By Molly Johnson-Jones
In 10 years, the vast majority of online delivered groceries will come from dark stores. Today, Ocado and Amazon have solely dark store fulfillment; as a result, they have a wider range, lower overhead, fewer substitutions, greater opportunity to develop technology, and the ability to generate decent margins from online. While dark stores require a comparatively heavy investment, they address the profitability problem that has weighed on online grocery since its inception. Ocado and Amazon’s market-leading capabilities will allow them to steal market share as more consumer spend shifts online, so supermarkets must act to future-proof themselves.
Online penetration will grow to an estimated 9.8% of the U.K. food and grocery market by 2022, up from 7.8% in 2017, as Millennials, who have been the greatest adopters of online food and grocery, start to have families and reduce reliance on top-up grocery shopping. Online also provides an opportunity for retailers to grow market share. The channel is currently unpenetrated by discounters, whose model would cause losses online.
Online food and grocery is a particularly difficult channel. Goods are low-value and frequently purchased—characteristics that lend themselves to the convenience of online. But since food and grocery items yield little profit, the more expensive fulfillment model of online, particularly the in-store pick used by the majority of grocers, brings down retailer margins even further.
Frequency of purchase is growing, with average transaction value falling, so the return from online is declining. Ocado’s Q3 results showed that online basket sizes continue to fall; this quarter saw -1.2% on top of -3.4% for Q3 2016. This trend is consistent across the sector as multibuys decrease, the use of delivery passes increases, and more mobile grocery ordering causes reductions in basket size while simultaneously increasing frequency of purchase. Though brick-and-mortar food and grocery retailers seek to increase this metric, it is problematic for them.
The larger the online basket, the greater the incremental profit, as every online order must be picked and delivered at an additional cost to usual in-store shopping. Therefore, operating margins are smaller, and we estimate that online baskets need to be above £60 to break even. However, by investing to dark stores, even though painful in the short term, retailers can grow volume and reduce online overhead through scale, potentially reducing the breakeven threshold.
There are limitations to investment in dark store capability, though. The big four retailers are all currently managing ambitious cost-saving programs and seemingly incompatible margin targets at a time of the highest consumer price index and producer price index that we have seen in over a decade. Simultaneously, grocers are expanding their online offerings in a constant battle to provide the best services. All offer delivery savings plans. Sainsbury’s and Tesco provide same-day delivery and even two-hour delivery in London (both have some dark store capability now, but it does not cover the majority of online fulfilment). And all are developing apps in a bid to win market share of the highest growth area of food retail. The investment into this is costly, and return on capital is currently low.
Moreover, if grocers choose to stop limiting the availability of online with more time slots, greater same-day geographical coverage, and better product availability, then online will grow faster than its current rate. This will bring margins down across the business as online contributes a greater proportion of sales and subsequently will impact store sales.
Current strategic thinking is short-term and does not fundamentally change the method of fulfilment. If anything, the novel ideas such as two-hour delivery are a way to keep up with Amazon and gain cheap advertising. Retailers need to stop trying to keep up with Amazon’s capabilities, and start defining the future of online food and grocery themselves. The channel will grow to take 9.5% of the food retail market by 2022, and if fulfilment improves, this could be even higher. Do grocers want to give that share away to the pureplays who are better placed to deal with the challenges of basket size and fulfilment issues? We don’t think so, and it can be mitigated by reinvesting cost savings into dark stores, not just choosing to sit on cash to return to investors.
Molly Johnson-Jones is senior food and grocery analyst for research firm GlobalData.