(AMZN -1.86%) may lead the online grocery market, but it badly trails behemoth Walmart (WMT 1.46%) in sales at physical supermarkets. Although Whole Foods Market gave the e-commerce giant its first real taste of store-based grocery sales, that chain's strict quality standards are a limitation preventing Amazon from ever really gaining ground.

That is likely the reason behind The Wall Street Journal's report that Amazon is aggressively pursuing a new grocery store model that will be completely separate from Whole Foods. With an ability to sell any and all food products and produce, Amazon can more effectively challenge Walmart and other supermarket chains.

Smiling woman leaning on shopping cart

Image source: Getty Images.

Grocery lives on slim margins

Despite the vast shadow it casts over e-commerce, even Amazon can't evade the costs associated with getting groceries to consumers. It's already a notoriously low-margin business, and the online channel adds layers of expense to groceries even as it removes those associated with having a physical presence. And Amazon hardly makes any profit as it is from its e-commerce ventures; Amazon Web Services is the primary source for the company's profits.

Moreover, online grocery sales are only a tiny sliver of the entire supermarket industry, and Amazon's lead over Walmart is fairly slim: 12.5% to 11.1% in 2017, the most recent figures say. Some analysts believe Walmart will overtake Amazon this year in the online grocery business.

So even though Whole Foods -- with its persistent pricey image -- gives Amazon some margin to play with, its self-limiting organic mandate means there is a large swath of the public the e-tailer is missing out on.

Check out the latest earnings call transcript for Amazon.

Lurching forward

Amazon's new grocery venture reportedly will include dozens of brick-and-mortar locations across the country, with the first appearing in Los Angeles, possibly as soon as the end of this year, and more to follow in 2020. The stores will be smaller than the typical supermarket -- 35,000 square feet versus the 65,000-square-foot average. 

It's another zigzag movement by Amazon as it tries to navigate the transition to omnichannel retailer from online-only, one that seems to be progressing in fits and starts. In just the past few months, Amazon has announced plans to:

  • Open 3,000 Amazon Go stores by 2022, which would require it to open 1,000 locations a year.
  • Stop expanding the 365 by Whole Foods discount chain, after which it said it was placing them all under the Whole Foods banner.
  • Expand Whole Foods' presence in suburbia by offering Prime delivery.
  • Close all 87 store-in-store pop-up locations inside retailers like Kohl's.
  • Expand its Amazon 4-star and Amazon Books chains instead.
  • Open traditional grocery stores, and pursue a strategy of acquiring smaller, local chains to accelerate its expansion plans.

Organized chaos

Groceries are a highly competitive space, dominated by the likes of Walmart and Kroger, with pressure from discount chains such as Aldi and Lidl. 

Amazon is already trying to bolster its own margins by telling consumer product companies to change the packaging for products it has a tough time making a profit on, or just eliminate them entirely. And it has abruptly stopped buying products from some wholesalers, telling them to sell their goods directly to consumers as having to buy, store, and ship these items makes them less profitable for Amazon.

A more-traditional grocery store opens up opportunities for Amazon to serve more customers, who'll be further immersed in its Prime loyalty ecosystem. And by refining its e-commerce business' profitability, Amazon is now ready to tackle the physical retail world, taking the vast consumer data it has accumulated over the years and creating a profitable grocery model.