Successful Entrance Into Online Grocery Market May Have Serious Value Implications For Amazon

| About:, Inc. (AMZN)

Shares of (NASDAQ:AMZN) bucked the trend in Wednesday's trading session as they traded with modest gains amid a general market sell-off. A much-anticipated move finally seems to have become reality as the company is planning the rollout of an online grocery business. A successful expansion in this area would support the bull case for a long-term investment in the company.

The Strategic Move

According to people familiar with the matter, Amazon is planning a rollout of an online grocery business, although the company itself has not commented on these rumors yet. CEO Jeff Bezos did make a remark about its AmazonFresh pilot during its annual meeting, saying that "the team made progress on the economics over the last year."

The company rolled out AmazonFresh in its home market of Seattle in 2007, in an attempt to deliver groceries with its own trucks. The venture has been run as a test case and allowed Amazon to learn from possible caveats in the online grocery industry, the last major segment of the retail sector that is still largely unaffected by the e-commerce revolution. According to a Reuters article, Amazon is contemplating serving 20 to 40 markets, including some international hubs. Most likely, Amazon will start testing in Los Angeles and San Francisco, both very densely populated areas.

Still, a possible move would be difficult. Groceries carry much lower margins, are more labor intensive, experience shrinkage, and require people to be at home at the time of the delivery. If Amazon manages to overcome these hurdles, it could achieve massive distribution economies of scale by delivering its normal goods including electronics and books as well.

Implications for Competition

Amazon has been testing its AmazonFresh concept for some time, and while the news has not been confirmed, it seems to be a natural extension for the company. Amazon started out as an online book retailer, but at the moment sells pretty much a broad range of online goods. Furthermore, the company is entirely focused on the long term and willing to subsidize loss-making ventures -- including its cloud-business, the Kindle, and streaming video content, among others.

The move seems even more likely as the company has massively expanded its warehousing and distribution capabilities in recent times. These investments and a headcount outpacing revenue growth might indicate that Amazon was preparing either for same-day delivery, the invasion of the grocery business, or -- most likely -- a combination of the both. Such a move would require Amazon to store millions of stock-keeping units as well as refrigerators in its warehouses.

Some firms already offer online grocery services, of which Peapod -- owned by Koninklijke Ahold (AHONY.PK) -- is the most advanced. The company claimed that it had delivered 23 million orders in densely populated areas like Chicago over the past year, charging a fixed fee of $4.95 per order. A successful entrance by Amazon would result in some serious competition in the medium to long term for established firm's such as Kroger (KR), Whole Foods Market (NASDAQ:WFM), Safeway (NYSE:SWY), and Wal-Mart (WMT), among others. Other companies that could be affected include UPS (UPS) and FedEx (FDX), which could see a short-term boost to their businesses, although Amazon might decide to create its own distribution network in the long run.

Implications for the Investment Thesis

A successful penetration of the grocery business is certainly a huge opportunity for Amazon. However, the process will go slowly and has some very major risks, given the specific complexities for the online grocery business. In the beginning, Amazon will target the most populated areas. People have busy schedules and have been early adopters of its current services already. By distributing groceries directly to its consumers, Amazon could save a lot on real estate and employment costs, which are major expenses for typical bricks-and-mortar stores. Amazon might be able to price the groceries at similar levels to actual bricks-and-mortar stores, while passing the cost savings on by charging no additional delivery fees.

In April, when Amazon reported its first-quarter results, I concluded that the company remains on its long-term growth trajectory path. The company operates with a net cash position of $5 billion, giving it plenty of flexibility to invest despite lackluster profitability of the business as a whole. The company is on track to generate annual revenues of around $70 billion for this year, on which it is expected to barely break even. This is despite a 240-basis-point increase in gross margins in the first quarter as the company boosted spending -- or, actually, investments might be a better word -- in technology, fulfillment, and customer service. Fulfillment costs were up a 136 basis points on the year to 11.2% of revenues, possibly due to its preparation for grocery fulfillment or same-day delivery.

One important thing to realize for investors is that while the grocery business carries low margins, the company is reporting low margins anyway. Overall first-quarter operating margins were merely 1.13%, although they were a more healthy 4.87% in the U.S. as foreign operations are still losing money. The increased delivery frequency and economies of scale brought forward by offering groceries as well could boost both long-term margins and revenue growth. In all, if the latest rumors turns out to be true, it will most likely cost the company a lot of money in the short to medium term. Yet the initiative is likely to eventually make money, as it will result in economies of scale throughout the distribution process after years of "overinvesting" into fulfillment.

With shares trading around $267, the market valuation of $122 billion is really high based on current metrics, and the valuation has been extremely high based on current metrics for the entire last decade. If Amazon manages to successfully infiltrate the grocery market, the current prices could still offer great appeal despite being expensive on current metrics.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.