Amazon (AMZN) may find automation is the key to reaching breakeven in its grocery business, according to a new report.
"Automation could significantly reduce labor costs, driving massive improvements to fulfillment and delivery efficiency overnight," said a Barclays report released Monday.
In particular, the research note said Amazon could use "robot vans" in urban markets given the proximity of the AmazonFresh fulfillment centers and the Prime Now drop-off area. What's more, it said automation in the Fresh warehouse might be achieved using a technology similar to the Kiva robots already deployed in Amazon's traditional warehouses.
"We think automation could [help] Amazon achieve breakeven by cutting prices aggressively and eliminating the subscription fees entirely," said the report written by a Barclays team led by Ross Sander. "Automation could drive higher efficiency gains in a Fresh warehouse given the number of manual steps currently."
AmazonFresh is a grocery delivery service run by the Seattle-based e-commerce giant offering everything from fresh produce, breads, meats and seafood to frozen and prepared foods. The same-day or next-day delivery service also offers beauty products and household goods.
Besides the delivery and warehouse costs, the report points out that the fulfillment center for groceries is different than traditional e-commerce and can sometimes be less efficient. Also, the delivery trucks for grocery are usually refrigerated and have a relatively high cost to operate and tend to deliver fewer orders at full capacity than ordinary parcel trucks.
"Delivery automation is one of the saving graces for online given that nearly 80 percent of the delivery costs are associated with labor expenses and wages," the Barclays report stated.
Barclays forecast that AmazonFresh could generate more than $40 billion in gross merchandise value, or total sales volume, in the next 10 to 15 years from its online fresh grocery business.
"AmazonFresh may have finally cracked the code to unlocking this massive market opportunity," Barclays said.
Indeed, Barclays is predicting Amazon has the potential to unlock big growth in online grocery by tapping into a "significant" share of its 45 million U.S. member Prime base and making them regular shoppers of the Fresh service over the next decade.
At the same time, the report indicated that Amazon is likely to face additional competitive pressures and other major hurdles as it ramps up expansion beyond the current 21 domestic markets. At breakeven, Barclays estimates the merchandise gross margins per grocery order would be approximately 21.5 percent, which compares with Kroger's (KR) 25 percent margin.
And AmazonFresh would need to reach about 4 million subscribers, or nearly one-third penetration in top 25 markets domestically and among high-income households, to attain that breakeven level on the Fresh business, according to Barclays.
Yet the researcher estimates that Amazon today has below 2 percent penetration in that "core customer base." It said the high-income households are those with $100,000 or more in annual income.
The higher-income households would presumably have a higher average order amount for their online grocery purchases and thus help smooth out the higher costs for the service. Moreover, they also might order more frequently and select higher-margin food and beverages.
According to Barclays, the average order for a brick-and-mortar grocery store is $32 per customer, while it calculates that for Amazon to breakeven on grocery the average order would need to be approximately $85.
"It is important to note that average order value is a key metric that decides how/when Fresh reaches breakeven," the report said.
CNBC reached out to Amazon for comment. A company spokesperson said Amazon doesn't comment on rumors and speculation.
The U.S. online grocery market currently has low penetration of around 1 percent of the roughly $900 billion total food retail market. By comparison, other countries such as the U.K., Japan and South Korea have much higher penetration rates.
Even so, Barclays believes things are about to change with the domestic online grocery market as Amazon flexes its muscles and becomes an even larger participant — both with online and a physical presence in food retailing.
While the company's AmazonFresh delivery service is perhaps the best known of its grocery offerings, the company also has a Amazon Prime Now service offering faster delivery.
The company is also beta testing two other formats with employees: Amazon Go, a grab-and-go convenience store, as well as Amazon Fresh Pickup, a service where Fresh members can pick up online orders in as little as 15 minutes at locations.
"We expect the next decade to be much more disruptive for food retail than the past with rapid expansion of Fresh delivery and pickup and with Amazon deploying its typical loss-making 'scorch the earth' strategy that has allowed it to win market share in many other categories," Barclays said.
In fact, Barclays is so upbeat on Amazon's prospects in the online grocery space its long-term model is for the company's Fresh service to potentially reach 15 percent-plus of total households in a decade.
Helping to grow the online grocery market is millennials who grew up using smartphones and are comfortable making digital transactions. They will have increasing spending power in the years to come and can shift more grocery sales online as they start their own households.
Clearly, the traditional supermarkets are fighting back. Kroger and Wal-Mart (WMT)are getting more aggressive and offering their own online grocery services and pick-up or delivery options.
Wal-Mart has slashed food prices this year and continues to expand its store pick-up service to more locations. Kroger's so-called ClickList also lets consumers select items online and pick orders up at stores or they can have it delivered to the home through a third-party service.
In addition, other online grocery sellers such as FreshDirect and third-party home delivery services such as InstaCart, Uber and Shipt are expanding into the grocery space through alliances with large national chains.
"While AmazonFresh's rollout could have a negative impact on all market participants, it is likely to have an outsized negative impact on retailers that have high operating/financial leverage because small share losses would have magnified impacts on financial results," Barclays said.
Specifically, Barclays identified Kroger, Smart & Final (SFS), and Dutch-based grocer Ahold Delhaize, which owns U.S. grocery chains such as Stop & Shop and Food Lion, as having "the most" sensitivity from a profit and loss standpoint to a 1 percent loss in sales. But it still believes Cincinnati-based Kroger still ranks high in its "ability to defend" market share along with Costco (COST) and Ingles Market (IMKTA).
As for Wal-Mart, the report believes the Arkansas-based retail giant "will likely face AmazonFresh the least" given the majority of its locations are not focused on the top-25 markets for high-income households.
According to Barclays, the retailers likely to face more direct competition with AmazonFresh are those in the top markets and with "a middle-to-upper income customer base," including Whole Foods Market (WFM), Trader Joe's and Costco, as well as "to a lesser extent" chains such as Sprouts Farmers Market (SFM), Target (TGT) and Kroger.
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