SPECIAL DELIVERY 2004

JON SPRINGER

LAKE ZURICH, Ill. -- Of all the stops in a tour of Peapod's warehouse here, Tony Stallone is perhaps most excited about what he calls the "Pepper Room." Chilled between 45 and 50 degrees -- one of eight different temperatures maintained in the 94,000-square-foot warehouse -- the Pepper Room, Stallone explained, makes ideal storage for items like peppers and green beans. In addition, it helps Peapod assure that Internet customers will get produce picked for them that's as good or better than that they would choose themselves in a bricks-and-mortar store.

By way of demonstrating, Stallone, Peapod's vice president of merchandise, retrieved a single green bean from the shelf and prepared to break it, saying, "I hope you can hear it snap."

He broke it, and indeed it snapped audibly.

There's been moments over the years when the sound of a green bean snapping was more metaphorical than musical for Peapod, the pioneering Internet grocer that serves Chicago along with several markets on the East Coast. The company, now a division of Ahold USA, Braintree, Mass., is recognizing 15 years in the direct-delivery grocery business. That's 15 Internet years, which are something like dog years, only longer. Since it was founded by brothers Andrew and Thomas Parkinson in 1989, Peapod has seen the birth and death of numerous competitors; conducted experiments with any number of business strategies, technologies and partners; and on at least one occasion heard its own last rites read aloud in the business press.

Yet today, said Chief Executive Officer Marc van Gelder, Peapod has never been healthier. Three years after Ahold acquired the struggling Peapod, the online grocer is turning a profit in each of its five mature markets and is once again expanding. Along with Rhode Island, which opened this spring, Peapod service will come to Baltimore, Mt. Vernon, N.Y., and Watchung, N.J., during the year. With $143 million in sales during fiscal 2003 -- up more than 25% -- 155,000 customers and more than 5 million orders delivered, Peapod is the country's oldest and largest Internet grocer. It is shaping up to be the kind of builder of incremental sales, data and loyalty that Ahold and Peapod's founders always hoped it could be. Earlier this year, SN honored Peapod with its Retail Excellence award in the online sales category (see SN March 12, 2004).

"We're doing great right now," van Gelder told SN in an exclusive interview here. "The key notion for us ever since we acquired Peapod was: Can we get our markets to profitability? Now we know we're able to do that.

"That's been our focus for the last two years and why we've been quiet and hadn't expanded for a while," he added. "We were working on how to make money in this business."

Balancing Demand and Logistics

Reaching profitability on a per-market basis -- Peapod is still a money-loser overall due to overhead and expansion costs -- has been a matter of "balancing consumer demand and logistical drivers," according to van Gelder.

Boiled down, it means offering a satisfying shopping experience without overtaxing the company's resources in the process. The effort draws on Ahold's expertise in both in-store and Internet operations, and is executed differently in its different markets.

Peapod serves consumers in its Northeastern markets (Massachusetts, Connecticut, Rhode Island, New York and, eventually, New Jersey) out of mezzanine storage space alongside certain Stop & Shop stores. It serves the Northern Virginia and Maryland markets via a Gaithersburg, Md., warehouse in an offering co-branded with the Giant Foods division. The Chicago business is not associated with an Ahold store; however, certain items are trucked to the facility from Ahold's Tops division. Meat is supplied by Stockyard Meats, a division of Ahold's U.S. Foodservice business.

Peapod's consumer offering is focused on creating a simple and fast shopping experience, but with an emphasis on growing the basket, van Gelder explained. The average shopping order at Peapod is $141 for 60 items, and is sparked by a consumer's shopping list: The Web site remembers everything a customer has ever ordered, and is there to remind her as she shops, which speeds the process and encourages repeat purchases. The Web page in the meantime can help create impulse buys by displaying online coupons and specials, and can generate "aisles" that would be difficult to replicate in a traditional store.

"Our specials have a price notion, but also a notion of getting that item onto the list," van Gelder stated. "If people see it on special and try it, it's there on the list for the next time they shop."

Recently, the Web site added the capability of accessing data from a consumer's Giant or Stop & Shop frequent shopper club card (at the consumer's request), further expanding the shopping list to include all of a consumer's in-store purchases.

New opportunities to sell come with creative arrangements of the merchandise database. A newly created "Carb Conscious" aisle combined low-carb products of all varieties. "We found that asparagus was low in carbs. We put it in the low-carb aisle, and asparagus sales went up dramatically," van Gelder observed. "Putting asparagus in next to other low-carb items is something that's very difficult to pull off in the store."

Getting products to consumers has been a traditional money-loser for Internet grocers, but Peapod has made strides there as well, van Gelder said. The effort combines strategic geographic expansion and marketing spends with incentives for consumers to choose delivery options that make logistical sense. It does help that the New Economy fantasy of free delivery in the 30-minute window of the customer's desire is dead and buried.

Peapod offers next-day delivery -- as early as 6 a.m. on orders made by 8 p.m. the previous night -- and charges between $4.95 and $9.95, depending on order size. Customers generally choose a two-hour delivery window, and can select attended or unattended delivery. (While the latter would appear to be more efficient, Peapod prefers in many cases attended delivery so as to collect the tote boxes in which it packs orders.)

Peapod carefully allots its marketing dollars to particular neighborhoods in which it is determined to build density. This helps Peapod crank additional efficiency from its existing delivery routes. "We're building density where we need to build density so we can be sure that when the truck goes out, it's full," explained Mike Brennan, Peapod's senior vice president of marketing. "And we're constantly watching areas which are overpenetrated or underpenetrated, and figuring out how to balance the marketing spend to attract the customers with the largest baskets in the right places."

For that reason, Peapod refrains from advertising to the masses, preferring direct mail in places like Chicago, or in-store advertising in the Giant and Stop & Shop regions. "We want to grow the business, but only in a smart way," Brennan said.

Market expansion is more easily accommodated in the Washington and Chicago markets served by a central warehouse. In the Northeast, where orders are picked in a store wareroom, Peapod must carefully monitor expansion so as to not stress the adjacent store's infrastructure. When customer count dictates Peapod open an additional store wareroom in the Northeast, the new center is "seeded" with certain customer ZIP codes served by the previous center. That helps speed the ramp of the new wareroom, and leaves the existing one with room to grow. "It's like an amoeba that subdivides and regenerates," said Brennan.

Logistics are further optimized by a proprietary routing technology that uses orders already in the system, which offers customers automatic incentives to choose delivery times that are convenient for Peapod. For example, if Peapod's system knows there are several orders to be delivered to a particular neighborhood at a certain time, additional customers in the same area may see discount offers of $1 or $2 on delivery charges if they select a delivery window in the same time frame. Known as SmartMile technology, the offering helps Peapod "profitably orchestrate supply and demand," van Gelder said.

New Economy Blues

As the Internet economy roared to life between 1998 and 2000, so did aggressive competitors. None was bolder or richer than Webvan, a Silicon Valley e-tailer that identified groceries as the Trojan horse of a home-shopping portal that would combine the product assortment of a Wal-Mart Supercenter with the delivery power of FedEx. In what would be remembered as one of the New Economy's most spectacular failures, Webvan raised $1.2 billion and burned it all in less than two years by building enormous warehouses and technology infrastructure backed by a consumer proposition -- free, on-demand grocery delivery within a 30-minute window -- that had almost no prayer of success.

Yet for companies like Peapod, Webvan's short life was a deadly threat. Webvan operated in several of Peapod's markets, and planned for more. "When they were here, we had to offer free delivery, and we knew there was no way we could make money doing that. It was like, if they jump off the cliff, you had to jump off the cliff," said Andrew Parkinson, co-founder and chief financial officer. It also spurred a fundamental shift in the business plan. Peapod, like its online competitors, would go at it as a "pure-play" -- building its own warehouses with an eye on "getting big" instead of partnering with local stores.

That would be expensive, so in the fall of 1999, Peapod hired an outside CEO, Bill Malloy, who was charged with putting together a much-needed private equity package.

He almost succeeded.

On March 7, 2000, an all-star team of venture capital and grocery industry investors assembled by Malloy, including Ron Burkle and Drayton McLane, arrived at Peapod's Skokie, Ill., headquarters to close a $120 million financing package -- only to find Malloy had not shown up for work that morning. He didn't come in the next day either, and the stunned investors summarily withdrew their offer. Malloy, reportedly suffering from exhaustion, resigned shortly thereafter. (Peapod officials, citing terms of their settlement with Malloy, declined to discuss the incident in detail.)

The turn of events left Peapod in flames. With just $3 million in cash and a battered stock price, the company scrambled to find financial and strategic partners over the next few weeks. One of them was the Dutch supermarket company Ahold, which sent a small team of representatives to Chicago that included van Gelder, who at the time was Stop & Shop's vice president of distribution.

"We reported back that there might be some potential here," van Gelder recalled.

Looking Ahead

As bad as this sounds, losing $120 million was one of the most fortunate things that could have happened to us," Parkinson reflected. "Had we taken that money and continued our model, we probably would have faced more trouble ahead."

Ahold in April 2000 paid $73 million for 51% of Peapod, and bought the rest of the company that August. The deal coincided with Peapod's exit from deals with other grocers in Texas and Ohio, and the abandonment of the one warehouse it had opened in San Francisco. (The money in the blown financing deal was earmarked to build additional warehouses.) Van Gelder, installed as CEO, retained most of the staff and the Chicago business, which was later bolstered through the acquisition of assets from belly-up Internet grocer Streamline.com.

Streamline's assets included the Lake Zurich warehouse -- a sophisticated, two-level picking center in which conveyors speed tote boxes in one direction and empty product cartons in another, where pickers wearing wrist-mounted scanners pack orders overnight from product shelves that spin automatically on carousels, and where perishables are housed in rooms carefully controlled by temperature and humidity. That facility was built in 1999 by private Chicago Internet grocer Scotty's Home Market, and was purchased by Streamline in early 2000 for a reported $30 million in stock. Ahold and Peapod picked it up -- along with the 75,000-square-foot Gaithersburg, Md., warehouse built especially for Streamline -- for $12 million in cash in the fall of 2000. How times had changed.

"The thing that surprised me most about coming here was the passion for the business that the people had here," van Gelder said. "When there's an acquisition, quite often you see people leaving, especially senior management. But in this case, we kept people like Andrew and Mike [Brennan], who were here for a long time. We kept the know-how."

While Andrew Parkinson concentrates on the finances, his brother Thomas remains in charge of Peapod's technology. Chicago marketing director Brennan has been with the company for seven years, while Stallone and Scott "Scotty" DeGraeve, the Chicago facility's general manager, date back to Scotty's Home Market, which was founded 14 years ago.

Though it's seen many transformations, Peapod today in many ways resembles the company imagined by the Parkinson brothers 15 years ago, particularly now as a marketing partner of consumer product companies aligned with a trusted local retailer. Peapod offers manufacturers the opportunity to offer coupons, free samples and cross-selling opportunities, and targets them with precision based on geography, historical purchases and other data.

Having survived the rough years, the current Peapod team sees a bright future. Van Gelder cited two particular trends -- broadband Internet penetration and women using the Web -- as key drivers. Currently, around 45% of home computer users work with "always-on" broadband connections, he said, with penetration expected to reach 75% by early 2006. The number of women using the Internet also continues to grow, he added, which is important because women are likely to make the majority of food-purchasing decisions for their households.

Moreover, research is emerging that indicates consumers who enjoy Internet shopping tend to outspend store shoppers, and are likely to have a favorable impression of the physical store that offers the service. "They're better and more loyal customers," said Kenneth K. Boyer, associate professor of supply chain management at Michigan State University, who wrote a study of the Internet grocery business released earlier this year. According to Boyer, overall food and beverage sales on the Internet will increase by 40% this year to $3.7 billion.

It's these trends -- fast growth, attractive customers and a large opportunity ahead -- that have allowed Peapod to remain an important, albeit small, division for Ahold, according to Bill Grize, president and CEO, Ahold USA. Whereas some of Ahold's U.S. divisions are undergoing consolidation or are slated for disposition, Peapod has remained safe.

"We're obviously pleased with what's been occurring at Peapod," Grize told SN. "Our customers like it, we've seen increased loyalty among those customers who use it, cannibalization is relatively insignificant, and it's turning out to provide a fair amount of incremental sales.

"We're opening four different locations per year. If we could speed that up a bit, I wouldn't be averse to it," Grize admitted. "The Peapod team has just been terrific. They've had some big challenges, but they've worked through them quite nicely."