Amazon

Next up for disruption: The grocery business

April 4, 2014: 11:21 AM ET

The logistics of "last mile" food delivery and the thin margins in the grocery business delayed the inevitable, but capital is finally pouring into online grocery shopping.

Amazon Fresh trucks

Amazon Fresh trucks

FORTUNE -- The grocery business is loaded with friction, at least from a purely economic perspective. Once a week or more, shoppers must drive to stores, traipse through aisles hunting for what they want, and stand in lines -- a gigantic, continual waste of time, patience, and gasoline. Grocers, which stand between food producers and consumers, must maintain chains of stores dotted across a geographical region or across the country, and each store must be serviced by a complex logistical and transportation infrastructure. If any industry is ripe for disruption by online shopping, it should be the grocery business.

But so far, it hasn't happened. Despite the fact that we now routinely order everything with a click, from books to beds, most people still don't get their groceries that way. All thanks to a lack of capital.

Now, though, investors are starting to pony up. Big companies like Amazon (AMZN), Trader Joe's, and Wal-Mart (WMT) are, to one degree or another, at least experimenting with grocery delivery if not going at it full-bore. Meanwhile, venture capitalists are starting to shower money on various startups. Online groceries generated more than $15 billion in sales last year, which represented big growth, but also represented a tiny fraction of the $1 trillion grocery market, according to Forrester Research.

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There are several reasons that investors have shied away from grocery delivery even as they have happily financed innovations in other sectors of the retail economy. The logistics are nightmarish. It's hard enough to deliver goods to the home in one day or less; it's exponentially harder when those goods are perishable. Also, until recently, investors weren't convinced that enough people would be comfortable with someone else picking out their produce to make for a big business. That factor might still dissuade a lot of shoppers, at least at first (and some people simply enjoy grocery shopping). That means that any business getting into delivering groceries must put quality at the top of its priority list. One head of wilted lettuce can lose a customer forever. Further, the margins in the grocery business are vanishingly thin, which means that economies of scale are needed before profits can even be hoped for.

But the reason most often cited for the hesitation of investors is the implosion of Webvan at the end of the dotcom boom in the early 2000s. That company's failure (it declared bankruptcy in 2001) was so horrific, and the losses so great, that for years nobody wanted to go near such a business. As venture capitalists were putting their money elsewhere, turf-protecting grocers were using the Webvan example as "proof" that grocery delivery wasn't worth investing in -- for themselves or anybody else. They "adopted it almost as gospel" says Bill Bishop of the consultancy Brick Meets Click.

But Webvan didn't prove that online grocery-shopping can't work. It proved only that capital must be patient. Webvan grew too big, too fast, trying in the heady days of the dotcom boom to behave like the information-technology startups that were its Silicon Valley neighbors.

Now that grocery delivery seems potentially viable again, all eyes are on Amazon. That company seems to be preparing for a major expansion of its current trials of AmazonFresh in three West Coast cities -- Seattle (where it's been operating for nearly seven years), Los Angeles, and San Francisco. There is guesswork all over the business media, and Amazon is silent on the matter, but insiders say that anywhere between 10 and 20 new cities (depending on which insider is talking) might be added to AmazonFresh's roster this year alone. AmazonFresh, for now, charges $299 per year in return for free delivery and all the other benefits of Amazon Prime membership, including access to free video content. That's pricey (and Amazon isn't lowballing on food prices either), but it's helping the company pay for the experiment while it learns what works and what doesn't. After a major roll-out, prices might fall. A major reason for Amazon getting into the business is likely to help fulfill founder and CEO Jeff Bezos's dream of near-instant delivery of everything Amazon sells. Even if it doesn't make much on the groceries, that might be made up for by all the higher-margin goods customers might order along with their eggplant and endive.

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When a big company bulls its way into an emerging market, the cliché is for existing entrepreneurs to say it's "validating the space." Often, clichés are clichés because they're true, and that's definitely the case here, according to Zach Buckner, founder and CEO of Relay Foods, based in Charlottesville, Va. That Amazon is planning a major expansion of its grocery business is "a secret that's no longer a secret," he says. But he's not worried that Amazon will step on his business, which delivers groceries in several mid-Atlantic cities. Amazon, he believes, will finally prove that grocery delivery isn't just about "hipsters doing fun things on their phones," but rather will appeal to "the soccer mom who shops at scale."

Relay is one of a handful of startups that have gotten fairly substantial venture financing in recent years. A year ago, it got a round of $8.25 million, bringing its total funding to $14.25 million. Like Amazon, it's expanding slowly and carefully, determining what works and what doesn't before moving to the next service or the next city. Relay offers both locally grown foods and traditional groceries -- a mix that the company believes increasingly appeals to mainstream shoppers. For locally produced foods, farmers get 65% of the revenue, with Relay getting the rest. Unlike Webvan, which often operated with negative gross margins (in its quest for fast growth, it lost money on every sale), Relay has "gotten to the point where our margins are right-side up," Buckner says. Eschewing the Webvan comparison, he says Relay is "the Whole Foods of the Internet."

Except that Whole Foods (WFM) might soon become the Whole Foods of the Internet. It's not yet known what that company's plans for delivery might be, but it's experimenting on a small scale. Still, during an earnings call in November, CEO John Mackey said: "We haven't seen our business model that really works. Lots of people have tried in this area, and I haven't seen anybody come up with a business model that is profitable and successful." And even in the long term, he said, he doesn't believe that food is going to be "disremediated" to the degree that other retail categories have been.

Possibly. But Blockbuster said much the same thing about video rentals before it was "disremediated" out of business by Netflix (NFLX). A company like Amazon, which has proven itself to be more than willing to lose money in return for market share, might force Whole Foods and others into a business they'd prefer to stay out of. For now, most traditional grocers like Kroger (KR) and Albertson's are moving slowly, if at all (Albertson's actually abandoned its delivery service in 2009 -- interestingly, just as Relay's business started to take off). It's a quandary for mainstream grocers: Move too quickly and they risk huge capital losses; move too slowly, and they risk giving up big swaths of market share. The unknown quantity in all this is Wal-Mart. It, too, is "experimenting" with delivery, and it alone has the resources and patience to compete head-to-head with a full-bore deployment of AmazonFresh.

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The oldest player, Peapod, launched in 1989 and went public in 1997. In 2000, it was purchased by the global grocery giant Royal Ahold, and it now mainly serves that company's U.S. chains, Giant and Stop and Shop. It's hard to know what place it will have in the future, but if the business really takes off, it's poised to play a major role.

As Amazon applies pressure to traditional grocers from the top, startups like Relay are applying it from below. Good Eggs in San Francisco and Greenling in Austin, Texas are similar. Good Eggs got $8.5 million in venture money last September. Greenling also has raised more than $8 million.

Another startup, Instacart, has drawn massive attention lately for its unusual business model. The company, which recently added New York City to its markets, sends personal shoppers to grocery stores to fill orders. The shoppers pay full price for groceries, then deliver them to customers by bicycle.

Instacart has raised more than $11 million in venture financing. The latest round was led by Sequoia Capital -- one of the biggest backers of Webvan. Sequoia Chairman Michael Moritz, who suffered mightily during the Webvan debacle, joked to the San Jose Mercury News in February that "we all held hands and prayed" before turning over a round of $8.5 million to Instacart.

For the time being, Instacart is on a growth curve, but it doesn't seem like a business model with staying power. In the absence of formal agreements with grocers, the service will remain pricey for customers and costly for Instacart, which says it's "in talks" with grocers to forge formal partnerships.

Rather than either removing or replacing an intermediary ("the middleman"), Instacart simply adds another one. Bishop, of Brick Meets Click, says that in the "near term" Instacart is proving that people really do want grocery delivery, while also generating "incremental sales" for grocers, which he says represent "a lot of profitability" for them, if not necessarily for Instacart itself.

Still, those incremental sales might not be worth it to the grocers. In the Bay Area, Trader Joe's has reportedly booted the company's shoppers, and the independent Berkeley Bowl has warned that Instacart or similar services could hurt the grocer's reputation if people believe there is an affiliation (if an Instacart employee bruises a shopper's bananas, that shopper might blame Berkeley Bowl.)

Instacart seems like a stopgap, but the mere fact that it has attracted so much financing makes it clear that serious investors are getting serious about grocery delivery. What's less clear is how big the business might become, and what it will look like once it reaches critical mass.

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