Amazon Goes Grocery

About:, Inc. (AMZN)
by: Janus Henderson Investors

By Joshua Cummings and Tom Roller

With Amazon's announcement to buy Whole Foods, the online giant takes another step toward upending traditional retail.

For years, Amazon (NASDAQ:AMZN) has used its online heft and focus on customer value to rewrite the business model for a number of retail segments. Now, with its announcement on Friday that it will acquire organic foods purveyor Whole Foods Market (WFM), Amazon is staking a significant claim in an area long thought to be immune to the e-commerce onslaught: grocery.

An Uphill Road for Grocery

The acquisition is nothing short of a tidal wave for the grocery industry, say Janus Henderson analysts. Before Friday's announcement, Amazon had experimented in the grocery business, rolling out AmazonFresh Pickup, a buy-online/pickup-in-person concept, and Amazon Go, a physical store without checkout lines. (It uses sensors instead to keep track of, and charge for, goods in consumers' shopping carts.) But both were just test projects with limited locations.

Now, with the acquisition of Whole Foods, which has more than 460 stores in the U.S., Canada and the U.K., Amazon is taking a significant step into the brick-and-mortar grocery business. The deal, valued at roughly $13.7 billion and expected to close later this year, is likely to create intense competition for traditional retailers. On the same day the deal was announced, shares of Wal-Mart (NYSE:WMT), for which groceries make up more than half of total revenues, declined roughly 5% on the news. Grocery store chain Kroger (NYSE:KR) - which earlier in the week reported same-store sales declines for the second quarter in a row after years of consistent growth - saw its stock fall precipitously, after a 19% drop the day before.

Indeed, Research Analyst Tom Roller, CFA, notes that Whole Foods saw same-store sales declines for the past seven consecutive quarters. "Whole Foods's management team did not predict the competitive intensity and pricing pressure that faces its business," he says. If other grocers had any doubt about that intensity, they certainly have been put on notice now. Says Research Analyst Josh Cummings, CFA, "The bulls hoping for profit margin expansion at Wal-Mart once the company ends its 'investment phase' in new technology can stop holding their breath."

Amazon's Dominance Grows

Amazon has turned into the online goliath that it is by building customer loyalty through its membership program, Amazon Prime. To keep shoppers coming back again and again, the company is willing to squeeze profit margins or sacrifice profits altogether. The investment team at Janus Henderson believes this membership-based model is the future of the consumer sector. They note, for example, that Amazon is likely to bring new value and loyalty benefits for shoppers at Whole Foods, where prices on both perishable and non-perishable items carry a 10% to 20% price premium to average prices at other major grocers, according to Janus Henderson research. And Amazon is unlikely to slow down. Earlier this month, the company announced it would reduce its monthly Prime membership fee for low-income customers who receive government assistance from $10.99 to $5.99.

In other words, Amazon's foray into grocery and potentially other segments of consumer staples could just be beginning. "Amazon is committed to grocery despite grocery's low profit margins because it is a conduit to higher-frequency shopping and loyalty," Cummings says. "It's all about growing and securing the Prime membership fee stream."

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