Amazon Fresh Is Finally Ready for Prime Time

After years of promise but uneven results, Amazon’s AMZN online grocery efforts reached an important inflection point in late 2019 following the removal of Amazon Fresh’s $15 monthly service fee and the introduction of one- and two-hour delivery window options for Prime members. In our view, this decision removed two of the key barriers preventing Prime members from fully embracing online grocery--cost and convenience--and has triggered widespread interest in markets where the service is offered. Our analysis suggests not only a meaningful uptick in consumer awareness of Amazon’s grocery delivery capabilities, but also a 30%-plus increase in consumer adoption and order frequency rates based on website traffic and physical activity at Amazon Fresh fulfillment centers.

Why should investors find this information significant? One, it plays directly into our thesis that Amazon is pivoting away from customer acquisition and finding creative ways to engage with consumers, enhancing the network effect that underpins our wide moat rating. Two, it should reassure investors that the heavy investments that Amazon made in 2019 and will continue to make in 2020 are driving revenue higher. Three, because grocery is a high-frequency category, continued consumer adoption in 2020 could set the company up for revenue upside surprises in the quarters and years to come. Taken together, we believe the accelerated adoption of Amazon Fresh supports the longer-term revenue growth assumptions that underpin our $2,300 fair value estimate and gives us greater conviction in Amazon as our top pick in e-commerce in 2020.

U.S. Online Grocery Primed for Acceleration in 2020 For many investors, online grocery in the United States feels like the ultimate waiting game. No category is as lucrative, with estimated food and beverage retail sales of $780 billion making up 18% of total retail sales of $4.2 trillion for 2019 (based on U.S. Census Bureau data and excluding motor vehicles and parts dealers). Unlike other retail categories, however, consumers have been slower to adopt online grocery purchases. While we've seen consumers slowly start to adopt online grocery recently, we don't believe we've hit the digital commerce inflection point that we've seen for geographies and other retail categories. Several reasons explain this phenomenon, some having to do with consumer behavior, some having to do with retailer operational complexities, and some having to do with cost burdens. Nevertheless, we believe there were several steps toward more widespread online grocery adoption that emerged in late 2019, none more significant than the elimination of monthly delivery fees and more convenient delivery windows for the Amazon Fresh online grocery platform.

Sales estimates for online grocery sales in the U.S. vary quite a bit by source, but we estimate that purchases through online order and delivery grocer websites--including Amazon Fresh, Walmart WMT, Kroger KR, Ahold’s ADRNY Peapod, FreshDirect.com, Target TGT, and meal kit services like HelloFresh and Blue Apron--made up approximately $23 billion in sales in 2019 (derived from IBISWorld, Business Insider, and eMarketer estimates), while online sales of packaged foods sold directly by consumer packaged goods companies also amounted to $13 billion (derived from Hartman Group and Business Insider estimates). This puts U.S. sales through online retailers and direct online sales from CPG manufacturers collectively at $36 billion for 2019 and implies a five-year compound annual growth rate of 16.1% the past five years.

Online grocery has been slower to catch on in the U.S. compared with other developed markets. Assuming our estimates are correct, online food sales represented 4.6% of food and beverage retail sales in the U.S. for 2019 (using U.S. Census Bureau definitions) and will grow to 9.0% by 2024. This falls short of other markets like South Korea (where 19.1% of food purchases were made online in 2018), Japan (7.7%), and the United Kingdom (7.2%), according to third-party data provider Kantar Worldpanel. While Kantar has not published estimates for 2019, we believe the U.S. will still fall short of global online grocery averages between 5.5% and 6.0%. Population density explains some of the discrepancy between the U.S. and other markets, as the average population density for South Korea, Japan, and the U.K. was roughly 1,330, 870, and 700 people per square mile according to the most recent government statistics in each country, compared with a land-only global average of 150 people per square mile and 87 per square mile in the U.S. based on data from the U.S. Census Bureau. However, we believe other factors have prevented consumers from adopting online grocery shopping in the U.S.

We identify three primary headwinds preventing more widespread adoption of online grocery shopping in the U.S.:

• Online grocery is perceived as expensive, especially when factoring in delivery surcharges, monthly service fees, and other markups.
• Consumers are often given inconvenient delivery windows, even though these are sometimes a requisite for online grocers to establish scale and route density.
• Consumers prefer in-store shopping because of an elevated experience or wanting to evaluate fresh food products before purchase.

We believe many of the barriers preventing widespread online grocery adoption continued to break down in late 2019, most notably with respect to consumer costs and delivery windows. Some of this is the direct result of expanded food/grocery offerings from mass merchants and grocers, new delivery alternatives, automated warehouse advancements like Ocado and AutoStore, and increased urgency among traditional grocers to adopt what could be an inherently more efficient business model generating less waste. However, several years from now, we believe the removal of Amazon Fresh fees and more convenient delivery windows may go down as the catalyst that prompted widespread consumer adoption across the U.S.

We forecast that online grocery and other online food sales will accelerate over 2020-24, averaging almost 20% growth annually. More important, this could indicate a change in consumer behavior regarding online grocery and restaurant delivery services, which we believe has implications for the brand intangible asset and cost advantage moat sources across our broader consumer coverage universe.

Revisiting Amazon's Uneven History in Online Grocery Amazon has had its sights set on the grocery category for over a decade. Its Amazon Fresh grocery delivery platform was first introduced in Seattle in 2008, followed by Los Angeles/San Francisco in 2013, San Diego, New York City/New Jersey, and Philadelphia in 2014, Baltimore and Sacramento in 2015, and Dallas, Chicago, and London in 2016. In conjunction with the Los Angeles rollout in 2013, Amazon introduced a new tier of Amazon Prime (dubbed Prime Fresh), which granted members free same-day or overnight delivery on orders over $35 for an annual fee of $299. In addition, Amazon has built a sizable pantry and household products business through its Prime Pantry, Subscribe & Save, and Amazon Mom offerings.

In June 2017, Amazon took steps to accelerate and expand its grocery platform when it announced that it would acquire Whole Foods for $13.7 billion. At the time, it was evident that Whole Foods would allow Amazon to start to remove the three barriers we outlined earlier: price, convenience, and preference for physical selection. After the acquisition closed, Amazon immediately announced several price cuts it had put in place at Whole Foods stores to stimulate consumer interest and chip away the grocer’s “whole paycheck” premium pricing reputation. In the months following the acquisition, Amazon introduced new delivery and in-store pickup options for consumers and worked with CPG companies to develop more efficient packaging for online orders.

While breaking further into the online grocery space was clearly a motivation behind Amazon’s acquisition of Whole Foods, there were more nuanced factors at play, including the potential for greater order frequency and engagement among Prime members; the opportunity to add new third-party sellers to Amazon’s marketplace (evidenced by Amazon’s October 2017 decision to lower its referral fee discount on grocery products, charging an 8% commission compared with the 15% commission it charges on average across other product categories); developing new technologies for its Echo portfolio of products and other hardware devices inside Whole Foods locations; gaining access to new sources of customer data that rivals can’t; and better insulating its marketplace from economic cycles--all while enhancing the network effect underpinning our wide moat rating.

While it has taken time to refine, Stephenie Landry, Amazon’s vice president of grocery delivery, said in October that “grocery delivery is one of [Amazon’s] fastest-growing businesses.” We believe this assessment is valid and estimate that Amazon sold $10.3 billion of grocery products on its U.S. marketplaces in 2019 (including first-party and third-party sales but excluding contribution from Whole Foods or other physical retail locations). While we believe Amazon’s U.S. online GMV growth (17.5% CAGR the past five years) essentially performed in line with the company’s consolidated GMV (five-year CAGR of 18.5%), we also saw meaningful acceleration in 2019 with U.S. online grocery growing an estimated 23%.

Although its move into online grocery hasn’t always been a smooth process, Amazon is the market leader in U.S. online grocery sales. According to third-party e-commerce data provider and consultant Edge by Ascential, Amazon’s 2018 U.S. online grocery sales of $8.2 billion were almost 3 times the $2.8 billion generated by number-two player Walmart. Rivals like Walmart, Kroger, and Ahold have shown that they represent serious competition, with new features like click-and-collect and curbside pickup. However, we believe that core Amazon Prime member retention (excluding monthly and other lower-priced subscription tiers like student memberships) remained north of 90% in 2019 and believe that Prime members will be more likely to test Amazon Fresh before experimenting with other grocery delivery platforms. Assuming Amazon can reliably meet its one- and two-hour delivery windows, we share management’s assessment that free delivery for Amazon Fresh will be “one of the most-loved Prime benefits.”

Based on our forecast of $10.1 billion in U.S. online grocery GMV in 2019, Amazon easily held on and extended its leading position last year. We also believe it is poised for further acceleration in 2020 with the removal of Amazon Fresh service fees and the added convenience of delivery windows.

Removing Fees Immediately Increased Prime Member Engagement In our view, the removal of monthly fees for Amazon Fresh's grocery delivery will go down as one of the more important digital commerce developments of 2019. On Oct. 29, Amazon announced that Prime members who order more than $35 from its Amazon Fresh site or Whole Foods will receive free shipping with options for one- and two-hour delivery windows. This was a significant change from Amazon Fresh's previous conditions, which required Prime members to pay $15 per month for unlimited grocery deliveries.

Why hadn’t Amazon Fresh dropped its monthly fees before 2019? It has been pushing into the online grocery category with mixed consumer response for the past decade, so a reduction or removal of the monthly fee seems like a natural way to bolster consumer adoption. We believe the answer lies with the Prime one-day shipping benefit the company began to roll out to U.S. Prime members in mid-2019. According to our proprietary framework measuring the e-commerce preparedness of various retail categories, immediacy of need is one of the most important purchase criteria when consumers make grocery purchases. In other words, despite its reputation for reliable deliveries, Amazon’s two-day shipping windows weren’t enough to satisfy most consumers who could just as easily make an extra grocery store visit. We believe the removal of Amazon Fresh’s delivery fees and one- and two-hour delivery windows is a game changer from a convenience perspective.

We also see other offensive and defensive reasons behind Amazon’s decision to roll out one-day shipping options. On the offensive front, we believe expanded one-day delivery capabilities will create new third-party seller monetization opportunities and unlock new subscription service offerings. From a defensive perspective, we believe competitors such as Walmart, Target, and Best Buy BBY have steadily been improving their delivery speeds, but few (if any) have reached the point of reliable one-day shipping that Amazon now offers. From a financial perspective, we believe the move will help improve average revenue per Prime member while attracting new third-party sellers that don’t have the capital or technical resources to compete with Amazon’s logistics velocity.

Amazon management has already signaled that one-day shipping is having the intended effect on consumer behavior. While some investors have correctly pointed out the margin hit that could come with increased shipping costs on lower priced-products--and we’ve factored that into our expectations for North America segment operating margins to fall more than 100 basis points year over year to just under 4.0% for 2019--we think the longer-term vendor and buyer engagement benefits are more significant. We forecast that Prime one-day shipping investments will approach $4 billion in 2019 ($800 million in the second quarter, $1.5 billion in the third, and $1.5 billion in the fourth). However, we choose to view these as investments that will facilitate better engagement with consumers (increased order frequency allows Prime members to evaluate higher-margin subscription offerings) and make the company’s marketplaces a more vital channel for vendors (unlocking future monetization opportunities).

By most accounts, the removal of monthly Amazon Fresh fees has already been a success. According to the company’s post-holiday press release Dec. 26, the number of Prime members who tried grocery delivery for the first time this holiday season increased more than 80%, Prime members ordered more than double the number of grocery items compared with last year, and the company delivered tens of millions of grocery items from Whole Foods Market and Amazon Fresh. While the service is still not available in every market and certain markets only have pockets of coverage, we believe the removal of the monthly fee and the one- and two-hour delivery windows essentially eliminated the perceived cost and convenience barriers that have kept consumers from more aggressively embracing online grocery in the U.S.

We believe the market recognizes Amazon Fresh’s potential, but it may not be giving Amazon enough credit for online grocery as a near-term sales catalyst or the impact it may have on longer-term consumer behavior. Although the company provided a few data points in its post-holiday release, we wanted to see if we could more effectively measure how successful Amazon Fresh has been since monthly fees were removed in October. First, we examined Google Trends data to assess consumer awareness that Amazon Fresh had dropped its fees. Based on Google website searches at the time of the initial announcement, U.S. consumers are more than aware of the change and have remained more interested in Amazon Fresh since the announcement.

Google Trends data doesn’t necessarily correlate with Amazon Fresh orders, though, so we wanted to look at other sources to corroborate our hypothesis. It’s difficult to get Amazon Fresh website traffic, just because there isn’t a specific Amazon Fresh landing page and Amazonfresh.com redirects to an Amazon Fresh storefront on the company’s primary website. Still, we used third-party website traffic data provider SimilarWeb to measure Amazon.com traffic rankings to see if we could identify any discernable trends the past few months. Amazon.com has seen a meaningful uptick in month-over-month desktop and mobile visitors--including more than 2.7 billion visits in December 2019--but given the overlap with the holiday selling season, it’s difficult to make any definitive conclusions for the success of Amazon Fresh based on these trends.

Next, we worked with third-party location-based analytics provider Placer.ai to develop a more comprehensive picture of Amazon Fresh trends. We first mapped Amazon’s Amazon Fresh fulfillment centers, which can be found at MWPVL’s Amazon Global Fulfillment Center Network listing page. Amazon operates a network of ambient and cold storage grocery distribution centers to service Amazon Pantry and Amazon Fresh customer orders, and some of the Amazon food-related facilities are shared with other facilities such as sortation centers. In addition, when Amazon acquired Whole Foods in 2017, it took ownership of the Whole Foods retail grocery distribution network (which is largely focused on consumables for its retail stores in each major market region).

Because some of the Amazon Fresh facilities are shared with other operations that might distort results during the holiday shopping season, we narrowed our analysis to four stand-alone Amazon Fresh fulfillment centers of varying sizes serving distinct geographic markets: Los Angeles, Dallas, Chicago, and Washington, D.C. (all of which have had Amazon Fresh availability for several years). We also chose Amazon Fresh facilities that had been open since 2017, just to avoid skewing the data with a fulfillment center that wasn’t operating at full capacity. The facilities we examined saw a meaningful uptick in visitor and employee traffic after Amazon Fresh monthly fees were dropped, with October visitations collectively increasing 25.3% year over year but accelerating to 27.9% in November and an impressive 40.2% in December.

While we didn’t track visitations at each of Amazon’s Fresh facilities, our discussions with Amazon Fresh competitors and other industry executives indicate that these results are generally on par with trends across the U.S. and lend further credence to the growing popularity of Amazon Fresh among consumers. Two months of data isn’t enough to make definitive conclusions, but we ultimately believe that the uptick in activity at the Amazon Fresh fulfillment centers and the magnitude of Prime members that tried Amazon Fresh for the first time over the past two months indicates that repeat orders will accelerate in 2020. We don’t believe Amazon Fresh’s potential contribution to Amazon’s top-line growth in the years to come is fully reflected in the current market valuation.

Because the removal of delivery fees also applied to Whole Foods, we included website traffic at Whole Foods Market in our analysis (although this was likely to generate less conclusive evidence, given that free shipping for Whole Foods orders only applies to orders made on the Whole Foods storefront on Amazon.com, which is separate from Amazon Fresh). Using data from SimilarWeb over the past seven months, Wholefoodsmarket.com experienced a 30.8% uptick in desktop and mobile visits in the month of November to almost 6 million visitors, setting a new high-water mark for the website. We believe this can be attributed to consumer curiosity regarding the initial announcement dropping delivery fees. However, we also saw that Whole Foods gave back some of the visitor gains in December with 5.1 million visitors during the month. We don’t believe these results indicate waning interest in Whole Foods delivery capabilities, but instead represent customers going to directly to the Whole Foods storefront on Amazon.com.

We also looked at desktop and website traffic at Instacart, Peapod, Shipt, and FreshDirect to examine traffic trends across the rest of the U.S. online grocery category before and after the Amazon Fresh announcement. Desktop and mobile website visits were positive month over month at each of the four competitor sites, but every competitor saw an uptick in traffic during November and December ranging between 2% and 11%. We suspect that some of the uptick from other online grocery platforms in November may have been part of a “rising tide” effect that Amazon triggered with respect to online grocery orders, supporting our U.S. online grocery industry growth assumptions.

Taken together, our Placer.ai and website traffic analyses give us confidence that Amazon’s U.S. online grocery business will accelerate from the high teens to the mid-20s the next five years, up from our earlier projections around 20%. Our model now assumes Amazon’s global online grocery GMV will grow at a CAGR of 24.2% the next five years, outpacing our forecast of 19.8% for the U.S. online grocery category and implying market share gains for Amazon.

Sizing Up Amazon's Consolidated Grocery Expansion Efforts Amazon Fresh is just part of Amazon's global grocery aspirations; we expect Whole Foods and other physical stores to play a part in the company's growth plans in the years to come. Our targets for Amazon's physical stores include mid- to high-single-digit top-line growth the next five years (based on mid-single-digit physical store square footage growth and low-single-digit comparable-store sales growth for Whole Foods and Amazon Grocery, and 50% average annual square footage growth from Amazon's other retail formats including Amazon Go). We also assume that Amazon's physical store operating margins will grow from roughly 2%-3% in 2019 to almost 5% over the next 10 years, driven by improved operational efficiency at Whole Foods (largely supply chain and store-level operations) and contribution from higher-margin small-format layouts (which benefit from lower labor costs due to innovations such as "Just Walk Out" payments and other in-store innovations).

Based on our estimates and data from grocery trade journal Progressive Grocer, we believe Amazon and Whole Foods finished 2019 as the seventh-largest grocer in the U.S. with roughly $27 billion in sales. While the company represents a relatively small percentage of the $780 billion in estimated food and beverage retail sales (extrapolating year-to-date data from the U.S. Census Bureau), Amazon is the fastest-growing player among the 10 largest grocers in the U.S., including Walmart, Kroger (which saw meaningful online sales growth through its partnership with Ocado), Albertsons, Ahold, Costco COST, and Publix. Assuming our projections are reasonable and no consolidation among any of the other leading U.S. grocers the next several years, we believe Amazon will be among the top four grocers in the U.S. by 2024.

On a global basis, we forecast mid- to high teens growth for Amazon’s combined online grocery GMV and physical stores the next five years. Our outlook assumes continued Amazon Fresh adoption in the U.S. and international markets, physical store openings, and increasing contribution from new third-party and private-label brands to the platform. This implies that grocery will account for $67 billion in global GMV by 2024, or almost 10% of the company’s consolidated GMV.

Can Grocery Acceleration Be the Catalyst for the Stock Price? Amazon's stock price rose 23% in 2019, lagging the S&P 500 index (up 30.4%) and Morningstar's consumer cyclical index (up 21.9% through Dec. 5). While we believe there were several factors at play, we largely attribute this underperformance to questions about Amazon's Prime one-day shipping investments, which are likely to result in a modest decline in consolidated operating margins in 2019 (we assume that Amazon's consolidated operating margins will decrease 30 basis points to 5.0%) and break a two-year streak of margin gains. Management did not articulate its plans for one-day shipping before its second-quarter conference call, which resulted in questions regarding the magnitude and duration of this investment cycle. However, we believe we'll start to see the impact of these investments moderate later in 2020, putting Amazon back on track to meet our five-year operating margin target in the high single digits.

Historically speaking, new investment cycles (loosely defined as periods where Amazon’s capital expenditures accelerate to more than 6% of revenue) tend to weigh on Amazon’s stock until the company starts to see some combination of top-line acceleration and margin expansion. While we believe Prime one-day shipping efforts will weigh on profitability through at least the first half of 2020--especially if the company becomes more aggressive in rolling out Prime one-day shipping across international markets--we view the acceleration in Amazon Fresh orders as potentially the catalyst that the market is looking for from a top-line perspective over the next several quarters.

Based on the website traffic and fulfillment center visitation traffic data we presented earlier, we believe it’s reasonable to assume that Amazon Fresh grew roughly 30% in the fourth quarter, implying almost $3.5 billion in online grocery GMV in the U.S. and more than $4.5 billion on a global basis. Because Amazon dropped the delivery fees for Fresh one month into the quarter and the program is still relatively early in the consumer adoption phase, we don’t believe it will be sufficient enough to drive revenue above the high end of management’s outlook for the fourth quarter ($80.0 billion-$86.5 billion), though we do expect results to come in close to the high end of its guidance range. Looking to 2020, however, we believe more consumers will adopt Amazon Fresh and order more frequently, with online grocery acceleration being be one of the key factors that pushes Amazon’s top-line growth close to 20% for the full year versus market expectations of high teens growth (based on S&P Capital IQ assumptions). This supports the longer-term assumptions underpinning our $2,300 fair value estimate as well as our view of Amazon as one of the top picks in e-commerce for 2020.