The supermarket business model is old, but it's becoming an increasingly diverse industry.
Many traditional companies suffer from a lack of real competitive advantages, which means the addition of digital disruption -- with retail giant Amazon.com (AMZN -1.17%) leading the charge -- results in some serious grief for supermarket investors. For some businesses, a rebound might be on the horizon, but it may be time to bail out on others.
Different approaches to evolution
Even before Amazon began its foray into the space with Amazon Fresh and now with its recent introduction of free two-hour delivery from Whole Foods for Prime members, big-box stores such as Walmart (NYSE: WMT) and wholesale clubs such as Costco (NASDAQ: COST) created some serious competition for the traditional supermarket.
Kroger, the largest grocery retailer in the U.S., has moved toward diversification over the years, operating under different regional grocery store names across the country. It also has fuel, jewelry, pharmacy, and food production operations. The broad nature of its business has helped stave off much trouble, but revenue and profits have begun to slow the past few years. Kroger reported comps of 1.5% (without counting fuel) for the fourth quarter of 2017 and issued tepid guidance of 1.5%-2% growth in comps for this year -- indicating that it doesn't expect the competition to lessen any time soon.
Kroger began offering online ordering and pickup services a few years ago, and now it's doubling down on its digital transformation. Through its "Restock Kroger" plan, more emphasis will be placed on digital sales and convenience, competitive pricing, artificial intelligence and robotics, and growing alternative revenue streams such as advertising.
SUPERVALU, on the other hand, has decided to transition to a wholesale-based model instead of a retail one. It has been offloading stores, most notably when it sold its Save-A-Lot chain to private equity firm Onex Corp. at the end of 2016. Other cost savings initiatives around its retail business have been pursued, but its wholesale business now make up three-quarters of revenue.
While sales have begun to improve through the change, profitability continues to head in the opposite direction. SUPERVALU's fiscal year-to-date earnings per share were down 77% from last year.
Though its stock performance has left much to be desired, Sprouts Farmers Markets has posted steady business growth since making its public debut in 2013. The chain operates in the organic grocery segment, and shares had a volatile 2017 as investors mulled the reality of having Amazon, via its purchase of Whole Foods, become a direct competitor. But seeing business results continue to go in the right direction helped assuage fears.
Sprouts is still a small grocer, with only 300 stores in 15 states as of the end of 2017. It has a lot of room to build, but it could also have the most to lose as Amazon expands its grocery offerings and better-established chains adapt to the new digital business reality. Despite the odds, Sprouts' revenue and profit grew 15% and 22%, respectively, in 2017.
Momentum is hard to beat
Old supermarket businesses are finally taking digital disruption seriously, but with mixed results. They may survive in some form, but the uncertainty should give investors pause. When competing against a force that has momentum propelling it forward, having to rethink the business model is an unenviable position to be in. Remember what Walmart did to retail during the last century?
If I were to keep one supermarket stock, it would be Sprouts, since it's been defying the odds and has the trend toward higher-quality food going for it. As for the others, I'd consider long and hard whether they even belong in a long-term portfolio.