On the podcast: Grocery fulfillment and dark stores—clear aisles, full carts, can't lose?

Prior to COVID-19, less than 4% of grocery purchases were made online. At the height of the pandemic, that share climbed to 35%. In this episode, we chat with Publicis Groupe chief commerce strategy officer Jason Goldberg about how more shoppers than ever are leveraging dark store and digital fulfillment technologies to meet their families' nutritional needs. Plus, we catch up with PitchBook's Alex Frederick—a senior analyst on the Emerging Technology team who focuses on food and agtech—about how the pandemic accelerated market adoption of digital grocery shopping by up to a decade overnight.

Explore more of Season 2 and subscribe to get new episodes of "In Visible Capital" every Tuesday on Apple Podcasts, Spotify, Google Podcasts or wherever you listen. For inquiries, please contact us at podcast@pitchbook.com. Transcript

Jason Goldberg: So a huge problem in digital grocery that we haven't talked about yet is the profitability of digital grocery.

Lee Gibbs: Hello, and welcome to "In Visible Capital." I'm your host, Lee Gibbs. In this season, we're diving into emerging technologies, to explore how those technologies are being leveraged during the ongoing COVID-19 pandemic.
Our first three episodes of the season focused on segments within health & wellness. Today, we're pivoting to foodtech, to take a look at how the pandemic has contributed to a drastic acceleration of ecommerce within the grocery industry—specifically, the infrastructure side of digital grocery fulfillment. But first, let's take a look at the grocery landscape as it stands and the key impacts COVID-19 has had on food and grocery.

To set the stage, we're welcoming self-proclaimed retail geek Jason Goldberg.

Lee: Welcome to the podcast, Jason.

Jason: Thrilled to be here.

Lee: Jason is the chief strategy officer at the agency holding company Publicis Groupe and is also co-host of the ecommerce podcast, The Jason and Scot Show.

Jason: To me, two of the biggest impacts of COVID, specifically on the grocery industry is, number one, the shift in where consumers get their calories. So, pre-COVID, you'd get about 60 percent of your calories in North America from a grocery store and you'd get about 40 percent of your calories from a restaurant or on the go. And obviously, during COVID, most of us are getting more than 90 percent of our calories from a grocery store. So that has had all sorts of pronounced impacts on everything— both the demand and supply chain to those grocery stores and how the goods are sold then and how people shop.

At the same time, people are less comfortable going to grocery stores and there's more health concerns about going to grocery stores. So we've had this huge acceleration of the amount of groceries that are sold digitally. So before COVID, in the US, depending on how you counted, you might say there were 2 to 3% of all grocery sales happened online. At the peak of COVID, there might have been 35% of all grocery sales that happened online. It's kind of normalized down now in the teens. So maybe we call it 15% today, but that's a level of digital penetration in grocery that a lot of people forecasted might have happened by 2025 or even 2030, depending on whose forecast you look at. So you can kind of think of COVID as accelerating digital grocery shopping five or 10 years in the future overnight.

Alex Frederick: We've seen this surging ecommerce demand that's really accelerated digital grocery adoption.

Lee: That was PitchBook's Alex Frederick.

Alex: I am a senior analyst on the emerging tech team focused on foodtech and agtech.

Lee: According to research firm Brick Meets Click, online grocery sales for home delivery and pickup reached $6.6 billion in May of 2020, an increase of 65% from $4 billion in March.

Alex: We've seen this massive consumer adoption that's really strained the existing infrastructure. So we've seen stock outages; we've seen IT crashes, apps crashing; we've seen wrong or damaged items sent, issues with consumers finding delivery windows. And really, for new consumers who it's their first experience using these apps, it's been a challenging experience for them, which has turned some consumers away.

Jason: A huge impact of the demand shifting to digital is that very few grocers were prepared to manage that spike in volume. If you are a progressive digital retailer, let's say Walmart or Kroger, you had a grocery app before COVID, right? And in Walmart s case, like 25 million people use that app. And there's a whole team at Walmart whose whole job was to get more people to download that app. Well, good news, 75 million people downloaded that app in a week. So on the one hand, high five, like those people all made their KPI. On the other hand, oh no. All these new people are trying our digital grocery shopping experience for the first time. And it's the absolute worst version of this digital shopping experience we've ever offered.

We don't have any delivery windows. We're completely out of toilet paper. You're likely to order peanut butter and get glue sticks delivered instead. You're certainly not going to get your first choice of brands. That guy is not going to show up, and they are going to be missing a bunch of the product. And that's all assuming that your technology doesn't just fall down and that the site doesn't throw a bunch of errors to the consumer because your IT department wasn't prepared for that huge spike in volume. So the first challenge all these retailers had is, "How do we scale our capacity and harden our system so that we give a reliable and good experience to those grocery shoppers?"

Lee: In today's episode, we're going to try to answer that very question by taking a look at a few models of infrastructure that retailers and investors are betting on in the wake of a surge in online grocery. But before we get there, we need to understand what types of challenges these models are attempting to solve for.

Alex: So the two biggest challenges for online grocery are the costs to actually fulfilling the order and the cost to deliver the order.

Jason: Delivery for grocery is a unique challenge. For most of America, where we're more rural and the density between houses and the density of digital orders is much more spartan, the delivery cost is really problematic.

If you think about ecommerce deliveries for apparel, we use a system called a route-based delivery. And what that means is Amazon got 60 orders from different families that all want a sweater. We put all 60 orders on that UPS truck. That truck drives around the neighborhood for four hours and delivers 60 orders in one trip. And it's no big deal that some of those sweaters sat on the truck for eight hours. When I'm delivering milk, I've got a couple of problems. The milk can't sit in the truck for eight hours or I need a way more expensive truck that can keep the milk cold. And someone has to be home at the exact moment that I deliver the milk because it can't sit on my porch for eight hours.

So when we deliver perishable groceries, instead of being able to do a route, what we mostly have to do is a point delivery. That means load a specific customer's order on a truck, drive that truck straight to that consumer's home in a narrow window when we promise to be there and when someone is home to receive those groceries and put them in the fridge. And so what that means is the cost per delivery for perishable groceries is wildly higher than the cost per delivery for a sweater. And part of that cost is what we had to eat in digital grocery.

Lee: So scaling delivery for grocery is a challenge. But it's a challenge that grocers are likely going to have to figure out. According to PitchBook, while online grocery sales currently represent just 2 to 4% of the total grocery market—it is expected to grow to 20% of total grocery retail by 2025, which has many in the industry planning ahead.

Alex: So one of the impacts there is that we've seen grocers respond by either investing in improving their infrastructure ... or with small and independent grocers investing in infrastructure much sooner than we would have seen otherwise.

Lee: Take us down to maybe the smaller scale the mom-and-pop, the local grocers. How have they perhaps tried to pursue solutions in this time?

Jason: So before COVID, the largest three grocers in the United States—Walmart, Kroger and Albertsons—probably represented about 40% of all grocery sales. When the supply chain issues started hitting all these grocery stores, the large chains with buying power and leverage over the suppliers were the disproportionate winners. Albertsons was gonna get toilet paper before a mom-and-pop grocery store was going to get toilet paper from that supplier. And so one of the really unfortunate impacts of COVID on the grocery industry is it likely put a bunch of independent grocers out of business and shifted their volume to the big, established, more well-funded players. After COVID all these independents have closed and that volume has shifted. It's very likely that those same three grocers represent 62% of all grocery sales.

Lee: It's clear that the grocery giants are winning out, but some midsize retailers have managed to stay alive by partnering with an outsourced marketplace, like Intsacart, in order to remain competitive during the pandemic.

Jason: So Instacart is a really interesting player in this whole ecosystem, right? Pre-COVID, I would have said that Instacart will be a fulfillment provider, but they won't be a outsource marketplace like they are today. When shoppers buy from Instacart, they create an account not with Walmart, but with Instacart. And if Walmart ever said, "You know what, we're not going to use Instacart anymore, we're going to do this ourself," the first thing Instacart would do is do an email blast to all the people that used to get their groceries from Instacart Walmart and say, "Hey, do you guys know about Instacart Costco?"

And so as big grocers, we're waking up to the fact that Instacart was very helpful for this one stage of our growth. But as this is becoming meaningful, we should not be dependent on someone right? And so the dramatic need for more digital grocery capacity during COVID has given Instacart a huge second life. Like a lot of retailers that maybe we're moving away are suddenly like, "Man, I need the capacity. Let's get more of it from Instacart."

Lee: And that very response from retailers has contributed to Instacart's rapid growth in recent months. In June of 2020, the company raised a $325 million Series G and an additional $200M Series H in October, putting them at a post-money valuation of $17.7 billion.

Alex: Over the past few years, we've seen traditional grocers really scramble to adapt to shifting consumer buying preferences and keep up with Amazon, Kroger, Target and Walmart. So Instacart offers medium-to-large grocers sophisticated ordering software, built-in courier pool, providing traditional grocers a low-lift and robust online grocery offering. So we believe that these outsourced marketplaces are more of a temporary measure to get grocers up and running in ecommerce.

Lee: While the Instacart model could help independent retailers stay afloat during the pandemic, the larger, more established players are taking a different approach.

Alex: As brick-and-mortar grocers turn on digital capabilities, the most obvious way to supply orders is from stock out of local grocery stores. It's located close to the consumer, there is very little setup cost—you just need to pick and deliver. But there are several challenges to that. Customers are in store competing with pickers, so it makes inventory management very challenging for fulfilling orders when the system doesn't know if an item will be on the shelf when the picker goes to pick it. And also, it adds store congestion, which harms the consumer experience. The other issue is that it's inefficient for pickers. Brick-and-mortar layout is designed to have customers wander, discover new items. Whereas pickers want to complete an order as quickly as possible.

So there are several fulfillment strategies that are improving on fulfilling orders out of brick-and-mortar stores. Larger grocers are focused on investing in infrastructure to improve profitability and improve the consumer experience.

Lee: And one approach we're seeing many retailers take is investing in microfulfillment centers.

Jason: So microfulfillment centers, sometimes we call them MFCs, are automated product picking centers that are designed to support a small geographic area like typically the same area that an individual grocery store might serve. You could think of instead of putting all the products on shelves and having customers pick their own groceries, I would put all those groceries in individual bins in an automated picking system. And I would fulfill a grocery order by having a robot kind of pull all the products out of those bins.

Alex: So the benefits there: Highly efficient packing located close to consumers to allow pickup and reduced costs, last-mile delivery. But there's some challenges.

Jason: The typical microfulfillment center that's designed to live in the back of a grocery store or in the parking lot of a grocery store tend to be 5,000 to 10,000 square feet. So that's the thing to think about is if I'm going to augment a store with automated picking capability, I'm going to add a microfulfillment center to that store. And the amount of space it takes is critical because if it goes in the parking lot, I'm giving up parking spaces for it. If it goes in the back of a store, I'm giving up shelves that formerly sold products to customers for it. So adding a microfulfillment capability to a live store, which is most commonly how microfulfillment centers are used right now—the space is a huge priority.

Lee: So depending on how much physical space is available, there's a lot for retailers to consider before investing in on-site microfulfilment. But for large retailers, space is less of a commodity.

Jason: Another model is a regional distribution model. Like, let's put the food in a much bigger and more automated warehouse that holds way more and expect people to drive farther to do deliveries. The famous grocer in the US with that model is Kroger. They partnered with a UK digital grocer called Ocado. And Ocado has this model where they use dedicated warehouses that they call sheds. Kroger's building three or four of these. They're each over a million square feet. Instead of serving 10,000 families, they're intended to serve 100,000 families, and the thought is they can hold more stuff. They can be more efficient for the picking, but the delivery costs are going to be higher because you're going to have to drive the groceries farther away. The microfulfillment centers serve way less customers, but they can cost effectively be put way closer to the customer. So this is a great debate. Is it better to have big, you know, things that are sparsely populated or little things that are densely populated.

Lee: Which brings us to another fulfillment trend we've seen from many retailers during the pandemic: Dark stores.

Jason: What a dark store is, is it's a store designed for professional pickers instead of customers. So normally we invite customers to come in our stores. They walk up and down the aisles. They put all the products in their cart. They pay for them and they drive them home. If that customer's going to have the groceries loaded in their car for a curbside pickup or they're going to have the groceries delivered to their door, then you one way to do that is to have pickers competing with customers in the live store. And, you know, everyone listening to this has probably experienced that when they've gone shopping at Whole Foods and they're elbow-to-elbow with a bunch of Amazon employees that are picking orders for other customers. Or, you know, maybe you went to another grocer that you were competing with Instacart pickers to grab that last bunch of bananas off the shelf.

So what a dark store is, is, it's a store that's not open to the public and exists solely to optimize picking for grocery delivery. And in many cases, it was once a live customer store that got converted for that purpose. And that's where the dark store metaphor comes from— the store went dark. Today, lot of dark stores might have been built from the ground up intentionally to be these sort of local fulfillment hubs.

Alex: Amazon, Kroger, Giant Eagle—these are a few of the major grocers that have converted stores into dark stores during the pandemic. Dark stores are a good stopgap measure. It's something that grocers are able to turn on immediately and have local online grocery fulfillment centers. But they're typically not as automated. And they're paying higher retail leasing costs. Retail is being harmed or has been in decline and being replaced by ecommerce over the past decade. And so there is cheaper retail available, which might be providing retail space to dark stores at a lower rate.

Lee: Dark stores were already common pre-COVID, but during the pandemic we've seen a number of retailers close down some of their existing consumer-facing locations in order to use them as dark stores.

Alex: One of the original dark store concepts was Amazon Fresh. They've had, for several years, two locations in Seattle where consumers could order online and pick-up curbside. And they've since begun building out brick and mortar grocery facilities. They've also taken over leases from two grocery stores in New Jersey and converted them into dark stores. In the pandemic, we also saw Amazon converted a soon-to-be-open grocery store in LA, and they basically took this one store that was going to be an Amazon front, that was going to be an Amazon Fresh grocery store and made it into a dark store to fulfill Whole Foods orders for four different Whole Foods locations in LA. Amazon has also opened up a Whole Foods permanent dark store in Brooklyn to only service curbside pickup and delivery orders. Kroger, Giant Eagle, Stop and Shop have all converted stores from traditional brick and mortar grocery stores into dark stores during the pandemic.

Lee: As digital grocery fulfillment continues to be a challenge globally, we're seeing fully online grocery models attract investor attention as well. According to PitchBook, the online food delivery platform, BigBasket, who operates in India, has seen a flurry of VC activity in recent months. Not only did the company complete a $60 million round in April of 2020 led by Chinese retail giant Alibaba, but they are reportedly seeking a $375 million round of funding from Temasek Holdings, along with other undisclosed investors. And as of late October, are also in talks to be acquired by Tata Group for $1 billion. Another prominent example of investment in online grocery is the company Boxed, a wholesale online grocery platform that's been dubbed "Costco for millennials." In June of 2020, Boxed raised a $30 million Series E and is currently in talks to be acquired.

Alex: Boxed really sees itself as a wholesaler retailer and almost like a digital-first Costco. They sell groceries and bulk household items. The groceries are primarily dry pantry items, which means lower food waste, less perishable and cold storage supply chain issues. However, Boxed does have this new express grocery business line that does handle perishable foods available in select locations. So there's some benefits to the Boxed model over a Costco. There's no membership fees, and they really have a strong digital-first presence. That means attractive pricing, free shipping and an excellent consumer experience, which is very attractive for consumers who are used to buying goods online.

Lee: And Jason sees not just one solution, but a combination of these technologies and consumer offerings ultimately winning out.

Jason: What most grocers in America have discovered is that customers are willing to do their own delivery. And so that's a system we call curbside pickup. Both Walmart and Kroger said it's the highest net promoter score shopping experience they've ever offered. Kroger has said that for every customer that wants a home delivery, five customers want curbside pickup. So for most of America, with our residential density, the scale solution for grocery really isn't home delivery. It's curbside pickup. That's the high-volume play, and that solves the delivery problem. So if you're Walmart or Kroger, what you're saying is, let's make picking more efficient by having automated picking, which is a microfulfillment center, and let's make delivery more efficient by having a great curbside pickup experience. And by bundling those two things, the premise is you can get the cost of digital grocery at parity or very close with the old self-service grocery. And now you can profitably serve all these customers that have become addicted to digital grocery

That's the combination of solutions. So that dark store is really helpful when we're doing home delivery. The dark store is not particularly helpful for curbside pickup. And so that's why the microfulfillment centers mostly aren't just designed to replace a dark store. They're designed to augment a real store. And that's why they take up parking space in the case of Walmart's model. Or they take up shelf space in the case of Albertsons model.

Lee: With so much consumer demand for online ordering, operators in the food and grocery space are pushing to address this urgent need, while investors are increasingly looking to get in front of this quickly growing segment of the market.

Alex: Despite the pandemic and a slowdown in investment activity from the economic uncertainty, we're seeing high levels of investment focused on online grocery opportunities. Looking at online grocery sales, we're seeing adoption up significantly year over year. We're seeing active customers increased to $37 million in August, up from $16 million last year. Monthly sales have increased nearly fivefold to $5.7 billion, up from $1.2 billion last year. We're also finding that customers are spending more per trip. Average order size has increased to $95 in August, up from $72 last year. And the takeaway here is that online grocery is seeing massive growth, and we're seeing an acceleration of the adoption timeline, timelines and online groceries, quickly becoming tables, table stakes for larger grocers

In terms of VC activity, online grocery is one category in our larger category of food suppliers. And we're seeing that online grocery deal activity has increased. Online grocery peaked in 2019 with $1.7 billion invested across 47 deals. And as of 3Q 2020, we've seen $1.3 billion invested across 34 deals.

Lee: It sounds like as the industry continues to evolve or continues to try to find how this solution gets refined, it will be ripe for additional investment and additional acquisitions by a lot of these incumbents that are actively trying to put these solutions in place right now. Is that a fair assessment?

Jason: That's a very fair assessment. There's a ton of unknowns around the future of shopping and the long term impact of COVID.

But what's for sure is COVID is not going to magically go away and shopping's not going to revert to exactly how it was before. Like those extra 50 million people that downloaded the Walmart grocery app are gonna keep using the Walmart grocery app. And people that magically had toilet paper show up on their door and didn't have to go to the store aren't going to suddenly go, "You know, the most enjoyable thing I can do today is go get toilet paper." Right? And so a lot of those forced trials are going to be permanent digital shoppers. And so that means all of our job is to figure out how to make the unit economics work for that. And none of the answers are completely apparent. And the answer is probably some blend of all of these things. The exact ratio of that blend probably is going to vary wildly. It's gonna be different in New York City for Fresh Direct than it's gonna be for Hy-Vee in Iowa or H.E.B. in Texas, or Walmart, you know, is probably gonna have to have very different solutions across all the markets that Walmart plays in. But for sure, they're going to have to make significant investments to retool the entire chain of customer experience to accommodate this new reality of consumer behavior.

And so there are going to be opportunities for a lot of vendors to sell in those new solutions.

Lee: The development of the online food and grocery space has been rapidly accelerated by changes brought on by COVID-19. In order for players in this arena to build out the necessary infrastructure to meet this growing demand, they're going to have to make some major investments. Whatever solution, or combination of solutions, become standard—getting there is going to take a lot of work and a lot of capital.

As you can probably tell, we covered a lot with Jason—more than we could fit into this episode. So before we continue onto our upcoming discussion on ghost kitchens and restaurant delivery tech, we'll be publishing an extended interview with Jason next week to explore a bit more of this fascinating grocery landscape.

A big thanks to our guests Jason Goldberg and Alex Frederick.

In this episode

Jason Goldberg
Chief Commerce Strategy Officer at Publicis Groupe

Jason "Retailgeek" Goldberg is the chief commerce strategy officer at Publicis Groupe. Goldberg is a fourth-generation retailer who launched his first ecommerce site for Blockbuster Entertainment in 1995. With a focus on ecommerce and digital marketing for omnichannel retailers, he has worked with more than 100 clients on the Internet Top 500 and has been responsible for billions of dollars in online revenues. He is the executive chairman of the board of directors of shop.org (and the National Retail Federation Digital Advisory Board). Goldberg has served as an expert witness in federal court on ecommerce and as a guest lecturer on retail and ecommerce at the Kellogg School of Management for Northwestern University. He also hosts iTunes' top ecommerce podcast, "The Jason & Scot Show," and has been voted one of retail's top global influencers by Vend for five consecutive years.

Alex Frederick
Senior Venture Capital Analyst at PitchBook

Alex Frederick contributes to PitchBook's venture capital and emerging technology research. His coverage areas include early-stage investments across the venture space, with an industry specialization in foodtech. Before PitchBook, Frederick was a venture associate at Impact Engine, an impact investing firm focused on tech-enabled businesses. He holds an MBA in finance, entrepreneurship and economics from the University of Chicago and a bachelor's degree in business from Indiana University.