Shares of online grocer Ocado (LSE: OCDO) are down 4% in early trading on the news that Morrisons (LSE: MRW) is deepening its relationship with Amazon to include free two-hour delivery to Amazon Prime members. Morrisons already supplies the food for Amazon Pantry, so this next step caught few by surprise, but it's still a big blow to Ocado's hopes for several reasons.
For one, the deal adds extra competition to an already crowded sector that Ocado can't afford. The entry of Amazon, a deep-pocketed competitor willing to sacrifice margins for volume, signals further price cuts in the market to attract customers. For Ocado, whose operating margins in H1 were a paltry 2.1%, there isn't much room to attract customers by cutting prices while also investing heavily in expansion efforts.
Competition from Amazon will also be particularly difficult for Ocado because the two companies target the same relatively wealthy customer base. Ocado's average customer spends roughly £110 per shop, and there's likely to be significant overlap between these shoppers and those who dish out £79 a year for Amazon Prime. The tie-up between Morrisons and Amazon Prime will also begin rolling out in London and Hertfordshire, Ocado's geographic heartland.
The end of Ocado?
Is this an immediate deathblow for Ocado? No. The company is still consistently growing sales in double-digits and it has strong competitive advantages in its distribution network and logistics knowledge. But the problem is that these are the same strengths that Amazon is famous for. If Amazon follows its traditional game plan of ignoring margins in order to bring in new customers, Ocado's relatively weak balance sheet and small size will prove little challenge for the American giant.
What hope does that leave for Ocado? Well, the company desperately needs to land a long-promised contract with an international grocer. Putting its logistics knowhow, tech platform and distribution-related intellectual property to good use overseas in order to escape price wars and low margins at home could be a means of reversing the downward spiral share prices are stuck in. Otherwise, we could be looking at a buyout as Ocado's best hope of rewarding shareholders.
For Morrisons this deal is a net positive as it expands on the company's strength in wholesale foods and broadens its geographic reach into areas of the country where it has little presence. It also nicely complements the current turnaround programme that's focusing on closing non-performing stores and refitting the entire estate by 2018.
This plan drove overall revenue down 1.2% year-on-year in Q3 due to fewer stores but like-for-like sales at retained locations improved a healthy 1.6%. This means the additional sales from the Amazon deal will be very welcome as a way to balance out lower revenue from fewer locations.
Now, this doesn't mean Morrisons has escaped the increased competition and subsequent price wars that have battered the industry. H1 operating margins remained low at 2.7% and net debt, which is expected to be £1.2bn at year-end, is still worryingly high. The deal with Amazon will be a boost to sales, but price deflation and continued competition from discounters will be constant headwinds going forward for Morrisons.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon.com. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.