investing

Grocery Stocks After Amazon: It's Too Soon to Hunt Bargains

Amazon's bid for Whole Foods has depressed share prices across the retail sector, but don't go looking for deals yet.

It was the shot heard ’round the retail world. When Amazon.com (symbol AMZN) announced its deal to buy upscale grocer Whole Foods Market (WFM) for $13.7 billion, investors in everything from warehouse clubs to grocery stores to drugstore chains ducked for cover.

Fair enough. No one wants to compete with Amazon. The largest U.S. e-commerce company has a voracious appetite for growth and has proved willing to forgo profits in pursuit of it. As a result, Amazon has put relentless pressure on retailers that sell everything from clothes to consumer electronics.

Now it’s the grocery business’s turn. Share prices across the sector plunged after the deal was announced on June 16. Even investors in drugstores got nervous. What if Amazon’s move into brick-and-mortar retail gives the company a beachhead for invading their market, too?

Stocks of Amazon’s perceived victims have continued to struggle. From the June 15 close through July 5, shares of Smart & Final Stores (SFS) dived 23%, SuperValu (SVU) sank 14%, and Kroger (KR), which was also hit by disappointing quarterly results, fell 5%. Walmart Stores (WMT), which derives more than half of its sales from groceries, declined 5.4%. As for two retailers Kiplinger's has written about recently, Costco (COST) fell 12%, but CVS Health (CVS) slipped only 0.5% as investors quickly realized that the firm, which has a huge pharmacy-benefit business, is more than a drugstore chain.

When a sector sells off indiscriminately, bargains often materialize. The challenge in finding winning stocks in the grocery aisles is that food prices have been falling. When that happens, it’s harder to sell groceries profitably. The long-term drop in food prices makes all of these stocks tricky picks, at least at current prices, says Kim Forrest, senior analyst at the Fort Pitt Capital Group. She advises against buying up shares of Whole Foods’ rivals. “It’s too soon to go there unless they have a ‘magic’ formula to overcome the deflation that is omnipresent in the grocery business.” Moreover, she says, Amazon is just one factor behind falling food prices. “The expansion of discount grocers Lidl and Aldi should be concerning, too,” Forrest adds. “It’s great for consumers, not so great for shareholders.”

Against that backdrop, companies that have low prices baked into their DNA are in a stronger position than others, analysts say. Take Costco, for example. Analysts at Cowen & Co. say the warehouse club has proved itself adept at dealing with food-price deflation throughout its existence. It already knows how to thrive with low prices and so-called loss leaders, such as discounted gasoline. Besides, its business model goes beyond just selling groceries. It derives most of its operating profit from membership fees. Furthermore, part of its appeal is that you can stumble upon discounts while walking through the physical store, which is known as the “treasure hunt” effect.

Costco’s June sales indicated that it’s hardly in trouble. Sales at stores open at least a year came in well ahead of what investors were expecting. Costco's membership-based model also showed its strength. Rather than scare new customers away, a $5 increase in membership fees to $60 annually padded the company’s bottom line. "While many retailers have faced increasing pressure from online retail, Costco's latest results help serve as a reminder of just how powerful its membership model has become,” say analysts at UBS.

Walmart also deserves a closer look. The world’s largest retailer, with 4,700 stores in the U.S., Walmart has hardly been passive as Amazon seduces its customers. In January, the retailer eliminated the $49 membership fee for free two-day shipping and cut the minimum order for free shipping from $50 to $35. At Amazon, customers need to sign up for Amazon Prime, which costs $99 a year, to get free two-day shipping.

Meanwhile, Amazon is expected to turn Whole Foods’ 466 stores into distribution points, and there’s no reason Walmart can’t use its own stores in a similar way. Cowen notes that about 90% of the U.S. population lives with 10 miles of a Walmart store. At the same time, the company has made building up its e-commerce business a priority. With the real estate already in place, Walmart is also capable of selling groceries online and delivering them to customers’ doors. And, of course, Walmart’s motto is “Everyday Low Prices.”

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