TO BUILD OR NOT TO BUILD?

JAMES FALLON

LONDON -- British food retailers lead the world in on-line grocery retailing. They now face one major question as they expand their e-commerce operations -- which strategy will win?

On-line shopping already is offered by such U.K. food retailers as Tesco plc, Cheshunt, England; J. Sainsbury plc, London; the Waitrose subsidiary of The John Lewis Partnership plc, London; and Iceland plc, Deeside, England. These companies face a choice as they expand their Internet operations between fulfilling customer orders from their stores or building warehouses dedicated to e-commerce. Tesco, Britain's largest food retailer, has gone for in-store fulfillment. Its two largest rivals, Sainsbury and Asda, the Leeds-based subsidiary of Wal-Mart, are building dedicated warehouses.

It's not simply a matter of investment, industry executives and analysts said. The choice of fulfillment method will help determine not only the short-term success of any Internet shopping service but also the potential to fulfill long-term demand. And that, they predict, will be substantial over the next five years. The London-based consultant Verdict Research expects Britain's on-line grocery market to be worth $3.6 billion by 2004, accounting for 4.5% of the overall market.

"A lot of the long-term success of on-line grocery retailing will come down to the marketing and also the quality of the delivery service," said Mike Godliman of Verdict. "Retailers need to become more specific about their delivery times and make sure they hit them. That's what will make customers come back again and again."

Industry observers said they believe that in the end the U.K.'s food retailers will develop hybrid systems that combine both in-store fulfillment and dedicated warehouses. This certainly is the new Internet strategy being instituted by Sainsbury's new chief executive Sir Peter Davis. Even Graham Booth, supply-chain development and planning director at Tesco Stores, admits that in the end the retailer might move toward mixed fulfillment.

"Nothing is permanent," Booth said. "We will develop TescoDirect as the market develops."

Tesco said recently that it will combine its e-commerce operations into a new wholly owned subsidiary, tesco.com, increasing speculation the U.K.'s largest food retailer eventually might seek a separate listing for the operation some time in the future.

The new subsidiary will combine both its on-line shopping service and its Internet Service Provider. Tesco said it is forming tesco.com in order to give it the freedom to act quickly and to place greater focus on the business. Tesco expects to invest $55.3 million in the current financial year on business-to-consumer e-business.

Tesco's service currently covers more than 100 of its stores and has sales of close to $200 million a year. Tesco plans to roll the service out to a total of 300 stores by the end of the year.

"Europe lags the U.S. in all areas of e-tailing by about 18 months," said Alex Lintner, vice president of The Boston Consulting Group, which recently completed a study of all of Europe's 546 on-line retailing sites. "The one area where it leads is grocery and that statistical fact is driven by one country, the U.K., and one company, Tesco. About 70% of the U.K. on-line grocery market is accounted for by TescoDirect."

Carolyn Bradley, Tesco's director of e-commerce, told the recent ECR Europe conference in Turin, Italy, that the company's success is based on its in-store fulfillment strategy.

"We have a real business, which is a rarity in this new world," she said. "Our on-line grocery business is the biggest in the world with over 300,000 customers, 4,000 deliveries a day and 20,000 product lines. It covers 40% of the population and is growing."

Bradley said TescoDirect is showing sales growth of more than 700% year-on-year and has higher sales per user, frequency of visits and basket size than such comparable American services as WebVan, NetGrocer or Peapod.

"Running it out of our stores enables us to achieve the Holy Grail of e-tailing because we automatically cover 90% of the U.K. population," Bradley said. "It puts us way ahead of our competitors."

Tesco began exploring e-commerce four years ago as part of its move into home shopping in general. The service began as a pilot in November 1996 by offering the ability to order over the telephone or via fax. It was manageable, so Tesco fulfilled the orders from its store. It then added 10 more stores to the trial in 1997 but the Internet was still only 7% of total orders.

"But it gave us real behavioral data," Bradley said. "The customers loved it and were willing to put up with our mistakes because they learnt with us. But we had to improve the operation."

So Tesco stopped adding stores in 1998 and instead worked on installing logistics and operational systems capable of handling e-commerce. These included warehouse, in-store and delivery systems to make the fulfillment process quicker and easier. Previously the picker would fulfill the order, then take it to a checkout to be scanned. Tesco now has systems that enable the picker to scan the order as he fills it.

"It made the process in-store absolutely measurable in terms of cost and productivity," Bradley said. "By streamlining the service we made it capable of sustaining real volume."

The benefits of in-store picking are that it enables Tesco to offer Internet shoppers its full grocery catalog of 20,000 to 25,000 lines, compared with the 10,000 at Peapod and the 15,000 at NetGrocer, Bradley said. "No depot system in the world can offer the range we do in an economic way."

It also means Tesco is fully using its existing assets and generating more volume out of its store base. Running TescoDirect from the stores means the delivery areas can be smaller, cutting down on delivery times and enabling customers to be more specific about when they would like their orders to be delivered. While some analysts said the danger is that TescoDirect cannibalizes Tesco's stores, Bradley said the retailer never worried about it.

"We found that 30% of on-line customers were new to Tesco," she said. "We also found that the on-line basket was larger than the in-store one."

Now that Tesco has a significant customer base for groceries, it is using TescoDirect to sell products it doesn't carry in its stores, Bradley said. The retailer recently added books, videos, gifts, financial services and music to the site and there are reports it is considering adding apparel and home furnishings.

"We see TescoDirect as the jumping-off point to generate a broader e-commerce business," Bradley said. "We now are able to use the Net to give customers even more choice because there are no walls."

But Sainsbury and Asda disagree with Tesco's pure in-store fulfillment model. Sainsbury announced plans late last year to invest close to $50 million in the Internet, including the construction of a series of warehouses that would fulfill all its e-commerce orders. The arrival of Davis slightly altered that strategy, however, and the U.K.'s second-largest food retailer now plans to fill Internet orders both from its stores and from dedicated warehouses. The method depends on the location of the customer.

"Our view is that the long-term sustainable model is to satisfy demand through a network of warehouses complemented by some in-store fulfillment," Jennifer Baker-Hirst, Sainsbury's head of strategic development, said at the ECR Europe conference.

Sainsbury launched a home-shopping trial about the same time as Tesco and took orders via telephone or fax. It launched an Internet shopping trial about six months ago in 27 of its stores and fills the orders from the stores.

"We started with in-store fulfillment because the initial costs are small and you can use your existing stores," Baker-Hirst said. "It's a low-risk entry route financially and operationally because it's an extension of our existing business."

Since the product range was that of its existing stores, customers were more comfortable in using the service, she added. It also meant that all the electronic point-of-sale, supply-chain and human-resources systems already were in place.

But in-store picking has limits that make it impractical as the simple long-term solution. While its entry costs are low, it incurs net costs for every order processed, Baker-Hirst said. These can be reduced over time but the profitability of any Internet service will always be capped by the costs of in-store picking. In addition, the congestion and capital constraints become more and more difficult as the on-line business grows. Finally, in-store picking can result in more mistakes in fulfilling orders, with the potential that customers don't return.

"On-line customers, we've found, are less tolerant and fulfillment of orders has to be perfect. That's difficult in-store because of the high out-of-stock situations. Service levels will always be compromised."

For this reason, Sainsbury said it believes the best long-term solution is a chain of warehouses dedicated to Internet fulfillment. These can be constructed to maximize efficiency with products arranged by rate of sale or their positions in delivery cartons. This will result in lower costs and, over time, greater profitability. Dedicated warehouses also mean the service can be expanded exponentially.

"Pickers in stores pick 100 items per hour," Baker-Hirst said. "In a warehouse it can be 300 items per hour, which can be increased to 600 to 700 per hour with greater automation."

The other advantages of dedicated warehouses are that efficiencies can be increased by using already existing warehouse management systems, while fulfillment can be completed via just-in-time operations which cut down on wastage.

But Sainsbury recognizes that the key to success in the Internet world is to be flexible. It foresees a model where warehouse picking will be used for slow-moving items or in sparsely populated areas. In-store picking will be used to fulfill orders from customers living in densely populated areas or for fresh and chilled foods.

A third strategy is being followed by Asda, which offers its Asda@Home service of 5,000 lines from picking centers in Croydon and Watford. It plans to build two more warehouses within Greater London by the end of the year and another 11 nationwide over the next three to five years. Asda said it believes only warehouses can give the best service. In addition, these enable it to more rapidly penetrate southeastern England, where it has few stores.

"The differing strategies are about suiting the infrastructure to the delivery mechanism," Godliman of Verdict said. "Asda needs to build dedicated warehouses because it doesn't have very many stores in the Southeast. But Sainsbury's and Tesco can milk their existing store assets to drive Internet sales.

"It's not certain that one fulfillment method is inherently better than another," he added. "What is certain is that Internet shopping will continue to explode because people have more disposable income and less time."