Here comes Amazon! Here comes Amazon! Syllabically that phrase matches a famous Christmas song, but for holders of retail stocks, Jeff Bezos is no Santa Claus. Kroger shares gapped down on Friday on news that Amazon would be opening grocery stores in the U.S., with a location slated to open in Los Angeles before the end of 2019. Kroger shares have recovered some of Friday’s loss this morning, and it is unclear whether Amazon’s new stores (reportedly not to be branded as Whole Foods) would affect Kroger’s footprint.
When looking for “Amazon casualties” in the food retail space, Kroger is an easy candidate. Industry consolidation has left it as by far the largest publicly-traded food retailer. Kroger, does not just sell food, of course. While many years of following–and occasionally investing–in bonds of supermarket companies have taught me to fear the economics of food retail, it is not the “supers” that should be worried by Amazon’s move into non-Whole Foods physical stores.
No, it is the drugstores, and an easy target there is Walgreens Boots Alliance. There have been rumors of Amazon moving heavily into pharmacy retail over the past few years, but those have not materialized. Anyone who has walked into a Walgreens or Duane Reade in the U.S. or Boots in the U.K. or Thailand will know, though, that the pharmacy counter occupies a very small portion of the average WBA-owned store’s retail square footage.
Of course, drugstores and supermarkets both sell fast-moving consumer goods, and a bag of chips bought from Duane Reade is the same as one bought from Gristede’s. The most salient point from an investor’s perspective, though, is that those purchases are not as lucrative for retailers as are sales of health and beauty products, and that is where Amazon could strike a blow at Walgreens, as well as Kroger and the supers.
The Wall Street Journal took that angle this morning, and, coincidentally I had just attended a Walgreens Boots Alliance presentation at the SVB Leerink Global Healthcare Conference in New York last week.
Walgreens’ margins have been pressured in recent quarters, but Walgreens’ CFO James Kehoe made it very clear in his presentation that increasing sales in higher margin health and beauty products is a key component of WBA’s strategy to obviate margin pressures from competitive forces in an already overcrowded industry. That sounded like a decent strategy when I heard it on Thursday, but then the Amazon news broke on Friday.
If one needed proof of the attractiveness of health and beauty versus other retail categories, one might only need to look at margins. In its last reported quarter, Ulta Beauty posted a 10.8% operating margin versus Walgreens’ 4.1% and Kroger’s 2.3%. Yes, these are not completely perfect comparisons due to currency exchange, etc., but those margin differentials are a clear indication that health and beauty is a strong area. Those products are by nature OTC, and while there may or not be a “beauty consultant” in the cosmetics area of my Duane Reade when I shop there (I don’t check,) there are always multiple pharmacists at that counter, so clearly pharmacy is much more labor intensive than sales of health and beauty aids.
So, that’s another potential “Amazon casualty,” and the market really should be focusing on Amazon’s potential impact on Walgreens Boots Alliance, not Kroger. I heard Walgreens’ CFO Kehoe mention Brexit countless times in his speech last Thursday, and I believe the Street’s consensus estimate for Walgreens’ fiscal 2019 earnings–$6.51–is very much in jeopardy.
Of course it won’t be management’s fault, because of–you guessed it–Brexit. So, at only 10.0x earnings (Kroger gets 13.3x and Amazon gets 63.6x,) Walgreens is still a short here, in my opinion. Experience has taught me that fundamental changes will outweigh valuation ratios, and if Amazon moves aggressively into physical retail in the health and beauty category, Walgreens’ margins–and its stock price–will surely suffer.
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