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Amazon Is About to Blow Up Its Profits Once Again

By Jeremy Bowman – Oct 16, 2016 at 5:00AM

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The e-commerce giant is planning to launch a network of brick-and-mortar stores. Here's why that could be a problem.

Image source: The Motley Fool. (AMZN -0.59%) is plunging headlong into yet another industry. According to The Wall Street Journal, the e-commerce giant is planning to open convenience stores and curbside pickup locations nationwide to accelerate the growth of its grocery business.

The stores will carry perishable items such as produce, dairy, and meat that are often challenging and costly to deliver, and the company will also offer drive-through curbside pickup at other locations, much as grocery leaders Wal-Mart (WMT 0.82%) and Kroger (KR 1.09%) are already doing.

Amazon started its Fresh grocery delivery service in its hometown of Seattle in 2007, testing it for six years before expanding the program to a handful of cities including New York, San Francisco, and Los Angeles. Now, a network of stores may seem like a logical next step as Amazon seeks to grab a greater share of the $600 billion U.S. grocery market.

It's no surprise that Amazon would want to grab a greater share of Americans' grocery spending: The company seeks to be a one-stop shop everything a consumer could want, and there's no category bigger than grocery. But while Amazon has come to dominate retail segments including books, electronics, and (increasingly) clothes, grocery presents a distinct set of hurdles that may make it particularly difficult from to turn a profit.

Still, that has never been a dissuading factor: The company's founder and CEO Jeff Bezos has embraced risk-taking and failure, and is well known for thinking long term and his willingness to forgo profits. As recently as 2015, Amazon was reporting quarterly losses, but profits have spiked recently thanks to the strength of its cloud computing division. But opening up hundreds of stores would be a costly move, and is likely to put a dent in profits, at least over the near term.

Out of its element

On its way to becoming one of the most valuable companies in the world, Amazon has tied together a few key competitive advantages that have driven its e-commerce program to prominence. Its Prime membership is enormously popular, offering perks such as free two-day delivery, video streaming, data storage, access to the Kindle Lending Library, and more, all for a low price of $99/year. With millions of SKUs (stock-keeping units), the company has a breadth of inventory unmatched by any retail store, and its collection of reviews provides detailed data and recommendations, giving it an advantage over other e-commerce sites.

In the case of Amazon Fresh, however, none of those advantages apply. Grocery delivery is too costly to be included among the benefits of Amazon Prime, and instead costs an additional $15/month, which is more expensive than many competing services. Instacart, in which Whole Foods Market has taken a stake, offers free two-hour delivery for a $149 yearly fee, or nearly 20% less than Amazon.

When it comes to food, especially perishables, a wide inventory range is not particularly helpful and neither are customer reviews. Consumers tend to buy the same perishables over and over again, and no one needs to read a review on yellow onions or whole milk, meaning they are exactly the opposite of the kind of product Amazon excels at selling. If anything, consumers want to be able to touch and see such products before buying them, adding another hurdle to grocery e-commerce.

An uphill battle

With its dependence on brick-and-mortar infrastructure, grocery is one area where retailers like Wal-Mart and Kroger have an advantage over Amazon. Wal-Mart has been rapidly expanding its grocery pickup program and expects to have it available at more than 1,000 locations, or a quarter of its store base, by the end of next year. Amazon seems to have aspirations to match Wal-Mart here, but this type of program is much more cost-effective for Wal-Mart, which already has parking-lot space it can easily use for a pickup kiosk. Amazon, on the other hand, needs to find such real estate and convert it to its purposes. Wal-Mart also has stores within five miles of 70% of the U.S. population, making such a network difficult for Amazon to match.

Launching a brick-and-mortar network of stores seems to undermine Amazon's cost advantage as a strictly e-commerce operation, and even if it is successful in attracting customers, margins in grocery are notoriously thin. Kroger, the largest pure-play grocery chain, has a profit margin of less than 2%, meaning that even if Amazon is successful with its chain of convenience stores, the profits from it probably won't be enough to move the dial for a company already worth close to $400 billion. And it will mean significant costs over the coming years, which will weigh on the company's bottom line.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Kroger. The Motley Fool owns shares of and recommends and Whole Foods Market. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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