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Amazon and Whole Foods Admit Defeat

One needs stores, the other needs a business model

For all the hype and excitement around how the Amazon-Whole Foods deal will change retail forever, the acquisition is actually an admission on both sides that their current plans needed a jump start.

Enabling the Quest for World Domination

As Ben Thompson at Stratechery puts it, Amazon ultimately wants to take a cut of all activity in the economy. The Department of Agriculture indicates that food consumed at home represented 6% of total consumer income in 2014, and Food and Beverages is a category in which Amazon is a trivial player. A Bloomberg report estimates that Amazon captured only 0.8% of this market in 2016. Compare this to the estimated 17% share of consumer electronics sales that the company obtained in 2015.

Food and Beverages is a big market to miss if you’re looking for world domination. Unfortunately for Amazon, these products are largely bought in physical stores. CNBC reported earlier this year that only 4% of groceries are currently purchased online and even rapid growth expectations imply only 20% by 2025. However, building stores is expensive and slow. In its last two annual reports, Whole Foods indicates it opened 66 new stores while spending $911 million on the development cost of new locations. The numbers probably aren’t perfectly comparable, but call it at least $10 million per location.

Could Amazon spend a billion dollars building stores? Sure. Its operating cash flow in 2016 was $16 billion. They opened the first of a planned set of Amazon Go stores carrying groceries in Seattle earlier this year. But how long would it take, and where would those stores be? Every sizable company eventually faces the choice between building growth out of its own operations (“organic growth”) or buying growth by purchasing someone else (“inorganic growth”).

Amazon decided to buy. Buying growth is usually faster than building it. According to the same Bloomberg article referenced earlier, Whole Foods commanded 1.7% of the food and beverages market in 2016, meaning Amazon has more than doubled its market share with one acquisition.

Whole Foods’ Next Business Model

Meanwhile, Whole Foods may have hit the limits to its current business model. Sales growth has slowed over the last two years and profit has declined. Same store sales, an important retail metric, dropped 2.5% in fiscal 2016, meaning growth only occurred through new store openings. See “expensive and slow” earlier. Some shareholders may be relieved to get out with a 25% premium to current share prices, allowing that is still less than the stock was trading for two years ago.

Whole Foods was once ahead of its time in selling organic foods. They created a mass phenomenon out of a market that previously consisted of independent health food stores and farmers markets. Now times have caught up: most grocers sell organic foods, sometimes from the same suppliers as Whole Foods, and usually more cheaply. Further, there is probably a limit to the size of the market for expensive organics; existing markets may be saturated, and it may be harder to find new markets for Whole Foods stores that are as attractive as existing ones.

Companies with a quality strategy often run into limits of this kind. In a given market there are only so many customers willing to pay for high quality goods, meaning that growth eventually requires moving down market in your current product category or expanding to new product categories. Whole Foods has been experimenting with private label “365” stores to try to reach a lower price point, but it is too early to gauge success. Whole Foods needs to do something different to grow.

The Amazon-ing of Grocery Operations

The initial announcement indicates that Amazon will let Whole Foods continue to run as largely a standalone business with Mackey at the helm. I can’t imagine that decision will stand. Whole Foods needs to change and Amazon didn’t buy it to keep it the same.

Assuming the deal clears — as of this writing, there is some speculation another bidder might appear — the hard work will be assimilating Whole Foods into the Amazon empire. In some sense the companies are opposites. Whole Foods’ high prices to consumers famously support one of the 100 Best Companies to Work For in America, and the company is a conspicuous advocate for the Conscious Capitalism movement. Amazon’s rock bottom prices are the product of a relentlessly efficient corporate culture that has produced multiple stories around employee burnout and abuse. (As a friend of mine puts it, “a company that will abuse its employees until it can replace them with robots.”) Whole Foods’ shareholders may have had a good week, but Whole Foods employees almost certainly did not.

The operations of existing Whole Foods stores can certainly be made more efficient. Analysts are already speculating about applying the “cashierless” model of the Amazon Go store and wondering aloud about improvements in supply chain that the Amazon could apply. This would lower the cost base of Whole Foods stores, thus enabling lower prices that might increase traffic (all of the 2016 same store sales decrease was the result of fewer visits).

One has to wonder, however, about the effect of an “Amazoned” Whole Foods on the company brand, which still has strong value for a segment of consumers. Interbrand valued the brand at over $4B as recently as 2014. Will a more efficient in-store experience alienate existing customers? My guess is no, but it’s still a risk.

If I were Amazon I would try this experiment in a few stores before transforming the whole chain. The 365 stores would be a good place to start, since lower prices are part of the value proposition for those locations. Given the 365 stores are relatively new — there are four total, all opened in the last two years — they could probably be rebranded as “Amazon 365” with relatively little fuss. John Mackey has already floated the idea of a sub-brand that “wouldn’t be our standards.” A different brand reduces any potential damage to the core brand. At a minimum, many analysts expect Amazon to use Whole Foods stores to build out its Amazon Fresh delivery service with more perishable products — 2/3 of Whole Foods sales — and better logistics.

Given Amazon’s track record, other grocers are rightly quaking in their boots. This acquisition says Amazon is serious about groceries, and a technologically sophisticated, deep pocketed competitor is never good news. Fear can be a motivator, but it may also become a self-fulfilling prophecy. If you have already been struggling as a grocer, do you give up and look to sell? If you are an investor, do you want to invest in a Kroger today? If financing for traditional grocery chains becomes more difficult, will this further limit their ability to compete? The market has probably overreacted this week, but the long run outlook for the industry may be for more struggle and consolidation.

The Bigger Picture: 450 Pipelines to Well-Off Urban Consumers

Strategically, the larger implications of this deal have to be about real estate: Amazon has just bought 450 physical stores serving the same kind of well-off urban consumers who are likely to be Amazon Prime customers. (Recode reported earlier this month that 82% of households with incomes above $112K are Prime members.)

It’s easy to imagine both expanded product offerings and some kind of discount at Whole Foods for Prime members. Many analysts expect the company to use the stores as hubs for better pick-up and delivery options, solving the “last mile” problem. One particularly interesting analysis speculates that the stores could act as bases for Amazon drones. A portion of Whole Foods retail space could be devoted to an Amazon branded store with kiosks for easy browsing and buying (and later pick-up or delivery). Matching up grocery shopping data with other Amazon consumer data will no doubt suggest new options for the company.

Amazon’s business is ultimately about building pipelines through which they can drive as many sales as possible. The website started with books, then expanded to a kaleidoscope of over 230 million items by 2014. The digital selling infrastructure then became a streaming infrastructure for media and games. The Kindle Fire tablet, sold at manufacturing cost, is a portable window into the Amazon infrastructure; that and the Amazon app mean the store is always with you. And Amazon Echo puts the store within the sound of your voice. I expect Whole Foods stores will become another pipeline for the sale, delivery, and pick up of a broad range of Amazon goods. The Empire continues to grow, and all around it, retailers shiver in fear.

Bruce Clark is an Associate Professor of Marketing at the D’Amore-McKim School of Business at Northeastern University. He researches, teaches, and consults on managerial decision-making, especially regarding marketing and branding strategy, customer experience, and measuring marketing performance. This article is an expanded and revised version of one that appeared on the D’Amore-McKim School of Business’ Leaders at Work blog.