Why downsizing is not the solution to the online cannibalisation conundrum

Two recent reports, one from consultants Oliver Wyman in the US and another from investment analysts at Goldman Sachs in the UK, have suggested that the growth of online food shopping should lead to the closure of 20-30% of existing stores. They argue such a reduction in food retail capacity would allow the fittest to thrive and set the stage for an eventual profit recovery. I think this reasoning significantly underestimates how tough the transition to a smaller store estate will be and how long it will take. The “last man standing wins” theory, which used to apply when Wal-Mart came into new markets with its Supercenters in the 1980s and 1990s, is unlikely to work so cleanly for the online channel shift, for three reasons.

1) It assumes retailers as a group will act rationally to close the necessary amount of space, instead of holding on for as long as they can in the hope the other guy will bow out first. After all, if 10-20% of your customers have moved online, closing a store still means you will be giving up the other 80-90% to the competition! Food retailers hate giving up market share and will go to considerably uneconomic lengths to try to win it, as shown by the space race in the UK over the last decade, which is now moving online - despite this channel being even less profitable than stores.

2) The stores that suffer the most from the online shift may be some of the most profitable – i.e., those serving higher income customer segments. Another reason to hold off closing them.

3) Closing outlets that are marginally profitable or even loss-making has a negative impact on a company's profits due to deleverage of central costs such as logistics, marketing and admin. New income streams from alternative use of property that is owned could help offset this, but would require a major easing of existing re-zoning laws to be meaningful. 

The standard strategy for dealing with tougher competition - squeeze out more cost savings to reinvest in price, quality and "service" - is not going to be nearly sufficient to solve this dilemma. So, while a reduction in overall food retail space (especially the larger out-of-town stores) is no doubt desirable and indeed inevitable as weaker operators fail, the transition could be much more drawn-out and messy than most seem to expect, unless the bosses of the major players are willing to try to reinvent the model instead of continuing to tinker with it.

Why the Google vs Amazon battle matters for grocers

Google chairman Eric Schmidt recently said "Many people think our main competitor is Bing or Yahoo. But really our biggest search competitor is Amazon." In particular, Google lags Amazon in product search, where it lacks the customer purchasing data that retailers such as Amazon can collect. This explains why Google has been investing a reported $500m to drive its Express shopping service this year and has been busy signing up major retailers such as Office Depot, Target, Toys R Us, Raleys, Costco and Whole Foods, as well as smaller players in the Los Angeles and San Francisco area. It recently introduced a $4.99 same day delivery charge, along with a minimum order value of only $15 and a $90/year subscription for free delivery (compared to Amazon Prime's $99 sub fee). So far Google Express only offers non-perishable items, but there are reports it is looking to offer fresh food as well in partnership with supermarkets, with a mooted $7.99 delivery charge, waived for orders above $150 in value. 

Joining forces with Google Express could be a relatively low-cost way for brick and mortar grocers to test the market for fresh food delivery, as Google's cut of the revenues - estimated to be in the mid-single digit percentage range - is still less than what it is likely to cost food retailers to pick, pack and deliver the goods themselves. In other words, there may be an opportunity to piggy-back on the subsidy that Google is paying to achieve its strategic objective of creating a same day delivery service and hence product search portal to rival that of Amazon. The downsides of such a model being a) little or no control over the quality and continuity of the service offered; b) limited scalability (as long as the products are picked in-store); and ceding control of customer data to a (not just any) third party.  

The danger for the grocery industry as a whole is that this strategic battle between two highly cash-rich companies known for taking a long-term view on profitability could significantly drive down the cost and hence accelerate customer take-up of home delivery. This implies a double-whammy on brick and mortar profits due to the higher subsidy required to compete in this new channel, combined with greater cannibalisation of store sales and profits. (Remember that for the grocery market as a whole, the shift online only adds costs, not sales.)

It is possible that Amazon, whose profitability is starting to come under greater scrutiny by investors, may blink before Google and decide to put a limit on the delivery subsidy it is prepared to pay to drive its Fresh business. However, given the strategic importance of same day delivery of perishable and non-perishable goods, not just in the battle for highly lucrative advertising income but also in the determination of CEO Jeff Bezos to sell more stuff to more people at a lower cost, this limit is likely to be a lot lower than that implied by the current $6-$12 average service fee charged by those offering grocery home delivery in the US today. 

The good news is that next generation robotics technology could allow traditional food retailers to leapfrog Amazon Fresh and Google Express in terms of order fulfillment efficiency, while at the same time making much more effective use of their key assets - people and stores. 

Waking up to the elephant in the online grocery space

Last week at the World Retail Congress in Paris I heard for the first time ever a senior supermarket executive recognise publicly that the growth of online grocery shopping is not good for the industry. What's more, this admission came from Michel Edouard Leclerc, head of France's largest hypermarket chain that has been most aggressive in opening click and collect outlets (known as "Drive" in France) and now has a 40% of the EUR5bn online grocery market. Leclerc stated that once the initial benefits of first-mover advantage wear off and the competition responds, the online business becomes increasingly cannibalistic of store sales. Click and collect is only successful, he said, as long as it doesn't grow much more. Indeed, according to a study done in France last year by IRI, a leading market research firm, once "le Drive" accounts for around 8% of a store's sales, most of the incremental sales are taken from the store. 

This is obviously not what the CEOs, heads of e-commerce, and shareholders of major supermarket groups want to hear. It is more reassuring to look at research showing how customers who shop both online and in store at a particular chain spend two or three times more than those who use just one channel. However, this only works in the early growth phase and all it means is that each chain's most loyal customers are becoming even more loyal, but at the expense of each others' less loyal customers. It's a zero sum game: for the market as a whole, the online channel adds costs, but not sales.

These costs are obviously much higher for home delivery than for click and collect, which adds to the profit pressures already being felt from the rise of discounters in the UK, where home delivery already accounts for 5% of the total grocery market and the £3 average service fee represents a 10% margin subsidy on an average £100 order. This subsidy is likely to persist, or get even bigger, given retailers' desire to follow the customer and steal or defend market share, and the existence of pure online grocers such as Ocado, which could be more profitable than Tesco in a few years' time, and Amazon Fresh - whose main strategic purpose is to help Amazon sell more stuff to more people more regularly at a lower cost. 

So what to do? Some food retailers privately admit that e-commerce is uneconomic but that they have to provide the service because that's what an increasing number of customers want. In other words, the genie's out of the bottle and not going back in. At best, it can be temporarily contained, as in France. When questioned about the negative impact on profits, answers we've heard from supermarket executives in the US and UK vary from "It's not something we're really thinking about", "It's something the accountants will have to deal with", to "It will depend how it's presented to investors."

Unfortunately this problem will only get worse as more customers shop online and picking has to be moved out of existing stores into dedicated fulfillment centres, which further add to operating and capital costs. The only long-term solution we can see to the online cannibalisation conundrum is to: 

a) Invest in the next generation of automated technology to secure the lowest fulfillment costs; b) create a new bi-modal format combining the best of the online and in-store experience; and c) transform from manufacturers' agents into customer service providers that sell food.

The latter will require retailers to better SEE (Stimulate, Engage & Empower) their staff so they can better SEE customers. Investing more in staff when sales are stagnant or falling is not an easy sell. However, they - not stores - are a physical retailers' most valuable assets, and the most under-utilised today. 

Tesco - a tragedy in three parts

The saying “Pride goes before a fall” has its roots in ancient Greek tragedy, which was based on the inevitability of human hubris triggering retribution. Tesco’s increasingly precipitous fall from favour – with customers, shareholders and now regulatory and government bodies – is the stuff of which trilogies could be made. As this article in The Independent describes, the conditions that made it possible for Britain’s largest and best known (if not loved) retailer to overstate its first half profits by an estimated £250m arose from a widespread culture of fear, intimidation, aggressive chasing of targets and immunity to criticism at the top that has been the dark side of Tesco for decades.

In fact, as far back as 1986 Bill Grimsy, who was brought in by then CEO Ian MacLaurin as Tesco’s first ever customer services director and who later went on to run Park ‘n Shop in Hong Kong and Iceland and Wickes in the UK, described Tesco managers as “a bunch of leather-jacketed bully boys” who enjoyed terrorising those beneath them. Despite MacLaurin’s best efforts to get change such behaviour, it was already too deeply embedded and only grew worse as Tesco’s ascendance over Sainsbury (which was suffering its own period of retribution for its prior hubris) under Terry Leahy attracted hard-hitting “winners” and fueled managers’ belief in themselves and the superiority of the Tesco way. As the company’s market share, profits, international presence and share price rose continuously, so did the level of arrogance at the top, epitomised it must be said, by Leahy himself. As several Tesco insiders told me previously, Leahy’s word was God and not to be questioned. I found this for myself in a small meeting of analysts in 2008 when I dared ask whether he thought customers liked going to Tesco as much as they used to and if it might be worth investing a bit less in new stores and more in renovating existing outlets. Leahy took it as a personal affront and instead of answering the questions (whose validity has since been proven all too clearly) launched the most aggressive, condescending, and generally unpleasant  “counter-attack” I have ever been unfortunate to experience. It took me a while to realise this was the result of Leahy’s insecurity and lack of experience of being questioned, not just his dislike of City scribblers.

Leahy’s successor Phil Clarke was different but still a product of Tesco’s tough culture, having spent all his working life there. Like Leahy he was not naturally sociable and more of a loner, which may help explain why he ended up being the sole member of the management board left by the time he was given his marching orders by Tesco’s genial but utterly ineffective chairman Richard Broadbent (who it should be noted had given Clarke his full support up until the month before he was fired - we suspect shareholders told Broadbent either he or Clarke had to go).

The investigation into how Tesco managed to overstate its first half 2014/15 profits by £250m, and collapse of corporate governance along with its share price, clearly strengthens new CEO Dave Lewis’s mandate for radical change. The question is whether someone with no experience of food retail understands what needs to be done. Lewis’s recent comments about the need to change Tesco’s culture and put more staff into stores are encouraging, but one has to wonder whether he understands the importance of engaging employees at all levels, and if so whether he is capable of doing this. When Archie Norman took over a similarly disfunctional Asda in the early 1990s, he fired 70% of managers in order to break the culture before remaking it. It will be interesting to watch “drastic Dave’s” next moves and once again I can only wish him the best of British luck in what will be a truly formidable turnaround challenge at a time of unprecedented challenges for the traditional supermarket industry.

Tesco's formidable turnaround challenge

Following Tesco's latest and biggest profit warning, with group earnings now expected to be 15-20% lower than previously indicated and the interim dividend cut by 75%, incoming CEO Dave Lewis will no doubt be advised to cut prices more aggressively and take other radical measures. Price cutting is the easiest weapon to deploy in the battle for market share, but also the costliest and least effective when everyone is cutting prices at the same time. Despite the margin investment they have made so far this year, value perception for Tesco, Sainsbury and Morrison has continued to decline, in both absolute terms and relative to the hard discounters Aldi and Lidl. This is partly because the relative gap hasn’t moved that much and partly because it is very difficult for mainstream full range supermarkets to match the value for money that the limited range discounters’ own label provides.

Tesco’s main problem is customer satisfaction, which started declining before Terry Leahy left as CEO due to under-investment in staff and stores and continued throughout Phil Clarke’s tenure, reaching record lows today. People just don’t like the experience, it’s too bland and the staff attitude is too variable. Meantime the shift to online shopping adds more cost than it does incremental sales; Tesco’s share of the online market is nearly 50%, double its offline share. Yet that hasn’t helped stop erosion of its market share and profits. As we said in a previous blog, the changes Clarke was trying to make, notably adding staff and renovating stores, were along the right lines but far too incremental. You don’t escape a tidal wave created by a perfect storm of change by taking small incremental steps. So Tesco’s new CEO should heed calls to take much bigger bolder action.

Fundamental change is needed in three areas. First, Lewis needs to address Tesco’s culture, which is too siloed and still retains a bully-boy element that keeps good people down. Archie Norman’s turnaround of Asda and Justin King’s of Sainsbury were primarily cultural turnarounds. This is by no means easy and takes time, but is crucial in such a people-intensive business.

Second, Tesco store staff at all levels should be trained and empowered to be able and willing to advise customers on how best to choose, prepare and store food –i.e., actually sell food, instead of just sticking commodities on the shelves and letting customers fend for themselves. Consumers, especially the less well-off, desperately need help in figuring out what’s good for them and what’s not, and on how to prepare healthy, tasty meals easily and cheaply. Stop treating staff as robots or they will be replaced by robots (Amazon’s or Ocado’s). Take note of the fact that the food retailers that spend the most on their staff actually end up being the most profitable. 

Third, Tesco needs to find a way to address the elephant in the room – i.e., that the cost of serving online customers is eating into overall profits, and that this problem will only worsen as the online market grows, as picking is shifted from stores to “dark stores” that add incremental cost but minimal incremental sales. Solving this dilemma will require true out of the box thinking and testing new models and formats that combine the best of the online and in-store experience.

It will be a formidable challenge, especially given Lewis’s lack of food retail experience and the ineffectiveness of Tesco’s chairman Sir Richard Broadbent, who it could be argued should share some of the blame for Phil Clarke’s failure to stop the rot in his three and a half years at the helm. It will be interesting to see how Lewis approaches the task. In the meantime, I can only wish him the very best of British luck. 

Pouring oil on the fire

On holiday with friends in Tuscany recently I was struck by how little is generally known, even by professed foodies, about a product that has been used in regional dishes for thousands of years, and in recent decades increasingly throughout Western Europe - olive oil. Many people I've talked to use extra virgin olive oil to cook with, thinking it is healthy - which it is most of the time. However, extra virgin olive oil has a relatively low smoke point, which means it oxidises at medium to high heat, producing potentially toxic by-products and carcinogenic free radicals. Non-virgin olive oil - i.e., that which has been extracted by chemical means and/or has been more refined - has a higher smoke point but contains less healthy fatty acids and anti-oxidants that help "mop up" free radicals. On the other hand coconut oil, being high in saturated fats - which contrary to received wisdom recent studies suggest have no clear causal link to heart disease - is much better for high-heat cooking methods like frying. In fact, unrefined coconut oil has actually been shown to improve cholesterol and blood lipid profiles and has anti-bacterial properties. Clarified butter (made by heating ordinary butter and removing the milk solids that rise to the top) is also good for frying and can help the body absorb healthy nutrients. 

How is it that those responsible for selling basic food products such as olive oil and butter - i.e., supermarkets - don't advise customers on how to use them properly, even when misuse may be harmful to the health? How do you think customers would react if they received advice on how to choose, use and store food from staff who are well trained, engaged and empowered? Surely they would want to come back to that store more often, and tell all their friends about this cool new type of store that ... actually sells food, instead of just putting commodities on shelves and letting customers fend for themselves. 

A new meaning for customer service

Last week I was in the US attending the FMI Connect conference, where I was presenting on the challenges and opportunities arising from the growth of online grocery shopping (http://www.progressivegrocer.com/industry-news-trends/trade-associations/live-fmi-physical-retail-digital-world?cc=10). I also took the opportunity to visit several stores in the Boston and Chicago area, including Aldi, Stop & Shop, Demoulas/Market Basket, and Wegmans. What struck me was that, with the clear exception of Wegmans, I got better service from other customers than from store employees. From offering product suggestions and cooking tips, to discounts using their loyalty card, other customers were far more forthcoming, helpful and knowledgeable than the staff I saw in the stores.

Now, one can't expect much in the way of service from a limited-assortment operator such as Aldi, whose prices for comparable quality products are 20-30% below regular full-range and "service" supermarkets. However, at the Stop & Shop I visited there were virtually no staff visible, or customers for that matter. This might be due to its location right next to a Market Basket store, where there were plenty of both. However, the staff I encountered at that store, including those wearing "Here to help" badges, ranged from poorly informed to plain rude. This might have just been a bad day or bad store within the Demoulas chain, but it is not so dissimilar to my experience at the average Tesco store, the UK "leader" as measured by market share. The experience I had at Stop & Shop and Market Basket made me appreciate the Wegmans experience even more, especially the guy I met in the produce area who let me try some rambutans on the spot, took me over to the prepared foods area to show me his favourite dishes, and talked proudly of the training he gets, which includes tasting lots of what is sold in Wegmans. 

The point here is simple: treat your staff as robots and they will act like robots. However, given pure online retailers such as Amazon and Ocado are now using robots to crack the logistical challenges of fulfilling online orders, and that it is easier to build mechanical robots than change people and culture, brick and mortar grocers need to start redefining the meaning of customer service, as a matter of urgency.

Hello Fresh ... Amazon?

This week I received my copy of "Contagious", a new book about the importance of word of mouth in the digital age, which I bought from Amazon (and will be the subject of a future blog). As expected, the book arrived exactly when I was told it would. What I didn't expect was the accompanying £25 voucher from a company called Hello Fresh, which offers weekly home deliveries of the exact ingredients required to make healthy, tasty recipes. Turning to their website http://www.hellofresh.co.uk/versus_supermarkets/ I found that Hello Fresh claims to offer these meal ingredients for 20% less than the major supermarkets, as a result of having no store overheads and sourcing direct from local suppliers (including a high quality butcher, fishmonger and greengrocer). Furthermore delivery, which generally costs between £1 and £6 at Tesco, Asda, Sainsbury or Ocado, is free at Hello Fresh.

These financial incentives, together with my personal and professional curiosity, were more than enough to prompt me to place my first order for a total of six meals, costing £39 (before application of the £25 voucher). The order is due to arrive in a couple of weeks' time, when I'm back from a business trip, and I'll be posting an update on the experience then. In the meantime, this is worth highlighting as another example of how online is fragmenting the grocery shopping experience and enabling new companies to tap consumer interest in nutritious, tasty and easy-to-prepare meals, and reducing waste, better than many supermarkets.

However, what I find particularly interesting here is the role of Amazon. When I called Hello Fresh to enquire about this, they said Amazon's role is limited to marketing, as part of the Amazon Local service, which sends subscribers daily deals from merchants in their local area. Delivery is handled by Hello Fresh, using couriers. One has to wonder though what benefits Amazon may be getting in terms of understanding the market for fresh food delivery in major UK urban areas such as London, and how the partnership with Hello Fresh and other similar ventures could develop once Amazon launches its Fresh grocery business in the UK. The ability to deliver a wide variety of locally-sourced specialist foods, as Amazon Fresh currently does on the West coast of the US, is one its main points of difference vs standard brick and mortar online grocery offerings, which are still mostly limited to what's available in-store. 

Get ready to say Hello to Amazon Fresh...