Why supermarkets are struggling to profit from the online grocery boom
Jo Ronan had never done a grocery shop online before Covid-19. Now, she and her husband Mike doubt they will venture back into a supermarket until at least next year.
“I haven’t been in a supermarket since March,” says Ms Ronan, a retired teacher who lives in Essex in southern England and has asthma. “I do like going round shops. But until there is a vaccine, I cannot really see myself going back to a store. It’s too risky.”
Instead, the couple buy occasional items from a local corner shop and order bulky items online, from one of the UK’s big four supermarket groups. They are among millions around the world who have tried online grocery shopping for the first time during the coronavirus outbreak — and found that they like it.
In the UK, ecommerce took two decades to go from zero to around 7 per cent of total grocery sales. It then went from 7 per cent to 13 per cent in about eight weeks.
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Even in parts of Europe that have been ecommerce laggards, interest has picked up sharply. Researchers at Bain estimate that both German and Italian online grocery sales doubled during the pandemic and now account for 2.9 per cent and 4.3 per cent of the total, respectively.
But there is only one problem with the surge in online sales: many supermarket chains are struggling to make a sizeable profit — and in some cases, any profit — from ecommerce because of the huge commitment in resources that it requires.
The two largest UK operators, Tesco and J Sainsbury, have both said they expect to make around the same profit this year as last — despite a huge transfer of food consumption from restaurants to home and a property tax holiday. One of the main reasons is the high cost of expanding online delivery operations.
Sainsbury’s chief executive Simon Roberts summed the situation up, saying Covid-19 was “moving sales out of our most profitable convenience channel and driving a huge step-up in online grocery participation, our least profitable channel”. Most supermarket groups do not publish detailed figures for online sales and profits.
When ecommerce accounted for comfortably less than 10 per cent of supermarkets’ sales, improving its profitability could safely be regarded as a long-term project.
“Supermarket groups were hoping that slow adoption would give them time to find a model that was not so dilutive,” says Marc-Andre Kamel, leader of the global retail group at Bain. Companies now needed to “find a much more rapid fix” for the weak profitability of their online operations while “at the same time ramp up their ecommerce capacity to meet the surging demand”.
No one expects online grocery shopping to return to pre-Covid levels. Research by UBS in the UK found that 71 per cent of respondents said they will shop online “as often or more after the Covid -19 situation improves”.
Based on other survey evidence, Bain estimates that between 35 per cent and 45 per cent of the recent increase in online sales will turn out to be permanent.
Tim Steiner, chief executive of UK online grocer Ocado, which has prospered during lockdown, thinks the long-term impact of the pandemic will be substantial. He points out that the group he founded has more than 1m people waiting to become customers once it has the capacity to serve them.
“We find that if people do between three and five online shops in a 12-week period, then their propensity to carry on shopping online is very high,” he says.
“The whole world has also been educated in pandemics and virus transmission. Everybody is taking less risk than they did historically, and it’s about deciding where and when you want to take your risk. Do I take it to visit my family and friends, or do I take it to go grocery shopping?”
For many years, retailers were daunted by the capital spending and the technical challenges of offering ecommerce for food shopping at scale. The US in particular was scarred by the 2001 failure of Webvan, an early online grocery venture.
Even Amazon, whose financial might and technological innovation has disrupted sectors from books to electronics, seemed to have no ready solution for most of the past two decades to the problem of delivering temperature-controlled products to doorsteps.
In the UK, the launch of Ocado in 2002 forced the incumbents into action. Because it had no stores of its own, Ocado went for a model built around automation from the start, building a large distribution centre north of London. The inadequacy of the off-the-shelf solutions available led it to develop its own systems and software to pick orders and plan delivery routes.
Mr Steiner points out that traditional supermarkets also tried automation initially but were deterred by the complexity of it, and reverted to picking customers’ orders in stores and then putting them on to trucks for distribution.
That is the least efficient way of fulfilling orders. “You can polish the turd all day long, but store pick loses money,” says Steve Hornyak, chief commercial officer at Fabric, an Israeli start-up that develops in-store automation technology.
He added that having to pick orders in a store that is also full of shoppers limits picking capacity to 100-200 orders per day.
The additional costs of in-store picking were compounded by supermarkets’ pricing strategies for online services, which often involved widespread use of promotional coupons and offers of free delivery to lure customers.
“They launched with no fee, or a fee that was nowhere near enough to cover the costs,” says Mr Kamel. “They have educated customers that picking and delivery was free when actually it costs around €12-€14 per order.”
His research suggests grocers around the world are typically suffering a negative operating margin of about 15 per cent on online orders. Even a $7 delivery fee does not lift that number into positive territory.
The market developed differently in the US, where grocers’ lack of enthusiasm for ecommerce led to the creation of Instacart in 2012. Its freelance shoppers pick customers’ orders and deliver to them, with the customer paying an annual subscription and a per-order fee.
China went down a similar route. Early start-ups tried next-day delivery of fruits and vegetables, while another wave of entrepreneurs tried the intermediary model similar to that used by Instacart, ferrying items from grocery stores to customers. China’s grocery delivery market includes ecommerce leaders like Alibaba, JD.com and Meituan and start-ups such as Miss Fresh, Dingdong Maicai and Xingsheng Youxuan.
Miss Fresh embodies a new trend. Backed by funding that Crunchbase puts at $1.4bn, it has built out a network of small warehouses in 16 major cities with lower rents and fewer items than supermarkets.
Its pink-clad couriers on scooters deliver 60-70 orders a day while the micro warehouses can hold double the item count of similarly sized stores, according to chief operating officer Cecilia Sun. Ms Sun said it took three to nine months for each new warehouse to break even on a standalone basis.
But even though China has the advantages of densely populated cities and cheap labour, there is no indication that companies in the country have entirely solved the profit problem either. About 150 Chinese grocery delivery start-ups have failed in recent years, according to ITjuzi, a Beijing business information provider.
Mr Hornyak believes intermediaries are only a stopgap for big retailers. “If any grocer believes Instacart is a strategic solution for ecommerce then they are proclaiming the death of their company,” he says. “You are handing the keys to your kingdom to a third-party data and technology company.”
Supermarkets everywhere began to take ecommerce a lot more seriously after Amazon’s surprise 2017 acquisition of Whole Foods, a transaction that caused their share prices to fall.
Those with the financial capacity stepped up their investment. Walmart, the world’s biggest food retailer, poured money into both home delivery and click-and-collect — or “kerbside” as it is known in the US.
Others turned to Ocado, which started licensing the technology it had developed in 2014. Almost all of the deals it has concluded with retailers around the world were signed after the Amazon/Whole Foods transaction was announced. It is now raising £1bn through debt and equity to capitalise on the growing market.
Dave Lewis, the outgoing chief executive of UK market leader Tesco, acknowledges that online operations have at best broken even in the past, but aims to change that with greater efficiency and more realistic pricing.
“There is definitely an opportunity to be more commercially oriented in the way that we put delivery prices together,” he told investors recently. “Do I see a situation into the future where pricing becomes more rational? Yes.”
A flurry of recent agreements between retailers and food delivery apps like Deliveroo and Uber Eats, many of which involve delivery fees for consumers, suggests he is right.
Kroger, a major US supermarket chain that is a user of Ocado technology, is banking on capturing more spend. “When a customer first switches to online, it typically takes three or four years before that customer’s profitability is the same as when they shop in the store,” says Rodney McMullen, chief executive. “But what we find is we get a significantly higher share of that customer’s total household spend.”
Three years on from the Whole Foods deal, Amazon has done a lot of experimenting about how to use its vast infrastructure to operate delivery of groceries and offers a number of services to customers that include the sale of fresh fruit and vegetables. But it has yet to make a decisive push into online grocery, even if most executives in the industry expect that it eventually will.
Mr Kamel says advertising is a significant untapped revenue stream; just as brands pay for enhanced promotion in store, they could pay a premium for better positioning on a website. He notes that Instacart derives around a third of its revenue from this source.
One feature of the pandemic — larger transaction sizes — could also help profitability. Ocado’s own food retail operations saw sales grow by 27 per cent during the first quarter, but profit rose by almost 90 per cent because it made fewer but substantially bigger deliveries.
The other major lever is reducing the cost of fulfilment. Ocado is busy building 54 robotic fulfilment centres around the world for its clients. These high-tech sheds can pick a $100 grocery order in minutes, but their capital costs and lead times are significant and they take time to reach full capacity.
Others prefer to leverage what they already have. Mr Lewis says that Tesco’s large number of stores means that it is close to many customers, which allows it to scale up deliveries without heavy capital expenditure. “Owning [the] last mile in the way we do is the important thing,” he says.
Store picking efficiency is gradually improving. But traditional supermarkets are not arranged with rapid picking in mind. They are laid out to force customers to wander the aisles and make additional impulse purchases.
One company that has rethought that approach completely is China’s Alibaba, which designed its 207 Freshippo supermarkets with delivery as the main priority, rather than a later addition.
Pickers often outnumber shoppers in the stores, also known as Hema. Glued to their handheld devices, they scurry between shortened aisles to pick frozen dumplings, seafood and vegetables, and send the items whirring over shoppers’ heads on conveyor belts to an in-store packing station.
Orders are then delivered by scooter couriers, often in under 30 minutes. “We’re exploding with orders,” says one rider who earns Rmb5.30 ($0.75) per order delivered. Growth jumped to more than 100 per cent year on year in the first quarter.
A less radical alternative, appealing to those retailers with a surfeit of store space, are the automated micro-fulfilment systems which can operate within stores and are touted by companies such as Fabric, Auto Store and Takeoff. Mr Hornyak says such centres can increase the capacity of a store to more than 500 orders a day and reduce picking costs by up to 80 per cent. Tesco is already working with Takeoff on up to 25 of the centres in its UK stores; the first is due to start up shortly. Ahold Delhaize, the Netherlands-based retailer, has also deployed them in the US.
Mr Steiner is sceptical, saying such systems are less efficient than centralised warehouses and that much of the technology is unproven in a commercial setting.
But Mr Kamel points out that micro-fulfilment centres can be installed in a few months — as opposed to up to two years for a large automated warehouse — and at much lower capital cost.
And in recent investor presentations, Ocado has been emphasising that it can offer the full range of options from giant centres processing 200,000 orders a week to compact ones that would easily fit within a large superstore.
Its most recent licensing deal, with Japanese retailer Aeon, committed it to providing a mixture of different facilities. Other agreements have even featured a degree of in-store picking.
The future of online grocery looks increasingly like a mix of solutions: big automated facilities in big densely populated cities, smaller ones closer to shoppers in more suburban environments, and a mix of store pick or intermediaries in rural areas.
Mr Steiner thinks online grocery penetration could ultimately reach 70 or 80 per cent, with the market consolidating into a few giant Amazon-like players. If he is even half right, the need to fix the profit conundrum will become existential for many of today’s supermarkets.
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