We follow-up to our reaction to the Amazon/Whole Foods announcement with a list of comments and updated views on online grocery. Overall, we expect the sector to become increasingly dynamic, with a high potential for more corporate actions over the near term. In Figure 1 we reproduce the graph from our recent report Global Online Grocery: On the cusp of a seismic shift, which shows the expected growth in many key markets. This was compiled prior to the AMZN / WFM announcement, which we believe will hasten the adoption. Figure 2 shows the attitudes of customers towards buying groceries online, which shows those in the Americas are most amenable to trying the service.
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Facts and myths, Amazon and outlooks
Food shopping is time-consuming, labour intensive and inefficient. Supermarkets as we know them were born in the 1930s, and have only changed incrementally since then. Each day, 13% of Americans shop for groceries, spending on average 44 minutes to do so, according to the US Bureau of Labor Statistics. The process itself is inefficient; groceries are handled multiple times before even reaching the shelf. From there, customers take them off the shelves, put them in a cart, take them out of the cart, put them on a belt where someone scans them and carefully bags them for the trip home. Within this chain there is also a significant amount of waste – according to the US Department of Agriculture, Americans wasted over one third of all fruit and vegetables bought in 2010. The high level engagement required by customers is particularly inefficient given that the vast majority of a family’s food baskets are repeat purchases. After years of incremental growth and testing, it is clear that Amazon believes it can bring its efficiencies to bear on grocery. We view the acquisition of WFM by AMZN as the procurement of a national fresh food supply chain, including distribution centres specifically designed for food.
The ‘incremental online basket’ myth. The idea that an online basket is somehow incremental to a grocer – and therefore enjoys the full operational leverage of the infrastructure behind it – makes online grocery look more attractive than it actually is, undermines the long-term economics and muddies decision-making. The ability to use a large store network as a quasi-distribution system is alluring but very expensive once all costs are included. Our analysis shows that the business model of choice for developed countries is some form of centralised fulfilment, where automation is viable and high service levels are achievable. Whole Foods stores give Amazon significant optionality, but we expect it to drive the majority of online sales through its newly acquired supply chain, adding automation as it expands.
The problems facing traditional grocers are technology and real-estate related.
The technology required for efficient online grocery requires a high level of expertise, and while grocers may not have that talent in-house, it is readily contracted for via systems integrators and consultants. More concerning are the real estate portfolios of the incumbent grocers, particularly those with long leaseholds or large property portfolios. Rental expense, high levels of invested capital for freehold properties, high labour costs of maintaining stores and the costs of exiting property all weigh against grocers trying to refocus their business online. The high degree of operational leverage will plague retailers that maintain large store networks.
Online grocery will offer increasing value. Improved mobile phone interfaces, slicker web pages, tailored features, more valuable promotions, automated 24-hour pick-up points, delivery passes, integration with home automation systems and same day delivery all add tremendous value to the customer. We believe the benefits of centralisation will play an increasing role in customer acquisition and retention, including a wider assortment, improved freshness, and fewer substitutions. The offline model will be exposed as being static and passé, with a declining value proposition.
Delivery problems are the main challenges, but are solvable. The need for centralisation runs counter to delivery economics, which improve when the picking operations move closer to customers. Potential solutions exist to reduce delivery costs, including shrinking fulfillment centres in order to locate them nearer customers, stand-alone click and collect facilities, sophisticated routing algorithms, and driverless delivery technologies.
We expect M&A and corporate actions to increase, but not pure consolidation.Amazon is now a threat to incumbents everywhere. As we have noted previously, AmazonFresh as an offering should not be viewed just as an encroachment into grocery, but rather a broader rollout of same day delivery. Grocery is one of the last big steps, which should aid consumer engagement and frequency (lease see our report,The Key Product in Amazon Fresh is Not Just Produce but Rather Same Day Delivery from 17 December 2013).
Despite AmazonFresh’s slower-than-anticipated rollout to date, the strategic and tactical implications remain positive because grocery is: (i) the largest consumer spend vertical; (ii) drives greater engagement from higher shopping frequency; (iii) leverages existing fulfillment infrastructure; (iv) accelerates share gain in adjacent categories; and (v) decreases friction on handling returns. Its capital-light agreement with Morrisons in the UK highlighted its main strategic weaknesses elsewhere: the difficulty in creating a comprehensive fresh supply chain and the inability to solve last mile logistics for a wide catchment area. By contracting Morrisons as a wholesale supplier it solved its supply chain issues; by gaining access to Morrisons store network from which it is able to pick baskets, it solved its customer accessibility problem. We believe these two issues are a large reason why it decided to acquire Whole Foods.
We also believe the marketplace model promoted by Amazon may gain increasing traction in grocery. We are already seeing this in the UK, where Amazon’s arrangement with Morrisons offers customers access to multiple credible food sources. Marks & Spencer does not have an online food strategy, but it is testing models currently; we believe it would be beneficial for M&S to forge a deal with either Amazon or Ocado and bypass the fulfilment process altogether. These kinds of arrangements will be easier to execute for Amazon in the US once it controls WFM
We single out Canada as being exposed to a potentially dramatic shift. In many ways Canada has the best characteristics for online grocery of the countries we analysed in our global online grocery report. The population is clustered around five major centres and is highly consolidated, which is appealing to a disrupter like Amazon. For much of the country, the chore of driving to a grocery store in winter is particularly depressing – an extra incentive for consumers to outsource the process. Many grocers offer click and collect, but few offer home delivery. AmazonFresh is currently not offered in Canada but Whole Foods has 13 stores there, focused on the Greater Toronto area (6) and the Greater Vancouver area (5). These provide Amazon with a full fresh supply chain and access to the two richest markets in the country, and we would expect it to exploit this infrastructure.
We expect M&A and corporate actions to increase, but not pure consolidation. Prior to the threat of online grocery, food retail was dominated by the economics of scale and operational leverage; capital expenditures were largely focused on store expansions. The UK, which operates the most highly-developed online grocery market, has seen space growth of its main supermarkets trend to zero over the past four years, with no growth on the horizon. Their strategic response has been to retrench and expand in other directions; Tesco made deals with fashion and non-food retailers to put concessions within its large stores and is in the process of buying the wholesaler Booker; Sainsbury purchased non-food high street retailer Argos and is reportedly near an agreement to buy wholesaler / convenience operator Nisa; Morrisons made wholesale deals with Amazon. We see direct grocer-grocer combinations as value destructive when there is more than a superficial store overlap, but we expect more adjacent transactions to be announced as grocers try to retain traffic and stay relevant.Ahold Delhaize. The Ahold foundation owns a call option that allows it to purchase cumulative preferred shares, which could discourage, delay, or prevent the takeover of Ahold Delhaize. De Telegraaf reported on Saturday that Ahold Delhaize’s management is concerned about the risk of a hostile takeover after this option expires at the end of 2018. We believe that Ahold Delhaize’s US operations, which are highly concentrated, large-scale and have generally small store footprints would be an appealing target for many US retailers, many of which are regional. We think the purchase of Tesco’s European assets by Ahold Delhaize would facilitate that, as it would give European operations the scale required to stand alone if US operation were sold (please see pages 36-38 of our report Ahold Delhaize: A powerhouse, well-positioned for the future).
Ocado. We reiterate our three reasons why we see the AMZN/WFM deal as being positive for Ocado shares: (i) it provides an extra impetus for grocers to sign a technology supply agreement with Ocado, particularly in the US; (ii) it increases the likelihood that Ocado is seen as an acquisition target; and (iii) from a customer perspective, it helps move online grocery further into the mainstream. While the key deterrent to signing a deal with Ocado may have been cost (especially if third parties believe they can substantially replicate Ocado’s technology), the driving force now may be speed to market. Ocado has recently demonstrated its smaller, high-density, highly automated fulfilment centre, which is expected to materially improve picking efficiency.
Instacart. Instacart is a private company based in California and is the leader in 3rd-party fulfillment as demonstrated by its rapid expansion, the supportive store economics and its capital-raising ability (it raised $220m in 2014 at a valuation of $2bn and $400m in 2017 at a valuation of $3.4bn). The model uses an “aggregated” storefront that allows customers to shop for groceries online and then employs local labour to pick and deliver orders from a variety of shops. Whole Foods is a key partner for Instacart, signing a 5-year deal in 2016. We would expect once Amazon gains control of Whole Foods that it would look to modify/eliminate that arrangement, which would be negative for Instacart; however, the desire of other grocers to move online may offset any loss felt from Whole Foods. Ultimately, the Instacart model is by far the most expensive one for customer because it fully charges for the service, unlike in-house operations, so we do not believe this is more than a short- to medium-term solution for online grocery.
Appendix A: Selected US online grocers
Figure 3: We see significant concentration within the densest populations, but much room to grow
Source: Company data, Credit Suisse research