How Ocado ups the stakes in the online grocery prisoner's dilemma

For the last year or so Ocado has been marketing its "Smart Platform” as a turnkey solution for food retailers outside the UK looking to jump-start their e-commerce activities. CEO Tim Steiner has told investors they expect to be able to announce a couple of deals with international grocers by the end of 2015.

On the plus side, Ocado's proprietary web interface and order fulfillment technology delivers an excellent end-to-end service; Ocado and Morrison (their only client so far) are both top-rated for customer satisfaction, comfortably ahead of multi-channel competitors such as Tesco. On the other hand, Ocado's solution is expensive – they need other retailers to help finance their heavy R&D budget. Furthermore, one has to consider the strategic risk of outsourcing what is rapidly becoming a key capability (serving customers online) to a company whose CEO preaches the terminal decline of brick and mortar retailers as a result of online cannibalisation, and which could eventually be acquired by the likes of Amazon.

What is certain is that the option to go with Ocado makes the game of prisoner’s dilemma for brick and mortar grocers in Europe and the US that much more risky. Say no to Ocado, and you risk letting a competitor leapfrog ahead of you and steal your high spending customers. Say yes, then you trigger an online space race where first mover advantage is likely to prove temporary and which for the market overall adds only cost not sales. To extricate themselves from this dilemma, the players will need to look for new solutions outside the prison that is rising around them. 

Reinvention requires vision rather than focus

If there's a market that's ripe for reinvention, it's UK food retail. Profits for the major operators are down by between 25% and 100% (in the case of market "leader" Tesco) in the last two years. This is mainly due to the growth of hard discounters, which still has a considerable way to run to match penetration levels in Europe. The shift to online ordering with home delivery, which now accounts for over 5% of UK grocery sales, has also started to impact profitability, with average service fees falling from £6 five years ago to £2 today as the space race shifts online. However, industry executives are too busy thinking how to stem the advance of the discounters to think about the implication of the growth of online. Unfortunately, this represents a much greater existential threat to their business than the growth of the likes of Aldi and Lidl.  

For brick and mortar grocers, far more than for retailers of general merchandise, online adds considerable cost but usually little in the way of incremental sales. There are dis-economies of scale in fulfilment, as picking has to be taken out of stores to dedicated warehouses (aka cost centres) once online represents c10% of a store's sales. This implies significant deleverage of the grocer's fixed store costs. If nothing else changes, if/when home delivery reaches 15% of the UK market, sector profits will mechanically be around 40% lower than today's (already depressed) level. Closing stores might help, but is likely to be a messy, drawn out affair - what retailer wants to be the first to give up the other 85% of its sales to competitors?

When the going gets tough, most business leaders tend to batten down the hatches and become less rather than more open to new ideas.  Like fighters, their vision narrows - just when it should be expanding to see the bigger picture. This tendency to look inwards instead of outwards helps explain why so few incumbent companies manage to adapt successfully to major changes in their industry. Reinvention usually happens from outside, not within - Apple's legendary revival being a rare exception. 

True to form, the UK's major food retailers have reacted to an unprecedented pace of change by doing more of what they already know how to do - cutting prices and costs, "slim-lining decision-making processes", reining in capex and "refocusing on the basics". There has been some musical chairs in management, with former Tesco executives now heading up Morrison, the smallest of the "Big Four". To its credit, Tesco brought in a (semi) outsider as CEO, former Unilever executive Dave Lewis, as well as a new UK CEO with a track record of successful turnarounds in non-food retail and an encouraging penchant for treating staff as assets to be nurtured rather than costs to be cut. 

With this in mind, the questions I would like to put up for discussion are:

1) What will it take for the management of UK food retailers to realise that this is an industry that requires true reinvention, rather than a narrow focus on what's gone before? The longer they wait, the tougher it will be to execute a meaningful change of course.

2) How relevant is this discussion for food retailers in Europe and the US, where the rapid growth of new online food hubs/aggregators/retailers suggests considerable pent-up demand, and the entry of fulfilment services such as Google Express is starting to lower the price of delivery?

The great delivery outsourcing debate

One big choice many types of retailers face today as they think through their approach to e-commerce is whether to initially outsource the “last mile” to a third party (e.g. Instacart, Google Express, etc.) or to take responsibility for delivery themselves.

For food retailers, the key is to have a strategic plan that takes into account the unusually high level of uncertainty regarding the future nature, pace and extent of the online grocery channel shift. What is clear today is that being unprepared could have major negative consequences.

Click and collect is clearly the most desirable model from the grocer's perspective, as it eliminates the last mile costs, complexity and "in-house vs outsource" debate. However, it is by no means clear that consumers prefer click and collect to home delivery. The latter is still the dominant mode in the UK, where online accounts for around 6% of grocery sales (15% in the the two weeks before Xmas 2014) and is still growing at 15% p.a. I don't think Amazon would be expanding its US Fresh delivery service progressively across the West and East coast if it hadn't detected a certain level of demand for the service, even if they are just using groceries as a way of increasing purchase frequency and reducing delivery costs by bringing it in-house with their own fleet of vans. Furthermore, the explosion of online food delivery start-ups in the US over the last couple of years suggests considerable pent-up demand.

The only country in Europe where click and collect is the dominant model is France, which is partly due to the prevalence of the hypermarket format which is increasingly seen as too time-consuming to get round. There also appears to have been an active effort by the market leaders to keep delivery prices high in order to keep demand low. However, contrary to initial hopes, this Drive model leads to very few impulse or fresh food purchases in store. The head of Leclerc, which is the click & collect market leader in France with a 50% share of "Drive" sales, has even admitted that he hopes this channel does not grow too much more.

As with most things, the extent of demand for grocery home delivery will be largely determined by the price and quality of the service offered. In the UK, the average delivery fee has fallen from £6 five years ago to £4 in 2012 to £2 in 2014, as the major retailers, as well as pure online specialist Ocado, battle for customers in this new channel. One hour delivery slots are now the norm.

No-one can tell how big the market for groceries ordered online and delivered to the home will eventually be. Some people used to think consumers would never order fresh food online; in the UK it turns out that fresh penetration online is similar to that in-store. However, once the online space race genie is out of the bag, it won't go back in. Meanwhile the growing presence of pure online operators may make it more difficult for this game of prisoner's dilemma to have a favourable outcome for store-based retailers. Amazon and Google both have strategic reasons for driving online grocery sales, together with the financial clout to subsidise (i.e., drive down) the price of delivery further.

All this leads to the conclusion that food retailers should plan for uncertainty and stay flexible. As long as the likes of Instacart, Google Express and Shipt are willing to bear some of the service cost subsidy, they can be a useful, relatively low cost way of testing the level of demand and price elasticity for home delivery vs click and collect, while signalling to competitors that you may want to co-operate rather than be the snitch in the game of prisoner's dilemma (i.e., aggressively chase online customers). However, give the variety of different players in this game, it would also be prudent to start building in-house fulfillment capability and analysing the pros & cons of various options (pick in store vs dedicated warehouse, manual vs automated including next generation robotic picking technology) under different volume scenarios. 

Nice idea, shame about the execution

I recently came across a really nice idea in the expanded wine section of a refurbished Edeka (German supermarket) store. Next to some of the more expensive wines there was a huge red button for calling a customer service representative. It was too tempting, so I gave it a try. Within a minute someone arrived and asked how he could help. Excellent. I asked for some advice on what wine he though might be best with the (meaty, slightly spicy) meal I was having tonight, preferably a German wine as I wanted to try something local. He said unfortunately he couldn't help me as he didn't know much about wines... The wine expert wasn't in today. Did he know when he might be available? Sorry, no. Hum. 

Nice idea, shame about the execution. I wonder how that customer service assistant felt about admitting he couldn't help me. Probably too busy running back and forth from his regular duties to really care. However, I wonder how he might have felt if he had been given at least some basic training, not necessarily to expert level, but just enough helpful tips to please someone who knew absolutely nothing about German wine. Pretty chuffed I'd imagine. (Don't worry about me, I went for my regular high tannin/high alcohol inky Languedoc red and was happy enough. I'd even go back to that store just for the fun of pressing the big red HELP button.)

How supermarkets could take the lead in improving public health

As UK celebrity chef and child food education campaigner Jamie Oliver describes in this TED talk, the leading cause of death in the US and most other Western countries - heart disease - is largely preventable through changes in diet and lifestyle. The same goes for obesity, which is linked to cardiovascular disease as well as diabetes and cancer and has risen consistently over the past 60 years to reach epidemic proportions, despite (or some would argue at least partly because of) the rise of low-fat diets. It seems crazy when you think about it - if they wanted to, people could live longer, better quality lives, without the need for costly medication. So why don't they? 

There are two reasons for this strange situation. Of course, there's the natural human tendency to prioritise short-term pleasure ahead of potential negative longer-term consequences. However, when the latter are made clear enough, people do react, as shown by the sharp fall in the number of regular smokers in the developed world over the past 60 years. This leads to the second reason, which is (as Jamie Oliver demonstrates in his video) a deplorable lack of understanding among the general public as to what food is or isn't good for you. This isn't so surprising given the confusing and often contradictory advice not just in the media but also from health and nutrition experts and government bodies, which is sometimes based on flawed studies or outdated science. 

Jamie Oliver's solution is to teach kids about food at school, so they grow up knowing how to choose and prepare simple, tasty, healthy meals. Although this is an admirable goal that should be achievable, why limit such education to children? Supermarkets could and should take more responsibility for educating their customers about the products they are selling. This would not only improve the lives of customers, but also those whose jobs are currently limited to boring, relatively unrewarding jobs such as restocking shelves and working at the checkout. Given the potential to reduce ever-growing healthcare costs through better education at the point of sale, supermarkets should also be able to ask for government funding to support investment in training staff to help customers help themselves to eat more healthily. 

What a revolutionary, crazy idea - that staff in stores should know more about what they are selling than their customers! Actually, what is really crazy is that food, which can have such a major impact on the quality of our lives, is virtually the only retail sector where this is not yet the case. 

Aiming high

As a legendary football manager used to say "Aim for the sky, and you'll reach the ceiling. Aim for the ceiling and you'll stay on the floor."  For food retailers, the importance of making the effort to lift one's thoughts above day-to-day operational issues is greater than it's ever been. We've said it many times before but as we go into 2015, with the combined profits of the UK's publicly-listed food retailers forecast to be down by around 50% compared to a year ago, it's worth reiterating: you can't escape a tsunami of change by continuing to take small, incremental steps in the same direction as before.

Our New Year's To-Do wish-list for food retailers struggling with a structural shift away from large, out-of-town stores to convenience, limited range discount and online channels:

1. Aim high, really high, think Big. When considering a new idea, instead of asking "who's done this before?", try asking "why haven't we thought of/done this before?".

2. Test small, fail fast, test again. 

3. Take a more holistic view of online. Instead of treating digital as a completely separate unit (which is still the norm for most retailers we've met), consider the impact that the growth of online will have on your store business, and what can be done to preserve the latter's profitability. The fact that for the market as a whole the shift online adds costs and complexity but not sales is probably the most important strategic conundrum that food retailers will have to face up to over the next few years. All the more reason to refer back to points 1 & 2 above.          

Feedback welcome

Thanks to everyone who has taken an interest in my blogs this year. Since I started posting in March 2014, I've had over a thousand visits and several thousand page views. I would however like to take this opportunity to encourage readers to let me know what they think of my ideas. The good, the bad and the ugly - all feedback is welcome and a potentially useful source of debate.  Special thanks to Bill Bishop, Chief Architect of leading US online grocery think tank BrickMeetsClick, for being the only one to post comments on my site so far..!

Wishing you all the best for 2015. 

Marc de Speville