Why Kroger's deal with Ocado is a strategic mistake

The most remarkable thing about Kroger's deal with the UK's Ocado to build up to 20 large Customer Fulfilment Centers (CFCs) across the US is not how many £billions have been suddenly added to Ocado’s market value, nor the cutting-edge nature of the technology that will now be at Kroger's disposal. It is that virtually no-one appears to realize the negative aspects of this move for Kroger, and the US supermarket sector in general. Indeed, far from being a coup, it is a strategic mistake. One could even go so far as to say Kroger has bought an expensive shovel to dig its own grave deeper. There are three reasons for this:

1. Dedicated order fulfilment centres directly undermine store sales and profits

Picking from stores may not be the most efficient way to fulfil on line orders in terms of speed and accuracy, but it remains the most cost-effective method for brick and mortar operators as it leverages their existing fixed costs and minimises delivery distances. The efficiencies from large centralised automated facilities in terms of faster picking and lower wastage are far outweighed by the fact that the cost of building and operating them is largely incremental to that of the existing store business. Delivery is also more expensive and less timely.

The main arguments for centralised picking facilities (or “Customer Fulfilment Centres” as Ocado calls them) are scalability and superior service levels. However, even in the UK, where stores are much smaller and sales densities much higher than in the US, in-store picking remains the norm. This then leaves the question of whether the superior service metrics that automated picking facilities deliver compared to in-store picking, in terms of availability, picking accuracy, freshness and range, can generate sufficient market share gains to offset the extra capital and operating costs.

In markets where Kroger already has a significant presence, the answer is almost certainly no, due to cannibalisation of sales and profits at their existing stores, whose costs are mostly fixed.

It might be possible in markets where Kroger has minimal presence (such in the Northeast) and hence can go after largely new custom. However, the profitability of pure online grocers outside of very dense urban zones appears marginal, based on data from both Peapod in the US and Ocado in the UK. Furthermore, the competitive impact of Amazon’s ambitions in grocery following its purchase of Whole Foods has yet to be felt.

2. Online grocery inevitably adds more cost and complexity than sales.

This applies even for first-movers, whose advantage is quickly eroded as competitors react to keep their higher-spending (i.e., loyal) customers. Kroger’s deal with Ocado is set to accelerate the online space race in the US, which can only intensify margin pressure for all supermarket operators.

This has been demonstrated very clearly in the UK, where the online shift is relatively advanced - partly due to the very aggressive initial growth strategy pursued by market leader Tesco. However, the cost of subsidizing home delivery helped undermine Tesco's ability to invest pro-actively to stem the growth of German limited assortment discounters Aldi and Lidl in the wake of the 2008 financial crisis. The result has been a 60% fall in Tesco’s profits over the last six years. The negative impact of e-commerce growth on profits also explains why the UK’s major brick and mortar supermarket chains have recently decided to raise fees and minimum order thresholds in order to slow their online growth, even if it means losing market share to Ocado and Amazon.

Kroger is already starting to feel the pain, warning last year that the expansion of Clicklist is a drain on store profitability that will likely worsen as the program gathers pace. That’s despite charging $4.95 for a service which is free at Walmart, and before the acceleration of home delivery, which is even more negative for margins and is now free for Amazon Prime members.

As supply ramps up, competition will drive fees down - as happened in the UK’s initial growth phase. Up to now, US grocers have been fortunate (smart?) enough to be able to share the financial burden of subsidising home delivery with the shareholders of the likes of Instacart and Shipt. The presence of these third parties has also helped maintain price discipline. Kroger’s deal with Ocado now threatens to disrupt this as a result of the stimulus it gives to competitors as well as its own incentive to minimise start-up losses by ramping up capacity utilisation at these expensive warehouses as quickly as possible.

Kroger's most recent positive quarterly result should therefore be seen as the calm before the online storm hits. 

3. Automation set to move to the store level

Of course, it could be argued that whatever the negative impact on near or medium-term profits, it is better to take the fight to Amazon pro-actively, instead of waiting for the e-commerce giant to unleash its full potential in grocery.

Leaving aside the danger of helping the genie out of the bottle before its true nature is known and potential impact can be contained, this brings us to the third and possibly most important reason why this deal is a bad move for Kroger. By the time its Ocado CFCs are up and running – i.e., in around three years’ time – the picking technology is likely to be out-dated and even potentially obsolete.

This is because of a move towards automation at the store level, which an increasing number of major grocers in the US and Europe realise is the best way to a) leverage existing fixed assets; b) minimise last-mile costs; c) match capacity growth with demand more progressively; and d) create an integrated supply chain serving both stores and online. There are at least three start-ups and one existing provider of picking automation that are working on systems that are specifically designed to be used as micro-fulfilment centres either next to or inside grocery stores.

Furthermore it can be safely assumed that Amazon, with all the resources at its disposal and a superior innovation culture, is also working to develop a picking automation system that is better suited to grocery than Kiva (which was developed for general merchandise) and could be used to support Whole Foods. Indeed, an article in the New York Post published in February 2017 described how Amazon is looking to use robots inside the store to develop a hybrid cashier-less store whereby packaged goods are bought online and picked automatically in a micro-fulfillment centre located within the store, leaving customers the pleasure of choosing their own fresh food. Such a store concept would be far larger and more scalable than Amazon Go. In fact, by combining a superior customer experience with much lower operating (notably labour) costs and hence prices, it could go a long way towards displacing traditional supermarkets.

The future of automated grocery fulfilment is with stores, not huge centralised facilities - aka double-running cost centres.