Amazon: Hitting Where It Hurts, The Periphery

There are mixed views on whether Amazon (NASDAQ:AMZN) is really killing it in grocery retail. At first glance, it does seem like opinions on both sides have merits. And since these opinions are mutually exclusive, it is easy to wonder about this discrepancy. I gave it a lot of thought and finally arrived at the following two conclusions. One, in grocery retail, Amazon may not have a big figure to gloat about so far. Two, traditional grocery chains are probably taking a big hit, and this is unlikely to be ascertained anecdotally.

Location, Location, Location

The oft heard aphorism location, location, location goes as well for grocery retail chains as it does for real estate. After years of competing and exhausting many options to differentiate themselves, grocery retail chains, the new and the old, are back to square one incurring more costs than ever. If one grocery store offers free parking, the other does too. If one offers a money-back guarantee, the other does too. In effect if one grocery retail store offers something to the customer, a competitor nearby is willing to match that experience. Therefore, grocery retail chains are now left with just three attributes to differentiate themselves.

First is the format. A hard discounter will have less than 2,000 SKUs whereas a supermarket will have 40,000. Retailers are institutionalized in one format or the other. For instance, a Kroger (KR) is not going to turn itself into a warehouse club like Costco (COST). Since, the format of the store generally remains the same, it has no influence over the earnings result year after year.

Second is marketing an effective price perception strategy. Just to make it clear, price perception is different from price. As summed up exceptionally in this HBR article, Amazon uses price as a psychological weapon and uses it better than anyone else in the game. Apparently Amazon sells the top moving items at a lower price compared to other retailers. Since, these products have high velocity, the perception that Amazon is cheaper is stuck. The study consistently found that other products were priced expensive relative to competitors.

And third is the location. A Kroger store in Chapel Hill, North Carolina, is not going to compete with an Aldi in Medford, Massachusetts. At competitive locations, price perceptions can feed into the impact on store earnings. And of all the three attributes, none of them affects quarter-to-quarter fluctuations in earnings more than location.

Why anecdotal verification can mislead investors?

In the past, when I wrote two bearish articles on Kroger, readers gave me stick arguing that competitive threats are not borne out by anecdotal evidence at company stores. Indeed, but why does anecdotal evidence defy numbers reported by the company? I think I have an answer but would like to add a caveat that this explanation is theoretical at this stage and was inspired by my reading of Foxall’s Consumer Behavior Analysis. I have not independently verified it, but readers can let me know what they think about my analysis.

Most grocery stores are more or less certain that customers located nearby will visit their store instead of a competitor’s. Saving a dollar on groceries is often not worth the time and gas expended on a trip to a distant store. Especially when stores hardly offer any differentiation. But for people located relatively distant from two different retail chains, the incentive to defect is higher. This number could be minuscule. But we are not talking about a 10% dip in sales or traffic. In fact sales growth and traffic are dipping just marginally at traditional chains. If Whole Foods succeeds in snapping just these customers at the sideline, and who were previously shopping at a Kroger’s or Wal-Mart (NYSE:WMT), the impact could be substantial. Here’s how.

Importance of volumes and impact on stock

The table below highlights the importance of volumes for grocery retail chains. The return on equity of all companies is driven by asset turnover and leverage. But what has an outsized effect on annual changes in ROE and short-term movement in stock is the net income margin. Even a 50 basis point decrease or increase in net income margins results in approximately -+10% change in the return on equity figure. And because of the high fixed costs, small changes in sales often see net income growth going from green to red.

Stock Net Income Margin Asset Turnover Leverage Return on Equity
Costco 1.98% 3.56 2.75 20.71%
Wal-Mart 1.70% 3.28 5.45 28.98%
Sprouts (NASDAQ:SFM) 3.07% 2.82 2.14 16.62%
Kroger 2.81% 2.44 2.56 16.65%
Amazon 1.74% 1.83 4.32 14.52%
Target (NYSE:TGT) 3.94% 1.78 3.42 22.89%

Therefore, if people at the sideline show up at, say, a competitor of Kroger, the company’s decline in net income margin is quite severe relative to decline in both sales and gross margins. The company’s recent earnings were a case in point. And since this competitor could increasingly turn out to be Whole Foods, Kroger does deserve the decline in its market cap. At the same time as long as Whole Foods nibbles at just the periphery, it is unlikely to post a massive increase in its own top line. Therefore, the opinion of weaker results at traditional grocery chains without, say, a double-digit growth in Whole Foods seems coherent. In terms of the impact this could mean more pain for Kroger, Wal-Mart, Sprouts, and Costco. Amazon should rise once these players start capitulating.

Note: Company related data have been sourced from Morningstar.

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Disclosure: I/we 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.

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