The Future Of A Profitable Online Grocery Service Is Here

In retrospect we all have 20/20 vision. In the past, however, I often warned that those willing to sell groceries online should proceed with caution. It was never a case of questioning the appeal it posed for busy, time-starved consumers. My main argument revolved around the elusive profitability of such service. Most will agree that for a business to be sustainable, customers must buy in, but whoever provides the good or service has to do it profitably. Over the last few years, most grocers who started selling online have seen their profitability decrease. Moreover, a majority of the purely digital grocers that have been spawned over the past 25 years have also been venture capital black holes.

Of course, in today’s market context, the online grocery genie is out of the bottle. No grocer can afford not to offer groceries online and yet very few are prepared to do so profitably. No, not even Amazon, not even Walmart. So, what gives? Simple: Amazon is cross-subsidizing groceries with other categories (even with AWS, which is entirely another service). Walmart, on the other hand, is seeing its net profit margins decrease at an accelerated pace as it ramps up its online sales. It still has not found more efficient processes to provide the service profitably and it does not have either the equivalent service to AWS.

But what about other grocers? Most are well aware that they are caught between a rock and a hard place. They know they have to sell groceries online. They also know it may be unprofitable in the short term or it will come with the existential threat that Instacart poses. But most also suspect that the current environment might be creating enough demand to generate the economies of scale to do it sustainably and do not want to miss the bus.

Why am I so apprehensive about the Instacart route? Because, as many analysts have pointed out, Instacart’s objectives are fundamentally opposed to those grocers it is supposed to service. Instacart is a Trojan horse that will enter the shopper base of unsuspecting retailers and ultimately steer them (and their revenue streams) away from their hosts. Having multiple retailers on the Instacart platform encourages shoppers to cherry pick, thus, eroding whatever loyalty, they may have for any particular one. Loyalty erosion also happens upstream as vendors are also encouraged to negotiate directly with Instacart. Grocers would thus become nothing more than convenient generic front-line warehouses for Instacart. Their brand equity and loyalty will be completely obliterated by Instacart’s superior and unbeatable proposition: “all these retailers, under one ‘roof’, conveniently delivered curbside or to your front-door.” Only Amazon poses a greater threat. Instacart should thus only be considered by grocers as a very fast and efficient stop gap solution until a more permanent solution can be reached.

When asked to comment, Instacart responded that they are not retailers, nor grocers, but a technology platform. This is technically correct, after all, Instacart does not count stores or merchandise among their assets. It is the same argument used by Uber and Lyft: they are not taxi, nor transportation companies, but technology platforms. The boundaries are certainly blurred. In this case, I would always revert to the mind of the consumer, (or even their competitors): what need is Instacart fulfilling in the mind of its consumers? If we consider the issue in marketing terms, then its is clear that Instacart competes for the same space in the mind of consumers as any other grocer. It is an alternative for stocking groceries much in the same way that Uber and Lyft are alternatives for taxi companies.

The obvious reaction of most self-respecting grocers during the early stages of the quarantine was thus to manually fulfill online orders. Just like Amazon and Walmart were doing. Yes, despite all the talk about automation that is how both giants fulfill most of their online grocery orders: manually. Manual fulfillment of online orders is the obvious path in the short term but not the way to go in the long run. Forget it. This may only be tried until they have in place a more efficient automated micro fulfillment. And they are both working on it.

Any grocer facing average net profits of 2% in their brick-and-mortar business, essentially bringing and stocking products on their shelves, cannot hope to manually fulfill online orders indefinitely. The labor expense will cause the P&L to bleed very quickly. Moreover, reallocating labor from restocking shelves and servicing shoppers to online fulfillment will negatively impact physical store (and more profitable) shoppers’ service level perceptions. This is simply not sustainable in the long run.

A recent white paper titled “How to win in online grocery” by Tim Laseter from Darden Business School surveyed consumer habits and preferences regarding service levels in online groceries. He found, as expected, that younger and more affluent cohorts were more likely to buy online than older and lower income folks. But next, Laseter did something very laudable: He identified which combination of attributes could entice most shoppers to increase purchases of groceries online. Of course, this was before the coronavirus crisis. Even though the exercise would seem moot by now, it left us with an excellent road map on which online grocery attributes are most valued by shoppers.

More important than the ranks themselves were the relative magnitudes of each attribute. Given the razor thin grocer margins, there is little in terms of pricing, the most valued attribute, that grocers can do without vendor support. The second most valued attribute is ‘service’’. Front door delivery is the most valued ahead of curbside or in-store pickup. If you consider that front door delivery must often be paired (for financial reasons) with the most reviled characteristic: a $4.95 service fee for online orders, it leaves many shoppers ambiguous about it. The real finding was that in third place to a 5% price discount, and ‘front door delivery’ the most valued attribute was ‘free services and same in-store prices’. Not surprisingly again respondents wanted more value at the same in-store prices. Think breakfast in bed at store prices. Immediacy (speed) was of course important and valued accordingly, but less overall than pricing and service. Unexpectedly, ‘Expansive selection’ (think nearly unlimited selection a la Amazon) when it came to groceries, was not as valued as ‘full store selection’.

Where does all of this leave us? There is a very appealing compromise at free same-day curbside pickup. Whereas front door delivery must come with some sort of (much disliked) delivery charges to be sustainable, free same-day curbside pickup (much like ‘Pickup’ from Walmart) is fairly valued by consumers and very attainable by most grocers. Especially if they manage to lower labor expenses and increase picking efficiency. What about the most valued ‘free front door delivery at store prices’ option? Well, it is also attainable if grocers can only redefine ‘free’ much like Amazon Prime and Instacart did. When a consumer has to pay in advance $119 for a yearly Prime membership to have access to the privilege of “free deliveries,” well, the deliveries are anything but “free.” Yes, I am purposely ignoring the other “free” services included in Prime, but bear with me. The point is that shoppers simply are not reminded of such charges every time they shop online. Grocers can thus also offer “free unlimited deliveries,” for a yearly subscription. These advance subscription payments offer the advantage of improving any grocer’s cash flow position. Moreover, the subscription would also have the advantage of moving grocers away from a purely transactional business model. It would allow them instead to focus on the lifetime value of a given customer. But this is a whole other topic.

The long-term solution is thus to convert selling space to dark (as unseen by the public) micro-fulfillment centers (MFC). These robotized and highly automated centers operate, in whole or in part, in what used to be grocery stores. If it operates in the back of an existing store, it will only require a few more employees to staff the automated fulfillment infrastructure. Most employees can multi’-function between the regular store tasks and the automated back store (mostly re-stocking and picking). The upside is likely higher sales levels and inventory turns with the subsequent increase in cash flow. The downside is slightly higher labor, depreciation and vendor expense.

If the MFC is to stand alone as a dark store, then the labor charges would be significantly less than a regular store of comparable size. The lease may also be lower compared to more premium retail locations. The assortment would probably be a bit more limited, however. Sales could be equal or higher (just ask Aldi, Costco and Trader Joe’s how to maximize sales with limited assortments). Some of the labor savings would be offset by higher depreciation and vendor fees but higher inventory turnover should translate to improved cash flow, all things being equal.

I am consciously leaving out the option of large centralized distribution centers that would service large populated urban centers. I believe this option was effectively ruled out by Amazon’s purchase of Whole Foods in 2017. Why would the leading retailer, with the best supply chain capabilities, buy a chain of physical stores? Simply because they learned all too well about the challenges of trying to deliver fresh products to individual households from large distant facilities.

The glass is thus half full. Yes, grocers started selling groceries online and the results are mixed, but the current environment is surely creating enough critical mass to make it sustainable. The path forward leads towards small scalable micro fulfillment centers to operate in the back of the existing stores. The new grocery store from Amazon in Los Angeles signals that this is exactly what they are doing. A floor space dedicated to shoppers for impulse and more experiential purchases combined with an automated MFC to fulfill commodities and branded products delivered to your car or front door. It took Amazon years and billions of dollars to arrive at this solution. Luckily, in the meantime, a host of startups have spawned to offer the same turnkey solutions at a fraction of the capital and headache investments. I am personally relieved to see that other chains and independents will have access to the same sophisticated technologies and processes as the two giants in the field without incurring the long and expensive lessons.