence presents “a significant issue for the companies to deal with,” he explained that the hard data analysis of pricing issues is much more relevant to how the court will rule.

“I would be surprised if the judge would base a decision to enjoin the merger based on the statements of a CEO or any other executive,” he said. “The federal courts, right up to the Supreme Court, have repeatedly pointed out that what matters in antitrust, and merger analysis is particular, is not what people say but what they do, and what they could do after the merger.”

MacAvoy noted that the judge, an appointee of former President Clinton, has handled antitrust cases in the past. “His questioning showed that he was fully up to speed,” MacAvoy said.

He added that both sides seemed to present their cases well, noting that there was no way to determine “who had the upper hand” in the hearing.

Although observers told SN before the hearing that merger antitrust cases are rarely appealed because of the length of time involved, the judge said he did expect his decision to be appealed. MacAvoy noted that Whole Foods could request an accelerated appeals process, although it would be up to the circuit court in Washington whether to schedule an appeal quickly.

In a third-quarter conference call with analysts that took place on the first day of the hearing, Mackey said he was looking forward to finding out whether the company can proceed with the acquisition, one way or the other.

“We've spent a lot of time and money on lawyers and submitting 20 million documents to the Federal Trade Commission, so we'll be glad to have this resolved so it doesn't take up any more of management's time,” he said.

“Regardless of that transaction, however, we have 94 stores in development,” he noted.

Some industry analysts have suggested that if the Wild Oats deal falls through, Whole Foods could itself become a takeover target, with Safeway a possible acquirer. Wild Oats is also considered to be a likely target for acquisition if the deal is unsuccessful.

Mackey said he is anticipating a judgment in Whole Foods' favor. “If the [temporary restraining order] is removed and an appeal is made and the FTC can't stop it, then we can close the transaction and start integrating the companies,” he said. “While the FTC may review the deal beyond that, once the eggs have been scrambled, it's hard to unscramble them.”

Whole Foods still anticipates selling off 35 stores operated by Wild Oats that carry the Henry's and Sun Harvest banners, he noted, “but what we do beyond that will be determined once the deal closes and we can get into the stores to see what we need to close or re-locate.”

Whole Foods' Sales Up, Profits Down

AUSTIN, Texas — Analysts were guarded in assessing the results of Whole Foods Markets' third-quarter results last week.

For the 12-week quarter that ended July 1, net income fell 9% to $49.1 million, with sales up 13.2% to $1.5 billion and comparable-store sales up 7%. For the 40-week year-to-date period, net income fell 6.8% to $148.8 million, with sales up 12.3% to $4.8 billion and comps up 6.7%.

The company, based here, said it was coming off tough comp sales numbers from the prior periods — increases of 9.9% in the year-ago quarter and 11.7% in the 40-week period last year. According to John Mackey, chairman and chief executive officer, a rise in comps of 7.6% during the first four weeks of the fourth quarter “is an indication that our comp-store sales growth has stabilized.”

Speaking in a conference call discussing the results, he defended the drop in earnings at the same time sales are increasing, explaining that is part of the chain's business model.

“As long as we have accelerated sales growth, there will be a temporary drag on earnings growth,” he said, “and when the rate of sales increase begins to moderate, you'll see an acceleration in the earnings growth rate.

“There's nothing wrong with that model. It's just that less mature stores don't earn at the same level as older stores, so while the balance of this year and part of 2008 will be investment years, 2009 and 2010 will be awesome years.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said Whole Foods appears to be back on track “after sharp declines in fundamentals, [which] bottomed out in the second quarter and achieved a positive inflection point in the third.

“Still, the rebound looks to be fairly tepid in the intermediate term,” he said, “and while the worst appears to be over,” he forecast flat earnings per share and 12% sales growth in fiscal 2008.

An improvement in gross margin to 35.54% from 35.25% a year ago marked the company's first margin expansion in seven quarters, Wolf noted.

Investors should not read too much into the gross margin improvement because “Whole Foods has no fear of taking price increases to make up for any perishables inflation that it feels,” said Perry Caicco, an analyst with CIBC World Markets, Toronto.

He said the chain's sales performance “is still in question, with some noise in the numbers and no real trend.” The “noise” comes in part from the strong impact of the new Whole Foods in London on results late in the quarter and its anticipated positive impact on fourth-quarter results, he said.

In other comments from Whole Foods executives during the call: