What Amazon’s Whole Foods Deal Means For The Future of Grocery

Jun 16, 2017

Amazon.com changed the way the world shops for almost every nonperishable item you can imagine: beauty products, books, electronics, and apparel. Here's the multi-billion question for today: can the e-commerce giant disrupt the $781.5 billion U.S. grocery market?

On Friday, Amazon (amzn) inked a roughly $13.7 billion deal (including debt) to acquire organic grocery chain Whole Foods Market (wfm), a takeover that would be the largest in Amazon's history when completed. "Millions of people love Whole Foods Market because they offer the best natural and organic foods," said Amazon founder and CEO Jeff Bezos in a statement to justify the deal. "They're doing an amazing job and we want to continue."

We don't yet know much about why Amazon is buying Whole Foods' fleet of 461 stores as Bezos and his management team declined to hold a conference call with Wall Street analysts and members of the media. But we do know the deal unites two Fortune 500 companies: Amazon currently sits at #12 with nearly $136 billion in revenue while Whole Foods ranks at #176 with $15.7 billion in sales. Their growth trends, however, couldn't be more different. Amazon's revenue jumped 27% last year and profit soared by nearly 300%. At Whole Foods, the top line inched up 2.2% while profit dropped 5.4%.

The grocery industry is notoriously difficult to tackle. Profit margins are razor thin when compared to almost any other retail category, as there is a ton of competition in local neighborhoods that results in a lot of price transparency. Whole Foods amassed billions of sales by making organic food mainstream, a trend larger brick-and-mortar retailers including Kroger (kr), Walmart (wmt), and Target (tgt) all successfully replicated. The traditional grocery store industry is also facing tons of competition from newer, non-traditional channels: There's meal-kit delivery services like Blue Apron and HelloFresh. And 52 million Americans are currently grocery shopping online. Millions more want to try it.

"Food has been insulated from the e-commerce revolution over the last 20 years, but the reality is consumers are going online, they are expecting mobile, and they want the ultimate convenience," said Michael Wystrach, co-founder and CEO of meal delivery service Freshly, in an interview with Fortune. "The evolution of the grocery store business is going to evolve dramatically over the next five years."

That's why the Amazon-Whole Foods deal is being viewed as so disruptive for the grocery store industry. Already, grocery stocks on Wall Street were pressured when Kroger reported soft quarterly sales on Thursday. Losses extended into Friday on the big merger news, as many view Amazon as a major threat to grocery now that it has hundreds of distribution points (i.e., physical Whole Foods stores) to use as they wish. Online grocery delivery services, like Instacart and Google Express, almost certainly will be burned by the deal.

"As other brick and mortar retailers have come to realize the hard way that competing with Amazon is a formidable challenge, supermarkets will now have to contend with not only competition with each other and non-traditional grocers like Walmart and Target, but with a retailer like Amazon which has the financial capacity to price aggressively, and the smaller regional supermarket chains and independents will bear the most pain," wrote Moody’s Vice President Mickey Chadha in an e-mail. "We expect this transaction to further accelerate the consolidation within the supermarket space."

Here's why: When Blue Apron filed to go public earlier this year, it commissioned a study by research firm Euromonitor to track the migration of grocery store sales to online channels. Euromonitor found that while the total grocery market is $781.5 billion, online sales last year only represented $9.7 billion, or about 1.2%, of the market. But Euromonitor estimates that the compound annual growth rate for online grocery sales will be 8.5% between 2017 and 2020 compared to the broader industry's slim 1.3% increase. Amazon will presumably use the Whole Foods business to ensure it can compete for those billions of dollars that will be up for grabs. Can Walmart, Kroger, and Target replicate that model successfully? Their e-commerce efforts have so far been sub-par in comparison to Amazon, so it doesn't look promising.

"Conventional grocery stores currently face many of the same challenges online as they do offline," wrote Blue Apron in the company's filing with the Securities and Exchange Commission. "They have high inventory counts, compete in the sale of commodity products, and confront considerable waste."

That's been the argument many meal-kit delivery executives have made to justify their businesses. They contend that shipping food from warehouses straight to homes is more efficient than shipping to a physical store and then expecting consumers to take a trip to the store, deal with the crowds, wait in line, and buy goods that could be purchased online. Millions of Americans almost exclusively buy their books, electronics, entertainment, and apparel online. What's to stop them from doing the same for grocery items as well?

The reality is Americans want every consumer brand they interact with to be digital and so far, Amazon has been the single-biggest success story in this e-commerce evolution. By buying Whole Foods, the retailer is telling Wall Street it isn't yet out of fresh ideas.

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