Battered by price wars and the rise of foreign discount stores, the grocery industry’s light at the end of the tunnel has been the growth online shopping, but will the entry of Amazon Fresh into the market have significant repercussions for market leaders such as Tesco (LSE: TSCO) and Ocado (LSE: OCDO)?
Amazon Fresh, the online retailer’s grocery delivery service, has rolled out a soft launch in Birmingham and London to select Prime members, but has yet to publicly announce further specifics on the cost of the service. However, one thing we do know is that Amazon’s notoriety for ignoring profitability in favour of building up market share means that the already low online margins that grocery chains enjoy are going to be pushed even lower.
Nearly 6% of all grocery sale are now made online in the UK, and a recent IGD research note predicts online ordering will account for 8.6% of overall sales by 2020 with a value of £17 billion. Meanwhile, the legacy chains are expected to shutter stores as discount competitors such as Aldi and Lidl expand and continue taking physical market share. This means that despite the low profitability, online sales represent a lifeline for the large chains to increase sales. With all the doom and gloom surrounding Tesco’s recent losses and £22bn mountain of debt, one of the few bright spots for management to point out has been their nearly 50% share of online sales. However, customers’ resistance to paying for the full cost of delivery means that Tesco is aiming for far lower than the traditional 5.2% margins they targeted on in-store sales. Tesco’s low delivery charges mean that they will likely hold a solid lead over Amazon Fresh, which in the United States charges both a yearly subscription fee and a high delivery fee, and will also be able to serve a much higher number of customers due to their vast network of stores. For these reasons, I believe Amazon Fresh will do little to affect the bottom line of Tesco; however, the company still faces significant headwinds from other sources and will remain toxic for investors for some time.
The company with the most to fear from Amazon Fresh is the online-only Ocado, which already operates with margins under 1%. Ocado has followed the Amazon model of pouring cash back into building out distribution networks, and has successfully built up a 10% market share and finally turned a small profit of £7 million last fiscal year. However, if Amazon decides to aim for market share at all costs — such as initially running the business at a loss, as it has done with other divisions in the past — Ocado shares will continue to be hit hard, as the growth baked into current valuations appears to be misplaced. Despite the stock being down 30% from highs in July, the company is still trading at an eye-watering 299 P/E ratio.
I see Amazon Fresh as a major issue for Ocado, as both companies will be fighting over the same high-spend customer and Ocado is incredibly limited in its ability to lower prices in response to any loss-making prices that Amazon can survive. For this, and the company’s lofty valuations, I would stay away from the stock until management can prove their ability to continue growing market share.