With its Whole Foods purchase, the online retailer is taking aim at grocers. Here’s who can fight the best fight.
By Bryan Borzykowski | 08-07-17 | 05:00 AM | Email Article

Years from now, we may look back on Friday, June 16, 2017, as the day retail changed forever. That morning,   Amazon announced it was buying Whole Foods , surprising analysts, investors, and shoppers alike. Several retail stocks peddling groceries took a hit that day, and many haven't yet recovered. As of this writing, Kroger is down 21%, Costco has dropped 15%, Target has lost 5%, and the list goes on.

Bryan Borzykowski is a Toronto-based business and investments writer. He’s contributed to the New York Times, CNBC, BBC Capital, CNNMoney and several other publications. Bryan’s also written three personal finance books and appears regularly on CTV News.

As the merger works its way through government approvals (antitrust enforcers will decide whether to give it the OK by the end of August), many investors are wondering if their now-beaten down grocery store stocks will ever rise again.

"It's going to be hard to invest in some of these companies, especially the ones that can be copied at a lower price," says Mike Liss, manager of American Century Value , which earns a Silver rating from Morningstar.

How will Amazon disrupt the generally staid grocery sector--and the overall retail market? Some think the online giant could implement its Amazon Go technology, which would allow people to pay for items without having to go through a checkout counter; others can picture a day when Amazon delivers groceries by drone. And many agree that Amazon's entry into the grocery space means additional pricing pressure for traditional grocery stores. Which companies can survive?

Break-Even Business Model
Although technology could, and likely will, alter the way we buy groceries, the shorter term threat that Amazon poses to the more traditional grocers involves its business model. Amazon has had massive success with offering items at nearly break-even prices. Amazon isn't making money on selling stuff. While it has been turning a profit for several quarters now, that's largely been due to its cloud business, Amazon Web Services, which saw operating income hit $916 million in Q2 2017, compared with a near $300 million loss for its combined North American and international retail operations.

Its retail operation is barely profitable, but that hasn't bothered investors: Amazon’s stock price is up 39% year-to-date as of this writing versus a 12% gain in the S&P 500.

It’s tough to compete with an operation that gets rewarded for earning next to nothing on its core business.

"Amazon can invest in all kinds of ideas because investors aren't demanding short-term profits," says Nick Kaiser, chairman of Saturna Capital, which manages the Bronze-rated  Amana Income . "That's been their business from the beginning and it's really tough for competitors."

With Whole Foods, Amazon is making its first purchase of a traditional brick-and-mortar business, but the company has been derailing stalwart industries and companies for years now. Staples is a good example, says Liss. He once owned the stock, but sold it at a loss in 2012 for $10. In June, private equity firm Sycamore announced plans to purchase Staples for about the same price per share that Liss sold it for five years earlier. Staples has "massively underperformed," he says, in part because it hasn't been able compete with Amazon on price.

"Amazon can deliver its stuff at a very small profit and that’s what they did," says Liss. "We knew Staples could stay in business--all they had to do was match Amazon's price--but shareholders are never going to win in a situation like that."

It's a similar scenario in the department store space, where companies like Macy's  and Kohl's  have been struggling to compete with Amazon's low prices and home delivery prowess. The former, in particular, is closing 68 stores this year, while its stock price is down 34% year-to-date.

"You see the same thing with department stores," says Liss. "We know they'll probably survive, but they're not going thrive. We're not investing in them."

When it comes to Amazon's most recent move, several companies could find themselves slashing prices in an effort to keep up. Costco, Kroger, Wal-Mart and Target are just some of the big retailers that could be impacted by a merger. But there are smaller operations in related industries, such as Blue Apron Holdings , a company that delivers meal kits. Its stock fell by about 7% after Amazon's purchase of Whole Foods was announced--though it has since picked back up--because of investor fears that Amazon could start delivering meals to people's homes, says Kaiser.

The Most Likely Survivors
Some companies are better positioned to survive the Amazon onslaught, says R.J. Hottovy, an equity analyst with Morningstar. The businesses that have niche products, or that can provide items that Amazon can't, will push forward.

"What are the things right now that differentiate these companies from Amazon?" asks Hottovy. A retailer like Lowe's , for instance, isn't facing the same headwinds as some other retailers because it's not easy to send drywall and two-by-fours via UPS . The company's shares are currently trading in 4-star range, suggesting they're undervalued.

Costco is also better positioned to withstand Amazon's advances, says Hottovy. It has two things going for it: it sells gas at its stores and it sells items in bulk, neither of which Whole Foods does. Costco also generated revenue through membership fees, and while Amazon does the same through Prime, the latter is capturing more of a younger demographic, while Costco has targeted an older crowd, he adds. Shares are currently fairly valued, according to Morningstar.

Kroger could be at risk for disruption, but it too has gas stations at its stores, which Hottovy thinks is a plus, at least in the short term. A lot of Kroger's customers fill up at the store's stations and then go inside to buy groceries. Kroger can also link its two offerings, providing gas and groceries discounts. It's also the largest traditional grocer in the U.S. Kroger is trading in 4-star range and is therefore undervalued today.

If there's any company that can go toe to toe with Amazon, though, it’s Wal-Mart, whose shares are also trading in 4-star range. It's larger than Amazon from a size and revenue perspective--it's the biggest retailer on the planet--which means it can compete on cost, says Liss. While it doesn't quite have the online presence or distribution capabilities that Amazon does, Wal-Mart is working hard to ramp that up. In August 2016, it bought Jet.com, an Amazon-like company that gives Wal-Mart a foothold in the online retailing space.

"They have the scale to do this, to be even bigger than Amazon," says Liss. "And they can take a hit on price and keep sales growing."

Hottovy agrees, saying Wal-Mart is the best positioned of the bunch. It has strong relationships with its food suppliers, it has an expansive logistics network and Jet.com's founder Marc Lore "knows what he’s doing."

Target, meanwhile, is less certain. While Liss says Target has created several strong brands that consumers still want, Hottovy says that's not enough, as people change brand loyalty all the time. Target, says Hottovy, doesn't do anything that Amazon can't do.

"It"s going to be hard for them to stand out," he says. "They don't do anything better than Amazon."

In general, companies that can't go after Amazon’s Prime members--a loyal group that get even greater discounts in exchange for a $99 annual fee--or can't slash prices will be in trouble. Brick-and-mortar stores that don't give people a reason to visit their locations will struggle, too.

Yet, Amazon is still just one company, and while it is disruptive, it's not going to put everyone else out of business.

"The markets act as if whenever Amazon does something, they'll take 100% market share," Liss says, "but they won't."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

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