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The past decade has been a trying time for traditional supermarkets. A look at the results of Kroger (KR) and Safeway (SWY) underscore the difficulties. At both companies, sales have risen at a relatively pedestrian clip since 2000, while operating margins, particularly at Safeway, have narrowed noticeably, weighing heavily on profits. 

Both stocks reflect these difficulties, fetching lower prices now than was the case ten years ago. And, on a price-to-earnings basis, each currently trades at a discount to the broader market, suggesting investors have concerns about each company’s ability to expand its profit base from here. We suspect the past difficulties, and ongoing investor skepticism, are at least partly attributable to the efforts of alternative retail concepts to take market share from traditional supermarkets.  

The biggest threat has come from discount-oriented formats, most notably the supercenters of Wal-Mart (WMT – Free Analyst Report). Others making a bid for the food-shopping dollars of price-conscious consumers include club stores, such as Costco Wholesale (COST), and Wal-Mart’s main discount rival, Target (TGT). Supermarkets have been under pressure at the other end of the market, as well. Whole Foods (WFMI), for instance, stocks its shelves with natural and organic foods that typically sell at a premium to comparable items found at grocery stores. The chain, though, has won a large following, allowing it to expand rapidly across the U.S.   

We suspect rivals such as these will remain the big threat to profits and shareholder returns over the next several years. Investors, though, particularly those with a long-term view, also need to scan the horizon for other potential hazards. The Internet grocery space is one such area to monitor for developments. Some may remember the on-line grocery business model as one of the high-profile casualties of the collapse of the Internet bubble.

There are, however, a number of companies out there still trying to make a business of selling groceries over the web and delivering them directly to the consumer. These services at present are generally based in and around large cities. We suspect that relatively affluent and computer-savvy consumers, facing time (and perhaps, transportation) limitations find these services appealing.

While none of these enterprises has anything approaching the scale of a Safeway or Kroger, some do have fairly ambitious plans. In recent years, Peapod, which was founded over twenty years ago, has been expanding into many new markets, primarily along the east coast. The company’s expansion has been helped along by its ties to some leading U.S. supermarket chains, which like, Peapod, are owned by Ahold, a Dutch retailer. Fresh Direct, a New York City based enterprise, also appears to be gearing up for growth. In a recent New York Times article, its CEO indicated a desire to enter the country’s 25 largest food markets in “as short a time as possible.” He expects Internet grocery shopping in and around these cities to represent a combined market of $25 billion to $35 billion over time.  

At present, investors intrigued by the profit potential of home-delivered groceries appear to have fairly limited options. Fresh Direct, for instance, is privately held. Meanwhile, in the near term at least, we don’t expect developments at Peapod to have much of an influence on the shares of Royal Ahold, which generates more than $35 billion in revenues from its far-flung global operations. (The company’s ADRs were delisted from the New York Stock Exchange in 2007, though they continue to trade over-the counter.). Internet giant Amazon (AMZN) also features food and other supermarket items on its web site, but we doubt this segment of its business will be significant enough any time soon to meaningfully move its stock price either.  

Fresh Direct’s CEO has stated that the company generates annual revenues of $250 million, and was profitable, for the first time in its history, in 2009. Overall, though, there is a paucity of information available regarding how big (in terms of revenues) or profitable the Internet grocery business is. This adds to the difficulty of evaluating how serious a threat these competitors might some day be to traditional supermarkets. As illustrated by the success of discount stores and natural-foods chains, traditional supermarket operators hardly have a lock on the loyalty of their customers. And, any meaningful threat to market share arising from the efforts of Internet retailers would likely put greater pressure on grocery stores to compete on the basis of price. Also, the need to ramp up their own Internet based operations would add to the complexity of their businesses, likely having negative implications for margins and profits. (Safeway and Kroger do offer home-delivery services in some markets, but there are no indications that these operations are currently significant contributors to revenues and profits.)