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The Virtual Grocer

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The looming cloud of the internet age may have overshadowed traditional ways of doing business, but happily it comes with a silver lining. Just as e-mail has revived the art of letter writing, so too the arrival of online grocery shopping has restored some of the conveniences last enjoyed by shoppers of yesteryear, when the local grocer knew his customers and their shopping preferences, offered helpful product recommendations and provided home delivery.

With what it boasts is the largest and most profitable home grocery shopping business in the world, Tesco, Britain's leading supermarket chain, is at the forefront of this shopping revolution. As recently as a year ago, when British papers heralded Wal-Mart's $10 billion purchase of the discount chain Asda with headlines predicting the humbling of "rip-off" Britain's domestic supermarket giants, Tesco's future seemed precarious. But rather than throwing in the towel to the Arkansas-based behemoth, Tesco has fought back, expanding aggressively into foreign markets, extending the scope of its online operations and launching a highly publicized $80 million price-cutting campaign.

Results have been impressive. The company has outperformed analysts' profit expectations by nearly 10% and earlier this year Tesco breached the $30 billion mark in sales for the first time. "The most interesting thing that's happened in the U.K. since Wal-Mart entered is not what Wal-Mart has done but how Tesco has responded," says food retailing analyst David McCarthy of Schroder Salomon Smith Barney. "Tesco has gone up a few gears, pulled farther away and has nothing to fear from Wal-Mart."

Tesco's tenacious defense of its core business and aggressive expansion are yielding handsome dividends, but to characterize the company's strategy as a reaction to Wal-Mart's encroachment does not do it justice. John Browett, chief executive of Tesco.com, the online business which Tesco spun off earlier this year, says that as early as 1994, when the concept of e-tailing was little more than a glimmer in even Jeff Bezos' eye, Tesco began formulating the approach that would eventually spawn its online business. "Customers have always wanted their groceries delivered," he notes. Before the advent of self-serve supermarkets, when grocers operated on gross margins as high as 50%, "if somebody wanted delivery service you were only too happy to do it and the relative labor costs were low. It just became uneconomic to do." As Bezos, Tesco and others quickly realized, the Internet would allow retailers to address age-old consumer demands in a newly cost-effective way. "The challenge," says Browett, "is that it's still not simple to do."

And what at first glance might appear to be the simplest element of the equation is in fact among the most complicated. A bricks-and-mortar merchant like Tesco that expands into e-commerce must first choose a distribution model. Products can be delivered to customers either from existing stores or a high-tech, purpose-built warehouse — or some combination of the two. A third model, still on the drawing board, would allow networks of suppliers to combine resources and deal directly with "upstream" manufacturers like Nestle or Unilever. According to Alan Taylor of online business consultants E-Insight, once these streamlined models of the future are in place, a product will be able to bypass both store and warehouse in its journey from point of production to the customer's kitchen counter.

For now, however, with online grocery shopping still in its infancy, the paradigms of choice are "pick and pack" and dedicated warehouses. Some industry observers, like Richard Perks of Retail Intelligence, maintain that picking from existing stores is "too disruptive" and are convinced the only way to "build a business of genuine scale is to base it on the warehouse model." With a distribution system for online food sales that relies entirely on picking and a reported $120 million in online revenues during the first half of this year, Tesco appears to be disproving that view. "We looked at doing it out of stores and looked at doing it out of warehouses," explains Browett. "We quickly realized that the only way to do it profitably, especially at low volumes — which you're always going to have at the start — is to do it within the stores."

Not every retailer has reached the same conclusion. Sainsbury's — Tesco's archrival and until five years ago the U.K.'s dominant chain — currently uses the picking model out of nine stores in the London area. But it is also developing what it claims will be Europe's largest grocery home delivery center. Sainsbury's online foray has been far more tentative than Tesco's, but that seems likely to change under the leadership of recently appointed chief executive Peter Davis, who in his previous post at Prudential was responsible for the development of Egg, Britain's first major Internet bank. Wal-Mart's Asda, the U.K.'s third-largest chain, has also pinned its hopes on the warehouse model. Two 4,000 sq m fulfillment centers in the London region currently comprise the full extent of its home-shopping infrastructure. But Asda has yet to venture online, providing instead a cd-rom-based service with customers placing orders by phone, fax or e-mail. As for Continental grocers, French giant Carrefour, second only to Wal-Mart in global sales, last year launched a limited online venture. Last month, however, Carrefour announced plans to scale back its Internet investment by as much as 40%. Instead of expanding its own operations, Carrefour will focus on cracking the online market through partnerships with established online shopping ventures.

With the online grocery field set to become as competitive as its bricks-and-mortar counterpart, Tesco's model will be put to the test. Even Taylor, who estimates that to generate a profit in e-commerce a product should be touched no more than six times from factory to consumer, acknowledges that despite the approximately 20 touches in the Tesco chain, "the momentum Tesco has created has given them such a lead in the U.K. that they will have sufficient scale to ... hold on to not much less than a third of the share of online business in the U.K." Besides, Tesco's commitment to the picking model applies only to groceries. Browett acknowledges that "if you want to sell 1.3 million books, which we do, you can't do that out of a store." So to handle the distribution of baby-care products and household supplies, clothing and electrical equipment — added to the online inventory just this month — Tesco has teamed up with German catalog retailer Otto Versand.

As for the oft-leveled charge that picking will "cannibalize" customers from Tesco's stores, Browett is dismissive. "If we had got het up about cannibalization, we would never have moved from small high street stores to supermarkets to superstores to hypermarkets. For us, grocery home shopping is just another format that delivers for a particular set of customer needs."

Whether his order arrives from a local superstore or a warehouse in the suburbs is irrelevant to a customer like Istvan Szoke, who loves to cook but thinks grocery shopping is a "waste of time." What matters is the scope and efficiency of the service, and on both scores, Tesco has some work to do. A venture capitalist who lives in London with his wife and baby son, Szoke has used Tesco.com since delivery to his neighborhood first became available a few months ago. "The first time was a disaster — they had to make three trips to deliver one order," he says, and even now "there are missing items in every order."

Szoke also thinks the website's format could be more user-friendly — he'd like to see better product descriptions, for example — and wishes there were a bigger online selection, but admits that he's an unusually demanding consumer. And despite the glitches, Szoke has stuck with the service and has nothing but praise for the "friendly and helpful" customer service response he has received when he has called to sort out problems.

With competitors expanding their own online operations, Tesco is working quickly to ensure that it retains customers like Szoke through satisfaction and not forbearance. One of the tools it sees as crucial to understanding and meeting shoppers' demands is loyalty cards. It is impossible to register at Tesco.com without a Tesco Club Card number, and if a first-time online shopper already has one, the system will recognize that. In this way, Tesco is able to track how many online shoppers are its own customers and how many it is drawing from other chains. Tesco uses the extensive data it gathers about its customers' shopping habits to customize products and services not, Browett insists, on a micro one-to-one level, but on a broad demographic scale.

In much the same way that an Amazon customer who buys a specific book is given additional title recommendations, a Tesco.com shopper who chooses a certain type of cheese may find suitable wine recommendations suddenly pop up on the screen. It may lack the personalized touch of the local grocer who was intimately acquainted with every customer's idiosyncracies, but then again, he was always a bit of a busybody, wasn't he?
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