What's Going On With Amazon's Whole Foods' Pricing?

Amazon (NASDAQ:AMZN) has been hard at work trying to shed Whole Foods' "Whole Paycheck" reputation ever since it acquired the grocery chain about two years ago. Those efforts have resulted in more volatility in its pricing than anticipated, however, as the company had to raise prices in February after suppliers' contracts ended and they complained of higher costs.

The retailer keeps working to lower the gap between Whole Foods' high prices and the rest of the industry, and a recent note from Morgan Stanley analysts suggests it's moving in the right direction. Whole Foods' prices fell 2.5% year over year last quarter, according to the analysts. That compares with a 3% increase in the first three months of the year.

Lower prices could help attract new customers to Whole Foods, especially if Amazon is able to drive traffic to the stores by leveraging its massive online retail presence. Amazon may have to sacrifice margins, however, in order to reach scale on par with less-expensive stores, including Kroger (NYSE:KR) and Walmart (NYSE:WMT).

Trimming the fat

Amazon has never shied away from taking a smaller profit margin on its sales if it meant it could grow faster. But in the grocery industry, where margins are already razor thin and growth is hard to come by, that can be a lot harder than in more discretionary spending categories.

Amazon reported its physical-store sales were roughly flat in the second quarter compared to a year ago. If you adjust for online orders for delivery or pickup from Whole Foods, however, sales grew about 5%, according to the company. That's considerably better than growth at both Kroger and Walmart U.S., which grew sales 2% and 2.9%, respectively, last quarter.

But if Amazon is primarily growing Whole Foods' sales through online orders and price cuts, it's taking a margin cut in two ways. Lower prices means the cost of goods sold is a higher percentage of revenue. Meanwhile, paying for workers to pick out items for online orders and footing the bill for delivery increases operating expenses.

Walmart has also seen margin pressure from its free curbside grocery pickup but mitigates delivery expenses by charging consumers. Kroger charges customers a fee for online orders, which varies based on how quickly the customer needs to pick up the order.

While Amazon is growing sales faster than its two biggest rivals in the grocery industry, investors might want to see even faster growth. That's especially true considering the hiccup earlier this year where suppliers forced Whole Foods' prices higher, indicating that reducing prices is even more costly for Whole Foods than it is for its bigger competitors.

Driving more sales

It's no secret Amazon is serious about increasing its grocery sales. It's expanding the number of Whole Foods' locations available for pickup and delivery, driving customers to Whole Foods' stores by installing Amazon Lockers, and even considering building an entirely new grocery chain with a focus on online ordering. All three efforts ought to help grow Amazon's share of grocery sales.

Amazon has proven particularly adept at driving increased foot traffic to Whole Foods' locations. The chain saw a 16.5% year-over-year increase in the shopping trips in the first quarter of this year, according to a study from inMarket. Unfortunately, those trips don't appear to be from new customers, as unique customers actually fell 2.5%. The increased foot traffic is likely the result of consumers using Amazon Locker locations to pick up orders and quickly move through the store for that extra item they forgot.

Amazon's main goal is to convert its 100 million Amazon Prime members into Whole Foods shoppers. Its best attempts so far are offering exclusive deals and discounts to Prime members, as well as extending the 5% cash-back rebate on the Amazon-branded credit card to Whole Foods. Amazon has made three rounds of price cuts for Prime members at Whole Foods, and investors should expect more going forward.

Increasing grocery sales could eventually provide Amazon the leverage it needs to sustain lower prices and demand better deals from suppliers, akin to Walmart or Kroger. Overall, greater sales, albeit at a lower margin, should produce higher profits. Amazon is still searching for the best way to do that, and prices may continue to fluctuate going forward.

In the long run, investors should expect to see Whole Foods' prices decline further, but it needs to be accompanied by sales growth that far outpaces the competition.

This article originally appeared in the Motley Fool.

Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.