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Equity Perspectives

Four Lord Abbett analysts assess the implications of Amazon’s recently announced plan to purchase Whole Foods. 

 

In Brief:

  • E-commerce’s penetration of the food and grocery business has a long way to go when compared to media, home and garden, and books.
  • But greater use of advanced technology, such as deep learning, machine learning and computer vision, should figure prominently in improved automation, check-out, and delivery systems.
  • The whole grocery experience, which many consumers find inconvenient, is likely to undergo massive change.
  • Much will depend on how efficient state-of-the-art delivery systems become.
  • While it is difficult to estimate the amount of capital that will pour into such a strategy, the risk of over-investment is real—so is the risk of not maintaining quality.

 

Just when times seemed fairly tough for food retailers, already beset by two German discounters expanding into the United States, along comes Amazon with plans to acquire heretofore struggling Whole Foods, in a deal that could revolutionize the grocery business through innovative e-commerce strategies.  

Of course, it remains to be seen how Amazon plans to leverage its prodigious technology, logistics, and strategic advantages to disrupt yet another retail distribution channel—there certainly will be challenges, especially when it comes to delivering perishables such as meat, fish, and vegetables, which helps explain why supermarkets still dominate food retail sales. (See Chart 1.) But the investment and industry implications of this blockbuster deal reverberated loudly among Lord Abbett investment professionals, ever mindful of how much money consumers spend on food each year versus other expenditures. (See Chart 2.)

Portfolio managers and research analysts for both the equity and fixed-income side have been sharing their perspectives ever since the deal was announced on June 16. After all, the food retail sector already has been struggling with low margins, the loss of market share to big-box discounters and club formats, and the formidable expense of upgrading their e-commerce capabilities. Now Amazon was moving aggressively into the food chain itself, conjuring all kinds of questions about online shopping, pricing, expanded merchandising (like drugs and health and beauty aids), market segmentation, customer loyalty programs, and new delivery methods, like drones (which are used more widely for other goods in China). 

Suffice it to say, e-commerce’s penetration of the food and grocery business has a long way to go when compared to media, home and garden, and books, to cite three of the categories that have changed the most. (See Chart 3.)  But greater use of advanced technology such as deep learning,1 machine learning2 and computer vision should figure prominently in improved automation, check-out, and delivery systems, said Lord Abbett research analyst Eric Ghernati. “The whole grocery experience, which many consumers find painful, is likely to undergo massive change.”

Enter John McMillin, Lord Abbett partner and research analyst, who has been covering all kinds of consumer companies for the last 32 years; Lord Abbett equity research analyst  Anthony Attardo (consumer discretionary); and Lord Abbett partner and fixed-income analyst Emanuela Scura (consumer)—all of whom have keen insight into the investment opportunities and the pitfalls in industries that have been transformed by technology, consolidation, and demographics.

McMillin described the Amazon–Whole Foods deal as a “binary event, “which is to say that it either will work or it won’t work—an allusion to the fact that many customers still prefer to squeeze bananas, inspect beef, or check the color of fish before they buy them. Trusting an anonymous clerk in a remote warehouse to fulfill orders properly could be a huge leap of faith for some consumers.

“Right now, online food purchases are pretty low as a percentage of industry-wide volume, and I think it’ll take a while to get them significantly higher” McMillin said. “But a lot will depend on how efficient state-of-the-art delivery systems become.”

“Most companies have flunked the ‘last-mile’ test,” said Ghernati, alluding to the potential perils of getting perishable foods from a nearby store or warehouse to the consumer. Crop failures, severe weather, network issues, and delivery snafus are just some of the things that can complicate matters.  

Even so, Amazon’s aggressive move into the consumables space definitely had a negative impact on the shares of department stores covered by Attardo, particularly stores with customers who already pay an annual fee to Amazon for free delivery of all kinds of goods. But much depends on whether Amazon uses its expanded brick-and-mortar locations to distribute non-consumables.

Another big question is whether Wal-Mart decides to compete more aggressively with so-called “dollar stores.” Wal-Mart already controls the biggest share of the U.S. food and grocery market, with about 14.5% of all sales, according to GlobalData Retail3—but the retail giant will be watching Amazon closely.  Several recent reports say Wal-Mart is already telling some partners and suppliers that their software services should not run on Amazon’s cloud infrastructure.

Scura said the Amazon acquisition of Whole Foods underscores the threat of e-commerce to existing food retailers, particularly smaller ones that have been hard pressed to invest in the technology it takes to make grocery shopping more convenient for consumers. “We are likely to see not only accelerated e-com penetration but also more aggressive promotions from both e-com and traditional players,” she added. “Will there be an apparel target as well?”

In any case, Scura believes the food retailers most at risk, at least in the short term, are those with overlapping demographics with Amazon and with overlapping geographies with Whole Foods. 

 

Chart 1. Supermarkets, Warehouse Clubs, and Supercenters Still Dominate U.S. Food Sales
Estimated U.S. food retail sales by channel

Source: U.S. Census Bureau 2012 Economic Census and BofA Merrill Lynch Global Research estimates. 
Note: Wal-Mart grocery sales are split between two categories: supermarkets/warehouse clubs and supercenters.  The supermarket category includes spending at Wal-Mart stores where grocery accounts for a majority of sales (e.g., neighborhood markets).

 

Chart 2. U.S. Consumer Spending by Category, Fiscal Year 2015
$ in billions

Source:  Barclays Research, U.S. Census Bureau, U.S. Bureau of Economic Analysis, and the Bureau of Labor Statistics.

 

Chart 3.  E-commerce Penetration by Category

Source: Barclays Research, U.S. Census Bureau, U.S. Bureau of Economic Analysis, and the Bureau of Labor Statistics.
Note: Penetration for e-commerce estimates excludes non-e-commerce categories, such as motor vehicles, gas, and event tickets.

 

A Potential Game Changer
While the stocks of major food retailers and discounters sold off after the Amazon–Whole Foods announcement, McMillin thinks the market might have overreacted a bit. In other words, he doesn’t believe e-commerce will make grocers as endangered a species as on the ground booksellers have become in the last decade, but grocers definitely will have to sharpen their approach.

“This is a game of trying to stay relevant to your consumers,” McMillin said. “Some major grocers have already adopted ‘click and collect’ systems in place, which allow consumers to order online, then pick up their orders more quickly and conveniently. Some have made good use of loyalty cards, which helps them know their customers, and anticipate, and discount, future purchases based on prior shopping patterns.  One major discounter is even paying some of its employees to drop off packages on their way home from work.”

Whether such systems will be enough to satisfy consumers in the long run is another matter. Imagine going into a store in the not-to-distant future, where built-in sensors immediately identify you from your smartphone, where you can pull products of the shelf, automatically get billed, receive targeted promotions, while you continue to shop—and then just walk out of the store. 

“The ‘secret sauce’ will be knowing exactly what to have in stock based on knowledge of purchasing behavior, and that’s even more important in the grocery market because of perishables with a much shorter shelf life,” said Ghernati. “So look for much greater innovation aimed at a wide range of potential outcomes and ways of getting closer to consumers and providing them with greater value than they get from their current grocery experience.”

Now, ask yourself how many investors would want to own supermarket companies in the face of such transformative and capital-intensive innovation. Sure, some retailers may have been oversold in the wake of recent deals, but investors still may be reluctant to bet on a short-term bounce upward.

“The grocery industry has become increasingly competitive and harder to read in just the past two to three years,” said McMillin. “And nobody is keen to consider companies engaged in a race to bottom to see who has the lowest prices. However, a pickup in inflation could benefit some grocers.”

How Big Is Too Big?
With numerous Amazon warehouses already in place around the nation, there has been considerable speculation about the role of the Whole Foods’ 460 stores.4  While the back end of such stores will probably undergo automation, Ghernati expects those locations could well become “hubs” for distributing a broader range of merchandise over time.

At this early stage, it is difficult to estimate the amount of capital that will pour into such a strategy, but Ghernati said the risk of over-investment is real. So is the risk of not keeping the identity of Whole Foods, maintaining quality or, for that matter, rushing into a market customers aren’t familiar with or willing to accept.

Meanwhile, could all this lead to unfair trade practices, as some antitrust law experts and consumer advocates have suggested? 

Ghernati believes such concerns are overblown. For one thing, U.S. antitrust authorities have generally looked favorably on deals that reduce consumer prices. For another, consumers increasingly prefer the convenience of shopping anytime, anywhere, anyplace.

“Antitrust regulators typically come to companies that use monopoly power to raise prices or keep competitors at bay,” said Ghernati. “With e-commerce today, prices are actually dropping, and competitors are dropping out because they are stuck with decade-old technology and not willing to adapt to the new reality of changing consumer behavior and consumption.”

 

1 Deep learning is a fundamentally new software model, where billions of software “neurons” and trillions of connections are trained, in parallel, which has caused a significant change in chip demand and applications based on graphics-processing units. Deep learning, the fastest growing part of machine learning, is used to help solve many big-data problems, such as computer vision. Practical examples include vehicle, pedestrian, and landmark identification for driver assistance (including predictions of where traffic jams might occur); image recognition; speech recognition and translation; natural language processing, and life sciences.
2 Machine learning is a branch of computer science that evolved from the study of pattern recognition and computational learning theory in artificial intelligence. Arthur Samuel, a scientist perhaps best known for computer checkers, defined machine learning in 1959 as a "field of study that gives computers the ability to learn without being explicitly programmed."
3
Lauren Thomas, “Don't Worry, Wal-Mart; Amazon Buying Whole Foods Is Just a 'Drop in the Bucket,'” CNBC, June 21, 2017.

4 Diane Bartz, “Critics Say Whole Foods Deal Would Give Amazon an Unfair Advantage,” Reuters, June 22, 2017.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.  If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments involve risk, including possible loss of principal. No investing strategy can overcome all market volatility or guarantee future results.

The opinions provided in this posting contains the current opinions of the author are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This commentary is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This commentary is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.

Not FDIC-Insured. May lose value. Not guaranteed by any bank. Copyright © 2017 Lord, Abbett & Co. LLC. All rights reserved.  

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