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The entry of Amazon into the grocery business in a meaningful way has shone a spotlight on an industry already in the midst of disruption. The rise of online grocery shopping is a significant, though not the only, contributor to this disruption. As more consumers buy their groceries through a smartphone or a few mouse clicks, it spells trouble for traditional grocers as well as consumer packaged goods (CPG) companies and real estate investment trusts (REITs), particularly those that own shopping centers with grocery stores as their anchor tenant.

What’s more, Amazon’s recent acquisition of Whole Foods and Walmart’s 2016 purchase of Jet.com make clear that the digital revolution taking place in the industry isn’t just about customers skipping out of stores to shop online. It’s also about how innovative digital companies will reshape the brick-and-mortar landscape and, from an investment perspective, whether or not traditional industry players will succeed in keeping up.

 

Consumers Are Shifting Online

E-commerce accounts for nearly 12% of all retail sales in the United States. For groceries—including “center store” items such as packaged foods and household and personal care products—that number is much lower, at approximately 2% of sales. The penetration rate is higher in countries like South Korea, the United Kingdom and France, and we see significant room for growth in the United States (Exhibit 1).

Exhibit 1

Because the grocery business is mature, its annual growth rate tends to be in the low single digits, and an increase in online shopping could cannibalize much of that growth, leaving little left over for brick-and-mortar retailers. Further exacerbating this shift is consumers’ willingness to spend larger amounts online: The average basket size in a brick-and-mortar store is $40 to $50 compared with $150 for online retailers.1

Certain dynamics are in play online that have implications for traditional grocers and CPG companies. Currently, there are three key players in the online grocery space: Amazon, Walmart and Kroger. As consumers become accustomed to the convenience of online shopping and confident in the quality of the experience, they’ll form habits that are likely to favor these early leaders and increase the barriers to entry for other grocers. What’s more, while Amazon is technically a retail company, its focus on innovation and efficiency, supported by deep technology roots, is likely to propel it forward and keep other companies on the defensive. Amazon is also valued by the marketplace on the basis of its long-term growth prospects, not current profitability, and that gives it an advantage when competing with companies that are valued on more traditional earnings and cash flow metrics.

Another factor at work is how items are displayed online. For online shoppers, search results are the equivalent of store shelves, and products at the top of the list are more likely to get bought. In traditional brick-and-mortar supermarkets, CPG companies have significant control over shelf placement, which helps “category captains” maintain their dominant positions. The same isn’t true online, where unlimited shelf space affords a deeper product selection and retailers build their own algorithms to determine how products are displayed in search results. These algorithms may be less brand-centric and can give smaller brands and private label goods an opportunity to rise to the top. Again, as consumers form habits, they’re more likely to visit the same sites and buy the same items repeatedly. Thus, once smaller brands or private labels gain a foothold, it may be difficult for established brands to dislodge them.

 

How Amazon May Transform the Brick-and-Mortar Experience and Expand Its Private Label Offerings

During its relatively short history, Amazon has developed a reputation for improving the consumer experience through technology. Before Amazon, for example, it could take more than a week to receive an item ordered from a traditional retailer. Today consumers expect 48-hour delivery of items purchased online. We believe Amazon’s ability to change consumer behavior and expectations will translate from the digital domain to the brick-and-mortar world.

One innovation to watch is the checker-less Amazon Go concept store currently being tested at the company’s Seattle headquarters. Amazon has developed “Just Walk Out” technology that tracks customers’ mobile phones as they walk through a store and pick out items tagged with sensors. The company then charges the customer as they leave without requiring them to pass through a traditional checkout process. Before the Whole Foods purchase, the expectation was that Amazon would perfect the technology and roll out its Go concept one store at a time. Now, it appears more likely that the company may launch it widely across Whole Foods locations. Assuming customers try out and like the frictionless checkout process, it could create a competitive advantage for Amazon that, given the complexity of the technology required, might be difficult for other traditional grocers to replicate. It may also lower labor costs for Whole Foods stores, as cashiers are replaced with technology.

Further, Amazon has acquired Whole Foods’ thriving “365” private label portfolio and is already making it available online. Unlike store brands of the past, these products are associated with healthy ingredients and quality, and may offer one of the faster ways for Amazon to monetize the Whole Foods transaction. The company has already cut prices on many of these private label (and other) items, demonstrating its desire to draw price-sensitive shoppers to Whole Foods, a move designed to increase market share and compete with Walmart. The price cuts may also exert downward pressure on prices industrywide.

 

Implications and Investment Opportunities Across Sectors

As discussed, the growth in online shopping stands to hurt the majority of traditional grocers that lack a strong online presence, while CPG companies may lose share to smaller brands and private label products, and face increased pricing pressure. These forces are also pressuring grocery-anchored REITs. With little, if any, growth in brick-and-mortar grocers, the amount that retail stores can earn on top of their fixed costs, like rent, utilities and labor, is shrinking, and thereby hurting margins. REITs in urban locations could feel the pinch first because the online shopping model works particularly well in more densely populated locations where delivery to apartment houses is more efficient compared with sprawling suburbs. Amazon, however, has broad geographic coverage with existing warehouses and infrastructure, so it is in a good position to compete even in non-urban areas.

Given significant pressure resulting from many factors, fewer customers in stores, and smaller grocery store footprints becoming more desirable in part because of the success of hard discounters like Aldi and Lidl whose footprints, on average, are 80% smaller than traditional supermarkets, we expect to see industry consolidation and less demand for square footage (Exhibit 2).2This change may lead to a rise in anchor-tenant vacancies for these grocery-focused REITs. With no large grocery store drawing customers into shopping centers, the foot traffic that smaller stores in the shopping centers rely on will decline. As these smaller stores subsequently close or move, it will further increase vacancies and pressure rents.

Exhibit 2

Groceries are an integral component of life, and this theme has implications that transcend portfolios. Ultimately, consumers may see the biggest gains as prices decline and conveniences increase. For many traditional industry players, however, the picture is less rosy, and we believe that the pressure on grocers, CPG companies and grocery-anchored REITS will take several years to resolve. In the meantime, many of these companies represent attractive opportunities for short positions as we anticipate a decline in some of their stock prices.

For more on this theme, see our recent blog: Price Check: How Hard Discounters Are Disrupting Grocers.

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  1. ^Source: General Mills Analyst Investor Day Presentation in 2017.
  2. ^Note: Estimate based on a comparison of the typical store size of Kroger, Albertsons, Publix, and Stop & Shop versus the typical store size of an Aldi.