For Amazon, Now Comes the Hard Part

This article originally appeared in The Wall Street Journal. Click here to view the original article.

With Amazon.com Inc. wheeling sharply into the grocery aisle, the business of selling food may never be the same.

Food retailing was already struggling with low margins and slow sales growth as shoppers shifted buying patterns. New players have swarmed the crowded market, with grocers ranging from giants Wal-Mart Stores Inc. and Kroger Co. to smaller chains fighting to attract consumers, in large part by slashing prices.

And the industry has been struggling to figure out how to sell fresh food online.

Amazon’s agreement to buy Whole Foods Inc. could add to the saturated market as it puts more of its own groceries into the distribution system, while putting new pressure on grocers to figure out how to sell fresh food online lest the web giant beat them. The deal is “a seminal moment in the world of eating,” said RBC Capital Markets LLC analyst David Palmer.

It isn’t at all clear whether the king of e-commerce can do in fresh cabbages what it has done in CDs, books and just about everything else. Amazon and Whole Foods combined still have a small fraction of Wal-Mart’s share of groceries. And Amazon faces a “last mile” logistics problem of getting fresh food to doorsteps that it doesn’t with other goods.

“This is going to be one of the hardest areas for them to get into,” said Kent Knudson, a partner at consulting firm Bain & Co., “because of some of the physical challenges of getting food into people’s homes.”

The challenges for grocers today include a new reality: The days of shoppers filling carts during a big weekly trip to their neighborhood supermarket appear over for now. Consumers are more targeted in their shopping habits. They are less loyal to retailers and more willing to buy groceries online. And they are buying more from stores at two poles: ones with cheap prices, and ones that offer high-quality fresh food, often at a premium.

Grocery sales last year barely budged from 2015 levels, after rising a bit more than 2% in each of the previous three years, according to market-research firm Nielsen. Kroger ended a 13-year streak of rising quarterly same-store sales this year, while Wal-Mart, which gets more than half its sales from groceries, and Target Corp., have struggled, too.

Consumers want “convenience, selection and the right price and they want it now,” said Natalie Kotlyar, head of the consumer business practice at consulting firm BDO USA. “Everyone is trying to meld those concepts to create the perfect shopping experience.”

Amazon, which has revolutionized the way people shop, is betting it can learn the business and solve at least part of the puzzle. It has shown a willingness to forgo profits for years to build market share in an industry. It has cash to burn, deep experience in logistics and a record of relentlessly driving down supplier costs. And its big push into fresh groceries will likely force other food retailers to accelerate efforts at making e-commerce work if they are to remain competitive.

E-commerce has been tough to crack for the more-than-$700 billion grocery sector because selling food online is inherently complex. Last year, online shopping accounted for 2% of the sector’s sales, according to consulting firm Kantar Retail.

People want to squeeze their produce, pick out their vegetables and inspect their meat. Making sure fresh groceries stay that way through transit is challenging yet crucial for attracting shoppers. “It’s really the fresh categories such as produce and meat that are driving people’s decision of where to shop,” said Bain’s Mr. Knudson.

Wal-Mart, Peapod LLC and FreshDirect LLC have been competing to deliver groceries faster and more cheaply. But fresh-food delivery is typically unprofitable, analysts and some companies said.

“Amazon has obviously reinvented supply chain and logistics in a way nobody has,” said Doug Ehrenkranz, a 25-year food industry veteran who is now a recruiter at Boyden Global Executive Search. Now, the more-than-460 Whole Foods stores across the country give Amazon access to the kind of refrigerated distribution system its regular fulfillment network lacks, all while tapping into the upmarket natural and organic foods market that it has barely touched.

“Wal-Mart and Kroger will feel pain for a while and the regional players that can’t move fast enough will disappear,” said Diana Sheehan, director of retail insights at Kantar Retail. “The bigger concern becomes, what does Amazon do next? Once they’ve navigated the Whole Foods space, they’ll learn how to play in mainstream grocery, too.”

Amazon and Whole Foods declined to comment for this article.

A Kroger spokesman said: “We’re in the middle of a transition today both because of the operating environment and the competitive landscape. We will continue to evolve.” Target said grocery is a key business for the company.

A spokeswoman for Peapod said it is profitable in its mature, established markets. “The grocery industry is a low-margin business and last mile logistics make margins even more challenging,” she said. Wal-Mart said: “We feel great about our position.”

Fresh-food logistics

While Amazon could put pressure on others to step up their e-commerce game, it has struggled for years with a logistical challenge in fresh food that it doesn’t in books and electronics. A Cowen & Co. report points out: “The entire fulfillment process is more complex and time consuming from the moment a ‘grocery’ shipment arrives” at a fulfillment center until it is shipped, what with the need for refrigeration and attention to factors such as “expiration dates, smell, and color, among others.”

The Amazon-Whole Foods deal came together relatively quickly, according to people familiar with the matter, indicating Amazon may not yet have a fully formed strategy for Whole Foods.

Amazon will try to expand the appeal of Whole Foods by using its efficiencies to lower prices, which would bring a fresh wave of pressure to the beleaguered sector, said Chris Baker, a retail and consumer-goods expert at management consulting firm Oliver Wyman. 

The supermarket business has always been tough, in part because American consumers have grown accustomed to cheap food. Supermarkets arose out of the Depression, as the efficiency and scale of larger stores made food more affordable for consumers than shopping at local cheese and meat markets, said food historian Andrew F. Smith. As suburbs developed after World War II, grocery chains expanded and found that stocking more inventory provided greater economies of scale.

By the 1970s, there was saturation in the supermarket industry, according to Mr. Smith, and a national recession led to the creation of discount warehouse stores. Competition from fast-food chains and price wars in the grocery sector fueled a wave of consolidation in the 1980s.

A seismic change hit the industry in the 1990s when Wal-Mart began selling low-price food and within a decade became the nation’s largest grocer. Ever since, traditional grocery chains have been scrambling to compete. In recent years, price competition has become even more fierce as the number of retailers has grown.

There were more than 262,800 stores selling groceries in 2015, up 17% from a decade earlier, according to an analysis by the Willard Bishop grocery consultancy. “There are so many places to food shop and there’s not an infinite number of consumers,” BDO’s Ms. Kotlyar said. “All of these different stores are just splitting up the shoppers among themselves.”

Recent commodities deflation has forced grocery stores to slash prices on such staples as milk, beef and eggs. Labor costs have risen, applying further pressure to profit margins.

Other changes have taken root in recent years. Consumers are far more curious and educated about the source and content of their food, thanks to books and documentaries about the food industry and the rise of television cooking shows. More upscale organic-food stores have opened in response, eating into grocers’ market share while simultaneous demand for convenience has fueled the rise of meal-kit services such as Blue Apron Holdings Inc.

Grocery executives say they are willing to lower prices at the expense of profits if that’s what it takes to keep shoppers from turning to online and discount stores. Even Whole Foods has taken a hit to its margins by lowering prices in an effort to win back customers.

“We are not trying to lead the market down on price,” Kroger Chief Executive Rodney McMullen said in an interview last week. “But we want to make sure we won’t lose a customer based on price.”

Meanwhile, new discounters are still entering the U.S. market. German grocery chain Aldi said this month it planned to invest $5 billion over five years to open nearly 900 stores in the U.S. and remodel hundreds more. Rival Lidl, another German discounter, entered the U.S. market with 10 stores this month—another “body blow” to the traditional U.S. industry, said Craig Johnson of Customer Growth Partners, a retail research and strategy group.

Aldi and Lidl have disrupted European grocery markets by offering low prices, and company officials have said they believe they can aggressively compete in the U.S. market as well.

Driving downward pressure on prices are frugal shoppers such as Meg Meyers, a 35-year-old psychotherapist and married mother of two in St. Louis, Mo. She said she buys food exclusively at Aldi to help stretch her household’s $79,000 annual income, which also goes toward student loans. “We have no disposable income,” she said, adding that she limits her purchases to about $100 a week using a meal-planning app that enables her to buy only what she needs.

Amazon, which first entered the food sector several years ago with dry groceries via its website, has slowly built its Fresh grocery-delivery business over years by targeting cities where it already owns large warehouses in part to avoid the need for refrigerated trucks. Still, Amazon has faced the same problem others have: Many consumers have been slow to buy produce and fresh items online.

Amazon has tiptoed into the brick-and-mortar grocery-store business this year, opening two Fresh Pickup stores in its hometown of Seattle and has explored various ideas for other types of grocery stores.

But Amazon’s deal to buy Whole Foods for $13.7 billion, including debt, may help close a gap in its offerings. “Amazon can’t compete in grocery without bricks and mortar,” said Ms. Sheehan of Kantar Retail. “Fresh food is at the heart of what grocery is. Shoppers trust their grocery store for fresh meats, seafood, produce and dairy and Amazon has struggled to convince shoppers that they should be the store people go to for fresh food.”

Amazon’s ‘last mile’

NPD Group Inc. food analyst David Portalatin said the Whole Food stores would solve much of “Amazon’s ‘last-mile’ delivery challenge for fresh groceries.” He said that logistics hurdle was a big reason Amazon hasn’t been able to make a dent in the grocery shopping of the 60% of millennials who already buy other items from Amazon.

The migration online for at least a portion of grocery purchases, led by Amazon, almost certainly means a further shakeout in the industry. The online grocery industry could grow into a $100 billion business over the next decade, according to Nielsen and the Food Marketing Institute.

“I would be the first one to sign up for Whole Foods delivery and would probably never step foot in the store again,” said Judah Ross, 29, an entrepreneur who lives near the Whole Foods flagship store in Austin, Texas, and shops there every other week. “Whole Foods is a pleasant place but I hate going out to shop for groceries. Even though it’s so close, there’s traffic, parking and waiting in line. The convenience of delivery would outweigh any benefit of picking out the food.”

Whole Foods currently partners with delivery service Instacart to offer grocery delivery in some cities.

Chains that don’t adapt quickly to the changes in consumer behavior and business dynamics won’t survive, say analysts, who, along with some supermarket executives, expect more consolidation in the coming years and predict more grocery stores will close.

To compete with Amazon, Wal-Mart is offering curbside pickup and home delivery in test markets. Kroger is expanding its platform for customers to order groceries online and pick them up at the stores. It also said it has invested $3.8 billion in lowering its prices over the past decade.

Albertsons Companies Inc., which owns Safeway, says it will offer grocery delivery in eight of the 10 most populated markets in the U.S. by February. It declined to comment for this article.

Even though it is expensive for Albertsons, Chief Executive Bob Miller said in an interview earlier this year, he doesn’t want Amazon to beat him to his customers. “Technology is changing rapidly. Amazon is a prime example of that,” he said. “We don’t want to be cutting edge, ahead of the curve, but we want to be understanding what’s going on.”

—David Benoit and Laura Stevens contributed to this article.

Appeared in the June 19, 2017, print edition.