Kroger Has An Advantage Over Amazon In Groceries

About: The Kroger Co. (KR), Includes: AMZN, WMT
by: Scott Perry

Investors have largely given up on Kroger, as Amazon aggressively moves into the grocery industry.

However, there are signs Amazon is struggling to adapt to the different approach needed for perishable goods.

News Amazon is looking to grow its retail presence in groceries shows Kroger's massive retail network is a fundamental advantage when expanding delivery and pickup services.

Trepidation is growing with each new breathless article on Amazon's (AMZN) plans to disrupt the industry. Investors have seen what happened to retail and aren't going to underestimate Amazon this time. But what if groceries are fundamentally different and require a new strategy which doesn't align with the model Amazon has used to dominate e-commerce. That's what Ben Thompson argues in a recent article where he suggests Walmart (WMT) has a fundamental advantage over Amazon due to the different value chain needed for groceries.

I'd argue Kroger (KR) has many of the same advantages, and while Walmart is ideally positioned, I believe an investment in Kroger offers more upside if the Amazon threat proves to be overblown. I've held Kroger stock for almost a year now and continue to accumulate stock on selloffs.

The more Amazon starts replicating grocer's retail network, the more investors should ask if Amazon really does have the upper-hand in groceries. Amazon's fulfillment model hasn't had to deal with the problem of perishable goods. Groceries call for a new strategy hence Amazon's acquisition of Whole Foods and its growing interest in expanding its retail presence.

The problem for Amazon is large grocers already have this retail network in place giving them a head start which allows them to more easily roll-out delivery and pickup services. Kroger is the second largest grocer in the US after Walmart. It should be able to grow its market share even if Amazon has some success.

The top four grocers in the US have consistently grown market share over the last 20 years but still have under 50% share. The rise of delivery will drive consolidation in this fractured industry, as smaller players struggle to compete which benefits Kroger with its massive scale.

The Amazon Threat

Kroger's stock price has been getting crushed so far in March. Investors may be confused in thinking they're suffering from deja vu, as this has happened basically with each new story about Amazon's grocery ambitions. The threat of more Amazon stories seems to be forever hanging over Kroger, destroying investor sentiment in the stock.

Recently, a drop in gross margins for Kroger and news Amazon is planning to start a new chain of supermarkets has set off alarm bells. The WSJ went from telling readers in September not to panic over Kroger to throwing in the towel.

Sometimes a company can do almost everything right but still fail to overcome powerful fundamental trends. Kroger is a well-run business, but it is simply worth less than it used to be and investors know it.

Management tried to explain gross margins dropped as it invested in new warehouses, lower prices, and above-average growth from the lower-margin pharmacy segment. This didn't stop Domesday analogies like "the perfect storm" being widely used by reporters and Wall Street. Less reported was the fact same-store sales growth in the quarter and forecasted growth in fiscal 2019 exceeded analyst expectations.

The narrative of Amazon's inevitable domination has become an accepted fact, so it was strange there was little mention of groceries in Amazon's recent earnings report and call. Additionally, Bloomberg reported in December Amazon was struggling in the space.

The number of Amazon Prime members who shop for groceries at least once a month declined in 2018 compared with 2017, according to the results of an annual consumer survey released Wednesday by UBS analysts. The drop was surprising given the company's Whole Foods investment and expansion of two hour delivery service Prime Now, the analysts wrote in a note to investors.

A separate study by research firm Brick Meets Click found that households using grocery delivery and pickup services from physical retailers spend about $200 per month and place orders more frequently than Amazon grocery shoppers, who spend $74 a month.

This might explain Amazon's interest in growing its store count. Its model, which relies on fulfillment centers and established delivery services like USPS, can't effectively be used to store and deliver perishables given their limited shelf life. Ben Thompson explains his reasoning for why this is the case. I explained when Amazon bought Whole Foods, perishable goods are not well-suited to Amazon's value chain. Superior selection has diminishing returns, quality varies on an item-by-item basis within a single SKU, and, most importantly, the quality of items degrades with time and transport. In other words, they are a great fit for stores, not distribution centers.

In this view, Amazon's purchase of Whole Foods was an attempt to acquire a first best customer for its grocery delivery operation, one that would efficiently store and sell perishable goods that weren't suitable for Amazon's traditional e-commerce model. And, to be clear, this strategy may yet succeed, but only to the extent Amazon builds a completely new set of capabilities and integrations that will probably end up looking a lot like Walmart, which has a massive head start it is clearly taking advantage of.

In other words, what matters is not "technological innovation"; what matters is value chains and the point of integration on which a company's sustainable differentiation is built; stray too far and even the most fearsome companies become also-rans.

Grocery chains are integrated around their stores in local markets and already have experience managing this problem, as perishable goods need to be stocked at the store and sold quickly to ensure freshness and quality. Customers then take care of the last mile problem themselves by transporting groceries to their homes.

Pickup and delivery do the sorting and transportation for customers and eliminate the need to visit the store. Existing supermarkets can layer on these services by redeploying/adding staff or making use of delivery companies like Instacart and Shipt. The perishable goods are already there for customers who shop in the store, so the local grocery company can start building pickup and delivery without having to change much.

In short, an existing nationwide network of stores close to customers is key to scaling demand for pickup and delivery. The fact Amazon still has to build out this network means it's at a fundamental disadvantage to Kroger and Walmart. To build out its own retail footprint will take years and massive capital spending. Everybody is afraid of the scale Amazon can bring, but Kroger has massive scale, as it had over $120 billion in sales in fiscal 2018.

Scaling The Supply Chain

While it's hard to gauge how Amazon's digital grocery sales are doing, Kroger has been more transparent. It grew digital sales 58% in the recent quarter and had close to $5 billion in sales in 2018. Management says the digital business has a run rate of around $9 billion currently. But as demand grows the problem for the industry is how to scale delivery profitably.

The current process is labor-intensive with people shopping for the customers and then delivering the groceries. Walmart, recently, reported strong comparable growth in groceries. However, a major issue is retail stores were not built to accommodate a massive increase in pickups and deliveries as management noted in its conference call.

You can get to a point and we do cap in some store locations, a place where we have too many pickers in the store and it gets -- they get in the way of our customer shopping and site counter so we got to manage that effectively...

The physical stores have allowed Kroger and Walmart to quickly accommodate growing customer demand. This labor-intensive strategy works as long as deliveries and pickup are still a small part of sales, but new solutions are needed if these services are going to scale on the supply side.

It's no surprise to see articles about companies losing money in deliveries whether it's restaurants or supermarkets. Walmart management didn't seem to have a clear answer when asked about this and the potential return on invested capital (ROIC) for deliveries and pickup.

I do think about ROI a lot. You're correct. I -- when we're together as a team, I am talking about Doug's team, we spend as you can imagine most of our time thinking through the prioritization of the various things that are going on inside the company and as we go through those discussions, we always have the P&L and the balance sheet and ROI in front of us as part of those discussions. And it's our job as the management team to make these things work together over time. The customer acceptance, we're seeing with online grocery in particular is a one where you look at it and say we are going to lean into this. And there maybe things along the line and we delay this or can we stop something else, but we're going to lean into things like this and see when we see them working for the customer and as a team we will ensure that it works out for our shareholders over the mid to long term.

To me, this meandering answer says they don't really have a plan yet on how to drive profits, but customers really love it, so we're going to lean in and figure out the rest later. They talked about increasing the productivity of pickers but that's not a long-term solution.

While Walmart's grocery sales growth looks more impressive than Kroger's results, the company needs a new last mile delivery and sorting solution to do what current fulfillment centers can't. Without that, it risks losing out again in e-commerce. In contrast, Kroger has a clear plan: partner with UK online grocer Ocado (OTCPK:OCDGF), which has been busy tackling this problem for years.

Ocado's Solution

In an article, titled How Ocado masters e-commerce grocery in the UK, Ocado's CEO notes 7 to 8 percent of the U.K.'s grocery market is online compared to 1 to 2 percent in the US. He believes this is because no US company has yet to offer the combination of "product variety, competitive pricing and timely home delivery." In the UK, Ocado is able to offer one-hour delivery throughout the week at low prices all while keeping food fresh.

"We have the highest penetration of sales of fresh food of any food retailer in the U.K.," he said. Forty-four percent of the company's sales come from its refrigerated facilities. When you add ambient produce like potatoes and bananas, over half the company's sales are fresh food.

The key is Ocado's automated warehouses which are substantially more efficient than the manual picking model. The picking model is what startups like Instacart and Shipt (now owned by Target (NYSE:TGT)) are using.

The company has three automated warehouses, one of which turns more than $1.2 billion a year and the other turns $1.4 billion a year. These automated warehouses individually pick 1.5 million items a day...

...Steiner presented a chart showing that the automated fulfillment center spends 15 seconds per order compared to an hour and 14 minutes for the store/manual picking method. The automated fulfillment center currently has 600 robots and will have 1,100 by the end of next year. A center currently under construction will have 3,500 robots...

..."We can talk to those 3,500 robots 10 times each per second, for two-way confirmed communications, 20 times the power of Wi-Fi. Nothing available from the likes of the Ciscos, the Motorolas, the Googles. We had to develop that in the U.K. with scientists in Cambridge."

This enables Ocado to offer convenient and reliable delivery all while having incredible product variety.

Ocado has over 99 percent item accuracy in its orders, Steiner said, and over 95 percent on-time delivery. Deliveries are made in one-hour time slots, starting on the hour or the half hour, beginning at 5:30 a.m. and delivering until 11:30 p.m., seven days a week. Ocado charges for delivery for some customers.

The company ships more than 50,000 SKUs, which is more than double that of Tesco, Sainsbury or Waitrose in the U.K, Steiner said. The inventory includes favorites of different nationalities, as well as organic products.

But price is the big driver where we're dramatically different," he said. Ocado matches Tesco's, "the Walmart of our own market," he said...While Ocado charges for some deliveries, "every one of our customers can find free delivery slots if they want them," Steiner said. The average delivery charge is 1.5 percent, he said, the equivalent of $2 per order.

Ocado still has a small share of the UK market, but I believe it would be more successful if it previously had a physical retail presence. To be successful large capital investments are needed and an established store network helps furnish demand and makes these investments in automated warehouses economical. This makes Ocado's strategy of partnering with established retailers around the world the right one. More partners mean Ocado can increasingly invest more in its technology leading to more success in turn for its partners.

Source: Ocado Q2 Earnings Slides

Kroger grew its ownership stake in Ocado to 6% in 2018 and is partnering with it exclusively in the US. They've been busy identifying sites for these automated warehouses, and Kroger has committed to building 20 of these warehouses. Maybe Walmart and Amazon will be rolling out their own solutions soon or just haven't bothered to explain their innovations to investors. The fact remains Ocado has had success and helped drive changes in consumer behavior without having a retail presence in a market where Walmart and Amazon both operate.

The superior efficiency of these automated facilities will drive future changes to the grocery industry. I believe we won't really understand the new services possible until this is scaled up around the world and complemented by driverless delivery.

Specifically, it could really drive costs down for Kroger's meal prep service. Blue Apron was always going to struggle to scale in a way a company like Kroger can. Kroger already has a platform which can sell meal prep kits without the recurring customer acquisition costs driving Blue Apron towards bankruptcy. Lower costs will drive increased adoption from consumers giving Kroger scale and an ideal competitive position.

Another crucial piece to enabling widespread delivery is driverless delivery. While self-driving cars seem to be more hype than reality currently, there is reason to believe it may be easier to grow unmanned delivery relatively soon. Kroger has already partnered with the startup Nuro for an unmanned delivery service in Arizona. The press release states the autonomous vehicles have completed nearly one thousand deliveries to the general public.

Kroger plans to expand the service to new markets, and it should be feasible as developing an autonomous delivery service, which can delivery over short distances and drive at slow speeds, should be much more doable than full-on autonomous driving.

The service can be gradually scaled up as improvements are made to ensure it's as safe as possible. This will drive down costs even further, incentivizing increased adoption, as autonomous driving solves the last mile problem for grocers.

Changing Competitive Landscape

Another exciting shift has steadily been going on as consumer brands see their negotiating power decline. Grocers, especially Kroger, have developed successful in-house brands. Kroger's proprietary brands reached a record 30.5% unit share in Q4 and continue to grow as a share of revenue.

The most notable example of this shift is Kraft Heinz (NASDAQ:KHC) where Warren Buffett has admitted he overpaid for his stake in the company due to the loss of bargaining power. For example, Costco's Kirkland brand sales exceeded Kraft Heinz's last year despite being a relatively new brand.

So here they are, 100 years plus tons of advertising, built into people's habits and everything else, and now Kirkland, a private-label brand comes along with only 750 outlets, does 50% more business," Mr. Buffett said.

Companies like Kraft Heinz have been able to earn enviable ROICs for decades, as they were able to pay for prime locations on supermarket shelves and drive brand loyalty through advertising. That's all changing now giving Kroger significantly more leverage and control over its supply.

Its acquisition of meal prep service, Home Chef, allows it to offer customers increasingly customized meal options. Its meal kits are in its own stores and it has started adding them to third-party retailers. Its future Ocado warehouses will allow it to scale this model, as it increasingly moves beyond selling groceries just from its own supermarkets.

Additionally, it's testing Kroger Express, an assortment of 2,300 products, in 13 Walgreens (NASDAQ:WBA) stores. Its ability to offer its own brands and meal kits mean the selection can be tailored for the specific shoppers Walgreens gets. Pharmacy's food offerings are generally poor, so if Kroger can improve selection this will drive more business to the rest of the store. If successful this could hugely boost Kroger's retail presence without the capital expense of new stores. With Amazon looming, pharmacies are under pressure to better compete giving retailers like Walgreens an incentive to try out these new concepts.

Kroger has even established a digital advertising service to take advantage of growing usage of its app and website. If customers are using Kroger for ordering, consumer companies will have no choice but to go where the customer is. Similar to what Amazon has donewith its advertising business.


Concerns over the expansion of discount retailers, Aldi and Lidl, have also scared off investors. Aldi and Lidl have been successful in Europe by drastically limiting choice, creating faster turnover, allowing them to have smaller stores and less staff with higher volume. Trader Joe's has a similar model which has done very well in the US.

I'm not concerned because delivery will fundamentally change the competitive landscape. Store efficiency will no longer enable these discount retailers to so easily take share from the larger players. Efficiency will come through delivery networks integrated with automated distribution centers.

Kroger is priced like a stale low-return grocer about to be disrupted. What if that's not true? And Kroger's retail network and strategy put it in a prime position to dominate and drive increased returns on invested capital.

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The industry is on the cusp of change due to technological innovations. If Kroger can grow margins, accelerate growth, and drive ROIC higher, the company's enterprise value won't be a fraction of its revenues like it is now. Make no mistake Kroger isn't a staid grocer anymore. Kroger will either succeed or be disrupted.

Investors are taking a results-oriented approach assuming because Amazon has disrupted countless retailers, groceries will be the next domino to fall. A more process-driven analysis reveals it's clear perishables require a fundamentally different approach putting Amazon at a disadvantage.

The risk-reward for Kroger looks favorable to me, so I've continued accumulating stock on these recurring Amazon panics. With Kroger just starting to ramp up its strategy, the story will take time to play out. The Amazon concerns aren't going away soon, so I'm planning on holding long-term and selectively building up my position over time.

Disclosure: I am/we are long KR. 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.