M&A Explained: The Amazon – Whole Foods Merger

Photo by MichaelGaida on Pixabay

By Joseph Baublitz, Staff Writer

Amazon has made headlines recently by requesting proposals for a second headquarters that will be a “full equal” to the Seattle campus.[1] Amazon projects that the new headquarters could add up to up to 50,000 jobs.[2] Pittsburgh is among more than 100 cities all over North America submitting proposals to attract Amazon’s development.[3] It has recently submitted 20 possible locations where Amazon could build its second headquarters in the city and surrounding areas.[4] In one version of a recent Moody’s study, Pittsburgh is named the second-best location for the new headquarters, only behind Philadelphia.[5]

The exciting news, of course, also evokes recent news of Amazon’s purchase of Whole Foods. Amazon’s ability to complete this merger speaks to the magnitude of the possibility of the company setting roots in the local area. Law, economics, and business regularly collide through mergers and acquisitions (M&A). When companies acquire or merge with another, the ramifications can be severe. The decision to merge, especially with large companies, is effected by business decision makers, in-house lawyers, regulators, and various economic factors.

The Amazon-Whole Foods merger allows Amazon to get into brick-and-mortar stores and expand its grocery business. Amazon, however, initially faced antitrust issues because it is nearing monopoly status. Nonetheless, the deal was ultimately passed by the Federal Trade Commission (FTC). To help better understand this acquisition and why allowing the merger to pass was the correct decision, this article will lay out three major concepts: mergers, monopolies, and Porter’s Five Forces.

The Deal

Amazon acquired Whole Foods for $13.7 billion, changing the retail landscape.[6] With 460 newly acquired locations, the company continues to expand, and people are starting to wonder just how big Amazon can grow. Amazon can sell just about anything, essentially becoming an “everything store.”[7] With the size of this deal, Amazon will gain tremendous market power through economies of scale.[8] Last May, according to Nitasha Tiku of Wired, “then-presidential nominee Donald Trump told Sean Hannity that [Amazon’s founder] has ‘a huge antitrust problem because he’s controlling so much.’”[9] With the addition of Whole Foods, more antitrust talk is rising.

Unfortunately for antitrust advocates, the law on this topic is on Amazon’s side. When trying to take down a potential monopoly, regulators look for market share. Whole Foods only held a 3.5 percent market share in the grocery market.[10] Additionally, companies who vertically integrate are looked upon more favorably than horizontal integrations.[11] With the economies of scale Amazon is developing, it can lower prices, creating “a net positive for consumers.”[12] Regulators are unlikely to call a company a monopoly if it lowers prices for consumers. A possible hang-up is curbing innovation, as new barriers to entry are created. Often, regulators review the impact of the merger a year or two later.

Retail stores are failing. Tiku mentions a few sources in her article, one of which was the co-director of the Institute for Local Self-Reliance, Stacy Mitchell. The Institute is “a nonprofit which recently authored a report on the threat that Amazon poses to communities, jobs, and innovation,” and Mitchell had been discussing the merger with politicians.[13] Another, Lina Khan of the New America think tank, expressed that “[b]rick and mortar retailers are struggling, in part because of the ease of shopping online, . . . and the sector has already lost at least 89,000 jobs.”[14]

Given the current political environment, politicians could have tried to get involved and sound the “antitrust alarm.”[15] The FTC recently cleared the deal, however.[16] While it is important to understand the reasoning behind the concerns of people like Mitchell and Khan, ultimately, as discussed more below, FTC’s decision was the correct one. The Amazon-Whole Foods merger may threaten some industries — but Amazon has precedent on its side, which helped it avoid antitrust and monopoly issues.

M&A Concepts

When dissecting a deal of this magnitude, there are multiple economic and legal concepts involved, such as mergers, monopolies, and Porter’s Five Forces — which is used for economic decisions affecting profitability.[17]

Mergers

Integration and merger activity is analyzed through the lens of market structure or the characteristics of a market.[18] Integration is the “uniting [of] productive resources,” and it happens through mergers.[19] Amazon and Whole Foods came to an agreement for $13.7 billion; thus, there was no “hostile” takeover[20] involved, as they mutually agreed to the purchase price, making this what is known as a friendly merger.[21]

Mergers can be vertical, horizontal, or conglomerate. For regulators, vertical mergers are ideal because horizontal mergers decrease competition.[22] A vertical merger occurs when a firm merges with another to carry out multiple stages of the production process to produce “components for a single product.”[23] Amazon was already in the grocery market with its Prime Pantry business.[24] Previously, it did not own the food distributors or local grown produce. Now, Amazon has a distribution center and a company that has contracts in place for local, organic produce. Instead of contracting with other companies that do something similar so that it can sell the products online, it owns the distribution channel to do that itself.[25] This will significantly reduce the transaction costs, drive down prices, and increase margins for these products. Ultimately, the synergy created by the deal will be a great benefit to Amazon.

There have been a few mega-deals that were not as lucky as the Amazon-Whole Foods deal. The key is to look for a decrease in competition. In 2002, two of the United States’ largest satellite companies — EchoStar and DirecTV — wanted to merge,[26] creating a horizontal merger. EchoStar tried to purchase DirecTV for $15 billion, and had the deal been successful, EchoStar would have served one-fifth of U.S. households as the nation’s only satellite provider.[27] Regulators, however, struck the deal down because it would “replace a vibrant competitive market with a regulated monopoly.”[28] Then in 2011, AT&T attempted to purchase T-Mobile for $39 billion,[29] but it was struck down by the FTC because it would “substantially lessen competition.”[30] The FTC has thus been clear that when a merger significantly decreases competition, it will be barred by antitrust law. As for Amazon, its merger with Whole Foods does not lessen competition; it just adds a step to the process — making it a vertical merger.

Monopolies

Monopolies are “a market structure in which a single firm serves an entire market for a good that has no close substitutes.”[31] Monopolies do not have to be global or even national; there are local monopolies that have no competition in a town, like local utility services. For the area in which the firm is a monopoly, the demand curve for the company’s product is the same as the market demand curve.[32] This means that monopolists can sell products for any price they choose. Some may call Amazon a monopoly because it functions as an “everything store.” Around 77 percent of U.S. consumers utilize at least one of Amazon’s products occasionally,[33] potentially lessening competition. As a result, it could create a market structure in which Amazon is the only company for these products in a given town, with no close substitutes.

Monopoly power can be derived from economies of scale. Economies of scale “exist whenever long-run average costs decline as output increases.”[34] When a company produces more of a certain good, average costs are distributed over more units, lowering the cost per unit. As the “scale” of production increases, the firm will derive value from cost savings.[35] The sale of Amazon’s business is significantly increasing from the nearly $14 billion acquisition. Whole Foods had 460 stores that Amazon is inheriting.[36] An increase in product (scale) will lower the average per unit cost, creating economies of scale. This will give Amazon even more market power, pushing it closer to monopoly status.

Clearly, the Amazon acquisition is a friendly, vertical merger. However, Amazon does display a few aspects of traditional monopolies. For instance, it is significantly increasing its economies of scale, which will give it more market power. Additionally, becoming an “everything store” made regulators hesitate. Nonetheless, the deal did not to fail based on antitrust violations, mainly because it does not lessen competition.

Porter’s Five Forces

As executives make economic decisions like whether to merge or not, Porter’s Five Forces are utilized to inform them. This framework, developed by Michael Porter, “organizes many complex economic issues into five categories or ‘forces’ that impact the sustainability of industry profits: (1) entry, (2) power of input suppliers, (3) power of buyers, (4) industry rivalry, and (5) substitutes and complements.”[37] These five forces all factor into whether a firm can sustain profits, which Amazon must know before making a decision. “Profits signal to resource holders where resources are most highly valued by society,”[38] and Amazon should have fully understood what society values before it spent billions of dollars to integrate with a new company. The framework helps managers make similar economic decisions.

Entry was a major cause for concern for Amazon, as it could have determined whether regulators will rule that it is a monopoly and was violating antitrust laws. Economies of scale are a major factor. When companies in the “everything store” industry have enormous economies of scale, it becomes almost impossible for competitors to break through this barrier to entry.[39] For many legal monopolies, government restraints are another barrier to entry.[40] Utility companies will sustain profits because the barrier is the government’s restriction.[41] If entry is easy, profits will not be sustained. In Amazon’s case, the industry has a high barrier to entry due to the sheer scale. Amazon will likely sustain profits on the entry factor.

The power of input suppliers and the power of buyers are similar. When input suppliers and buyers have more power, the firm produces lower sustainable profits.[42] “Everything stores” like Amazon and Walmart have tremendous power over input suppliers. Suppliers want to get their products into these stores because they control large shares of the market.[43] Therefore, profits can be sustained, as suppliers will not lessen the firm’s margins. The number of substitutes has a major impact on the power of buyers.[44] In this “everything store” space, few substitutes are available. The buyer does not have many choices when he desires to buy anything he needs at one place (or one website). Whole Foods, on the other hand, had many substitutes; this reduced its profitability, as buyers could choose different products. Amazon’s business model is much different.

The final two Porter factors are industry rivalry and substitutes and complements. Industry rivalry is intensifying. Profits may not be sustained if the rivalry is strong.[45] Amazon made a statement by purchasing Whole Foods, which threatens the likes of Walmart and Target. It is probable that the industry will react to this deal with moves of its own. A major element into this factor is product differentiation.[46] The products throughout the “everything store” industry are not significantly different. These companies are producing similar products and services, which will only deepen rivalry. As Amazon continues to grow, the number of its substitutes will decrease. Currently, Walmart is a major competitor, but Amazon is outpacing its competition. Regulators worry that consumers will one day only have a choice between the Amazon or Walmart store families.[47] With retail stores like Sears and Kmart failing, substitutes decrease — thus increasing “everything store” sustainability.

Based on Porter’s Five Forces, Amazon has a clear path to profit sustainability. There are high barriers of entry, low power of suppliers, low buyer power, medium-to-low substitutions, and high industry rivalry. With these factors, Amazon will likely have sustained profitability. The largest threat is the intense industry rivalry, but Amazon is one of the top players.

Legal Precedent

At the forefront of antitrust law is the Clayton Act. The Clayton Act of 1914 works as an amendment to the Sherman Act of 1890.[48] The Clayton Act clarifies that a merger cannot “substantially lessen competition, or tend to create a monopoly.[49] Vertical integrations, such as the one between Amazon and Whole Foods, do not lessen competition but, rather, just add a step in the production process. Through the FTC’s history, many deals have succeeded because of this distinction.

A lionized example to the Disney-Pixar merger of 2006 where Disney purchased Pixar for $7.4 billion.[50] Disney, which produces entertainment through many mediums, saw Pixar as a tool for its “flagging animation ambitions.”[51] Pixar would be the designer for Disney’s animation studio, in which its products could be produced and completed through Disney’s chain. The contract between the two studios was ending, and the merger made the relationship permanent.[52] This is a clear example of a vertical integration and, as such, did not face any problems with the FTC.

Conclusion

The Amazon-Whole Foods deal evokes the intricacies of antitrust problems that large retailers face. After its $13.7-billion acquisition of the health food grocer, Amazon cleared the FTC hurdle but was subject to much scrutiny. This merger was a vertical integration, increasing the company in scale, which is friendlier to regulators. People, however, were clamoring that this acquisition would make Amazon a monopoly.[53] Amazon is not considered a monopoly, however, because it is getting its market power from economies of scale through its vertical integration. Finally, Porter’s Five Forces show that Amazon will likely sustain profits, as four of the five factors are very favorable to the company. The merger has many implications in the marketplace, which is why consumers have considered the antitrust implications seriously. In the end, the deal may ultimately lower prices for consumers, which has diminished most of the antitrust concerns.

 

Joseph Baublitz is a J.D./MBA 2018 dual degree candidate at Duquesne University. He is the vice president of the Corporate Law Society and a student ambassador at the business school.

 

Sources


[1] Amazon announces 238 proposals for HQ2 from across North America, Amazon, https://www.amazon.com/b?ie=UTF8&node=17044620011 (last visited Dec. 18, 2017).

[2] Id.

[3] More than 100 contenders want Amazon’s second headquarters, Seattle Times (Sept. 16, 2017, 9:00 PM), http://triblive.com/business/headlines/12736673-74/more-than-100-contenders-want-amazons-second-headquarters.

[4] John Shumway, 20 Properties Submitted For Amazon HQ Proposal, Parkway Center Mall Reportedly On List, CBS Pittsburgh (Sept. 28, 2017), http://pittsburgh.cbslocal.com/2017/09/28/pittsburgh-amazon-headquarters-location-proposals/.

[5] Mark Zandi and Adam Ozimek, Where Amazon’s Next Headquarters Should Go, Moody’s Analytics (Oct. 12, 2017), https://www.economy.com/dismal/analysis/commentary/298321/Where-Amazons-Next-Headquarters-Should-Go/.

[6] Nitasha Tiku, Ready for a Monopoly Fight? Amazon and Whole Foods Isn’t It, Wired (June 20, 2017), https://www.wired.com/story/amazon-whole-foods-monopoly-antitrust.

[7] Id.

[8] According to Investopedia, this may be defined as “the cost advantage that arises with increased output of a product. Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs.” Economies Of Scale, Investopedia, https://www.investopedia.com/terms/e/economiesofscale.asp (last visited Dec. 19, 2017). See also infra note 35.

[9] Tiku, supra note 6.

[10] Id.

[11] “Horizontal integration is the acquisition of additional business activities that are at the same level of the value chain in similar or different industries.” Horizontal Integration, Investopedia, https://www.investopedia.com/terms/h/horizontalintegration.asp (last visited Dec. 19, 2017). “Vertical integration is a strategy where a company expands its business operations into different steps on the same production path, such as when a manufacturer owns its supplier and/or distributor.” Vertical Integration, Investopedia, https://www.investopedia.com/terms/v/verticalintegration.asp (last visited Dec. 19, 2017).

[12] Tiku, supra note 6.

[13] Id.

[14] Id.

[15] Id.

[16] Abha Bhattarai,  FTC Clears Amazon.com purchase of Whole Foods, Washington Post (Aug. 23, 2017), https://www.washingtonpost.com/news/business/wp/2017/08/23/ftc-clears-amazon-com-purchase-of-whole-foods/?utm_term=.ca68011c0e6e.

[17] Industry analysis and competition: Porter’s five forces, Mars (June 6, 2017), https://www.marsdd.com/mars-library/industry-analysis-and-competition-using-porters-five-forces/.

[18] Michael R. Baye & Jeffrey T. Prince, Managerial Economics and Business Strategy, 236 (9th ed. 2016).

[19] Id. at 216.

[20] “A hostile takeover is the acquisition of one company (called the target company) by another (called the acquirer) that is accomplished by going directly to the company’s shareholders or fighting to replace management to get the acquisition approved. A hostile takeover can be accomplished through either a tender offer or a proxy fight.” Hostile Takeover, Investopedia, https://www.investopedia.com/terms/h/hostiletakeover.asp#ixzz51r7FMLbp (last visited Dec. 20, 2017).

[21] Tiku, supra note 6.

[22] Baye & Prince, supra note 18, at 249.

[23] Id. at 249.

[24] Amazon.com: Prime Pantry, Amazon, https://www.amazon.com/gp/pantry/info?tag=mh0b-20&hvadid=78683835959123&hvqmt=b&hvbmt=bb&hvdev=c&ref=pd_sl_6s7c0l1d5_b (last visited Dec. 19, 2017).

[25] What We Missed In Amazon’s Whole Foods Acquisition, Seeking Alpha (Oct. 9, 2017), https://seekingalpha.com/article/4112539-missed-amazons-whole-foods-acquisition.

[26] Jessica Roy, 4 Corporate Mergers Shot Down By the Government, Splinter (Feb. 26, 2014), https://splinternews.com/4-corporate-mergers-shot-down-by-the-government-1793840916.

[27] Sallie Hofmeister & Edmund Sanders, EchoStar’s Purchase of DirectTV in Trouble, Los Angeles Times (Sept. 25, 2002), http://articles.latimes.com/2002/sep/25/business/fi-directv25.

[28] Edmund Sanders, EchoStar-DirecTV Deal Blocked by Regulators, Los Angeles Times (Oct. 11, 2002), http://articles.latimes.com/2002/oct/11/business/fi-echo11.

[29] Tom Schoenberg, Sara Forden & Jeff Bliss, T-Mobile Antitrust Challenge Gives AT&T Little Recourse, Bloomberg Technology (Sept. 1, 2011), https://www.bloomberg.com/news/articles/2011-08-31/u-s-files-antitrust-complaint-to-block-proposed-at-t-t-mobile-merger.

[30] Roy, supra note 26.

[31] Baye & Prince, supra note 18, at 278.

[32] Id.

[33] Which of the following Amazon services and products do you use at least occasionally?, Statista (2017), https://www.statista.com/statistics/705104/amazon-services-and-products-usage-in-us/.

[34] Baye & Prince, supra note 18, at 279.

[35] Id.

[36] Tiku, supra note 6.

[37] Baye & Prince, supra note 18, at 8.

[38] Id. at 7.

[39] Id. at 279.

[40] Id. at 281.

[41] Id.

[42] Id. at 258.

[43] Jeffrey Pfeffer, Here’s Why Amazon Is More Ruthless Than Walmart, Time (June 10, 2014), http://time.com/2850505/amazon-walmart-suppliers/.

[44] Baye & Prince, supra note 18, at 258.

[45] Id. at 254.

[46] Id.

[47] Tiku, supra note 6.

[48] Clayton Antitrust Act, Investopedia, http://www.investopedia.com/terms/c/clayton-antitrust-act.asp (last visited Dec. 19, 2017).

[49] 15 U.S.C.A. § 18 (West).

[50] Laura M. Holson, Disney Agrees to Acquire Pixar in a $7.4 Billion Deal, New York Times (Jan. 25, 2006), http://www.nytimes.com/2006/01/25/business/disney-agrees-to-acquire-pixar-in-a-74-billion-deal.html.

[51] Id.

[52] Id.

[53] Meyer, Robinson, When Does Amazon Become a Monopoly?, The Atlantic, https://www.theatlantic.com/technology/archive/2017/06/when-exactly-does-amazon-become-a-monopoly/530616/ (Jun. 16, 2017).

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