INTRODUCTION

It’s clear that Amazon’s $13.7b acquisition of Whole Foods will result in lower prices at the notoriously expensive grocer. What’s less clear is how Amazon will accomplish this. Most expect them to bring-to-bear their formidable supply chain and delivery know-how, driving prices lower by revolutionizing how groceries are shipped and distributed. While these are surely some of Amazon’s long-term goals, this presupposes that Amazon has already solved the unique challenges of storing and shipping groceries. The reality is Amazon does not yet have the core competencies required to operate a grocery supply chain. These they will learn from Whole Foods.

But if improvements to the supply chain or logistics are still a ways off, then the question remains: how will Amazon reduce prices? We posit that by automating in-store operations via technology (e.g., self-checkout) and pushing more private label products, Amazon will drive down expenses by billions of dollars. They will then pass these savings right back to the customer in the form of lower prices and better value for Prime members.

THE GROCERY CHALLENGE

Grocery is the holy grail of retail—nearly every individual must buy groceries on a regular basis, and what does get purchased is often the same from week to week (e.g., meat, eggs, milk, bread). At $650b, annual US grocery sales are 6x Amazon’s revenue, yet only 2% of those sales are done online. So grocery presents a massive opportunity for Amazon, but despite the company’s operational efficiency and extensive distribution network, they have not been successful in this space. Why?

Look no further than the unique challenges of selling groceries. Amazon may have mastered shipping uniform, non-perishable, and scannable items like books and electronics, but shipping goods that spoil, have inconsistent availability and fluctuating costs, require refrigeration, and varying quality of individual units, is a significantly more difficult challenge. Had Amazon already solved this, they wouldn't have needed Whole Foods in the first place.

WHAT IS AMAZON’S STRATEGY?

As Amazon experiments with logistics and distribution, their near-term strategy is likely to focus on three areas: improve in-store operations via technology and automation; introduce more private label goods like AmazonBasics and 365; and increase the value of Prime.

1) In-store Operations

In January, Amazon revealed AmazonGo, which is a suite of technologies (e.g., cameras and sensors) that enable customers to walk into a store, grab what they want, and walk out—all without needing to wait in line or see a cashier. By automatically detecting what a customer took off the shelf, Amazon can bill their account, monitor in-store inventory levels, and reduce “shrink” (i.e., theft). We expect AmazonGo technology to be pushed out across Whole Foods’s 465 stores.

If we assume half of Whole Foods’s 100k employees are cashiers—and that their total hourly cost to the company (including wages, benefits, perks, etc.) is $25/hour—then Whole Foods likely spends around $2.5b/yr on this expense—13% of total sales.

2) Private Label Goods

No longer seen as cheap, low-quality knockoffs, private label goods are now sought after by savvy customers because of their attractive value proposition: same quality, lower price. Brands like Kirkland, Trader Joe’s, 365, and AmazonBasics, are going toe-to-toe with expensive name brand alternatives; and in many cases they’re winning. And it’s not just customers who benefit. By selling private label goods, companies earn higher margins, gain product exclusivity, and have greater control over packaging and distribution. Since Amazon and Whole Foods have been independently selling more low-priced, high-margin private label goods, we expect the acquisition to accelerate this trend.

By improving in-store operations and selling more private label goods, Amazon stands to increase the profitability at Whole Foods. But rather than keep the profit, Amazon has other plans…

3) More Value for Prime Users

We expect Amazon to “give back” any profits to customers through lower prices and increased value for Prime members. To understand why, look no further than the company that serves as Prime’s inspiration: Costco.

Costco sells products “at cost”, meaning if it costs them $1 to supply customers 1lb of turkey, then that’s the same price they charge those customers. While this virtually guarantees Costco can offer the lowest prices, it also seemingly guarantees they’ll never make money. But there’s a catch—to get Costco’s low prices, customers must pay $60/year to be a “member”. It’s a unique but brilliant business model; customers win because they receive more than $60 worth of savings each year, and Costco also wins because there’s no incremental cost to provide a membership, so all membership fees fall directly to their bottom line.

This is the same model that Amazon Prime means to replicate. Since the company doesn’t need to make money directly off the goods it sells, it can keep prices lower than its competitors. The low prices drive more memberships, which increases sales, which in turn gives the company more leverage to get even lower prices from its suppliers. Rather than keep that margin, the company gives it right back to the members through lower prices, thus driving more memberships and restarting the virtuous cycle.

Because of the acquisition, Amazon will have a number of new opportunities to increase Prime’s value, such as: free grocery delivery, member-only sales/pricing, exclusive brands, online ordering/pickup, and easy re-ordering. And by increasing Prime’s value, Amazon attracts more Prime members, which increases sales, which in turn gives the company more leverage with suppliers, which drives prices lower, which….well you get the point.

CONCLUSION

While predictions of drone-delivered swiss chard may make for good headlines, the future success of Whole Foods does not depend upon it—nor any other single technology for that matter. What it will depend on is whether or not Amazon can create value for customers through low prices, great selection, and convenience. Over the next few years, we think it is far more likely for Amazon to achieve these goals through slightly less exciting—though no less impactful—methods like self checkout technology and selling more private label goods. Both changes will substantially reduce costs in the near-term, which Amazon will use to accelerate the virtuous cycle of AmazonPrime.