SUPERNATURAL MEGA-MERGER

ELLIOT ZWIEBACH and MARK HAMSTRA

AUSTIN, Texas — Whole Foods Market here has a reputation for buying only the best — which is why many observers were surprised last week when the fast-growing natural/organics retailer said it would acquire its biggest rival, Wild Oats Markets.

Although Boulder, Colo.-based Wild Oats has long been a laggard compared with Whole Foods and has been scoffed at as a competitor by Whole Foods' chairman and chief executive officer, John Mackey, he said last week that Wild Oats had improved over the last several years and could improve even more under the auspices of his larger, better-performing company.

Whole Foods said it would offer $18.50 per share for Wild Oats and assume the smaller company's debt of $106 million, for what it said was an enterprise transaction value of about $700 million. Whole Foods plans to borrow the $700 million and thereby pay cash for the shares.

The deal will combine Whole Foods' sales base of $5.6 billion with about $1.2 billion from Wild Oats, minus the volume from stores that will be shuttered as part of the transaction. Whole Foods declined to estimate how many Wild Oats stores would be closed, but one analyst estimated that the total could be as many as 30 of Wild Oats' 110 locations. Wild Oats operates in 24 states and in British Columbia under the Wild Oats, Henry's, Sun Harvest and Capers banners.

Mackey noted that the added volume would be roughly equal to 18 months of growth at Whole Foods, keeping the company on track toward its goal of reaching $12 billion in sales by 2010 and following a long string of smaller, regional acquisitions by Whole Foods.

The tender offer for Wild Oats stock was expected to begin this week, with the transaction slated to be completed in April, though Mackey said it could be two years before the full benefits of the merger are realized. “Within a year you will definitely see good progress,” he told analysts during a conference call, “but it will probably be two years until you see all the synergies play out.”

Whole Foods said Wild Oats' board had unanimously approved the deal, and that Wild Oats' largest shareholder, Los Angeles-based Yucaipa Cos., had agreed to tender its shares. Yucaipa has an 18% stake in Wild Oats.

It was not clear what would become of the private-label distribution deals Wild Oats has with another Yucaipa-owned chain, Pathmark Stores, or with other retailers that currently offer Wild Oats-branded products, including Stop & Shop, Price Chopper and online grocer Peapod. Mackey said in the conference call, however, that he considered Wild Oats' private-label line among the chain's better assets.

DEFENSIVE MOVE

Analysts applauded the deal as a good defensive maneuver by Whole Foods, which has seen increasing competition from mainstream supermarkets adding natural and organic offerings and from specialty players like Trader Joe's.

“Whole Foods is essentially getting the opportunity to purchase its largest competitor, which operates at 49% of the sales per square foot of Whole Foods,” said Stephen Chick, an analyst with J.P. Morgan Chase, New York, in a report. “This is where the true synergy potential is, as Wild Oats has been a significantly mismanaged company, in our view, with clear merchandising and cultural issues.”

Whole Foods, by comparison, is known for its strong corporate culture and merchandising acumen, he said.

Although he was bullish on the purchase, he cautioned that Whole Foods' aggressive pace of new-store openings — 88 new stores are in its pipeline — adds an element of risk.

Simeon Gutman, an analyst with Goldman Sachs, New York, described the merger as a “clear positive” for Whole Foods.

“By buying Wild Oats, Whole Foods essentially secures a $1 billion competitor that currently has real estate in several non-core Whole Foods markets,” he said in a report. “Rather than waiting for its own pipeline to develop in those areas, which would give the competition a valuable head start, the deal gives Whole Foods instant exposure to those regions.”

Mackey said that while Wild Oats operates in each of Whole Foods' 11 operating regions, three of Whole Foods' smallest regions — the Pacific Northwest, the Rocky Mountains and Florida — will gain critical mass once the transaction is completed, and Whole Foods will gain entry into “a significant number” of new markets.

Whole Foods will likely eliminate “a lot of redundant corporate overhead” at Wild Oats to achieve synergies from the deal, Mackey said.

Most of the merchandising opportunities he anticipates are likely to come in the perishables areas, particularly prepared foods and bakery. Whole Foods is widely considered to have a superior perishables offering, although Whole Foods executives on the call pointed out that the two companies have in common their high standards for the products they offer, whether perishables or dry goods.

‘JET PROPULSION'

Mackey expressed confidence in his company's abilities to improve Wild Oats' results. “With our retailing intellectual capital, we can put jet propulsion under those stores and get comps into double digits,” he declared.

He also said Whole Foods expects to make significant investments in remodeling Wild Oats stores — though he declined to pinpoint the amount of spending — before re-branding them under the Whole Foods banner. Many of the Wild Oats stores are smaller than the large, urban stores Whole Foods has been opening lately, but Mackey pointed out in the call that Whole Foods still operates a lot of very small stores, and does so profitably.

He said he initiated the buyout discussions with Wild Oats in a call to Greg Mays, the chain's chairman and interim CEO, “because Wild Oats' contract with [CEO] Perry Odak had not been renewed and the chief financial officer had resigned, and without a CEO to provide a clear strategic direction, I thought maybe this was a good time to approach the company.

“Over the years we've seen continuing operating improvements at Wild Oats. The company has definitely been getting better and become a stronger competitor, so I called Greg and floated the idea. We chased around price for a couple of weeks [before making a deal].”

The acquisition will be Whole Foods' 19th buyout of a competitor, Mackey pointed out. Significant Whole Foods acquisitions over the years have included Bread & Circus in Massachusetts, Fresh Fields in the Midwest, Mrs. Gooch's in California, and Wellspring Grocery in North Carolina, he noted.

Asked whether Wild Oats' culture will survive the merger, Mackey said each previous acquisition of a competitor had an impact on the surviving culture. “We will study Wild Oats and how it does things to find best practices, though we're not going to take the arrogant attitude that we have all the answers.

“However, we are five times larger [in sales volume] than Wild Oats, so more of our culture will survive, but we think we can learn from them.”

Asked by one analyst why the company's attitude about Wild Oats as a potential acquisition had changed, Mackey replied, “The last time we looked at them was 6½ years ago, but the company is completely different today and it's written off a lot of stores.”

He said he does not anticipate objections from the Federal Trade Commission because of the competitive nature of the industry. “Safeway, Kroger, Supervalu and Wal-Mart are all selling the same products we sell, and I don't contemplate why there should be any problem [with the acquisition]. And Trader Joe's flies under the radar but they are very competitive as well.”

Whole Foods also reported results for the first quarter that ended Jan. 14, which saw net income decline 7.8% to $53.8 million, while sales rose 12.2% to $1.9 billion. Comparable-store sales increased 7%.

The single-digit comp-sales increase follows three years of double-digit increases, “but Whole Foods doesn't have a comp problem,” Mackey said. “After three years of very high comps, people were thinking comps would not revert to the mean, while we knew they would.”

Analysts were disappointed in the quarterly results, citing concern about a comp-store sales decline at older stores.

At a Glance