SAN FRANCISCO (Reuters) - Amazon.com Inc is planning a major roll-out of an online grocery business that it has been quietly developing for years, targeting one of the largest retail sectors yet to be upended by e-commerce, according to two people familiar with the situation.

While food is a low-margin business, Amazon could outperform similar online grocery services by delivering orders for higher-margin items like electronics at the same time.

One of the people familiar with AmazonFresh's expansion plans said new warehouses will have refrigerated areas for food, but also space nearby to store up to one million general merchandise products, in some cases.

The company has been testing AmazonFresh in its hometown of Seattle for at least five years, delivering fresh produce such as eggs, strawberries and meat with its own fleet of trucks.

Amazon is now planning to expand its grocery business outside Seattle for the first time, starting with Los Angeles as early as this week and the San Francisco Bay Area later this year, according to the two people who were not authorized to speak publicly.

If those new locations go well, the company may launch AmazonFresh in 20 other urban areas in 2014, including some outside the United States, said one of the people.

Bill Bishop, a prominent supermarket analyst and consultant, said the company was targeting as many as 40 markets, without divulging how he knew of Amazon's plans.

An Amazon spokeswoman did not respond to a request for comment on Tuesday.

Amazon is searching for new, large markets to enter as the company tries to maintain a growth rate that has fueled a 220 percent surge in its shares over the past five years. The grocery business in the United States, which generated $568 billion in retail sales last year, may be a ripe target.

Amazon's expansion plans are a potential threat to grocery chains such as Kroger Co, Safeway Inc and Whole Foods Market, as well as general-merchandise retailers Wal-Mart Stores Inc and Target Corp, which also sell a lot of groceries.

"Amazon has been testing this for years and now it's time for them to harvest what they've learned by expanding outside Seattle," said Bishop, chief architect at Brick Meets Click, a consulting firm focused on retail technology.

"The fear is that grocery is a loss leader and Amazon will make a profit on sales of other products ordered online at the same time," he said. "That's an awesomely scary prospect for the grocery business."

Kroger, Whole Foods, Supervalu and Safeway did not respond to requests for comment on Tuesday. Target declined to comment.

A successful foray into groceries could also help underwrite the development of a broad-based delivery service employing Amazon trucks to deliver directly to homes, which could have implications for UPS, FedEx and other package delivery companies that currently ship Amazon goods.

Still, groceries have proven to be one of the most difficult sectors for online retailers to crack. One of the most richly funded start-ups of the dot-com era, Webvan, was a spectacular failure as the cost of developing the warehouse and delivery infrastructure proved overwhelming.

Roger Davidson, a former grocery executive at Wal-Mart and Supervalu, said Amazon will struggle to make money from AmazonFresh because fresh produce can easily go out of date in storage warehouses and get damaged during delivery - something known as "shrink" in the business.

"Will it work? I would bet against it," Davidson said. "The reasons these businesses have failed in the past have not gone away."

COMPETITION

Still, Amazon is not alone in wanting to expand in the online grocery business.

Wal-Mart is testing same-day and next-day delivery of online grocery and general merchandise orders in the San Francisco Bay Area and operates a grocery delivery business in Britain.

"We are ready and able to expand grocery delivery in the U.S. as the market demands," Wal-Mart spokesman Dan Toporek said.

FreshDirect delivers food to homes and offices in some parts of New York City and its trying to expand its service into the Bronx.

Peapod, owned by international food giant Royal Ahold NV, says on its website that it is the largest Internet grocer in the United States, delivering more than 23 million orders across 24 markets.

Davidson, who worked with Peapod for several years during stint at Ahold USA, said Peapod struggled to make money for most of its existence. But he believes it now turns a small profit due to supply chain efficiencies, population density in Chicago and its connection to brick and mortar stores on the east coast.

Davidson favors a strategy he called "Click and Connect" which is being used by Harris Teeter, a food and pharmacy chain on the East Coast of the United States. Customers order food online and choose a time to pick up the produce from designated areas outside the company's stores. There is a $4.95 service fee for this.

"Traditional grocery retailers will likely fight back against Amazon with Click and Connect," he added.

It is not clear whether AmazonFresh in Seattle is profitable because Amazon does not disclose results from the business.

Amazon Chief Executive Jeff Bezos was asked about the business during the company's annual shareholder meeting last month and he said that the team had "made progress on the economics over the last year."

"They've been doing a lot of experiments and trying to get the right mixture of customer experience and economics," he added.

COMBINED ORDERS

If online orders also include higher-margin general merchandise such as digital cameras, then AmazonFresh has a chance at profitability, said Manfred Bluemel of Zeitgeist Research, who was head of market research worldwide at Amazon until late 2010.

"Grocery is a frequency business. If Amazon can deliver to consumers' homes two or three times a week, they can up-sell other items," he said.

Bluemel said AmazonFresh's expansion will likely focus on areas where Amazon already offers same-day delivery, or will do so soon.

Amazon offers same-day delivery in several cities including New York, Washington D.C. and Chicago, and since last year the company has been building new distribution warehouses on the outskirts of the Los Angeles and San Francisco Bay areas.

(Reporting by Alistair Barr; Additional reporting by Dhanya Skariachan and Lisa Baertlein; Editing by Jonathan Weber and Tim Dobbyn)

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