Online grocers mushrooming, but bagging profits is difficult

The online grocery-delivery business seems to get more crowded - and more competitive - by the minute. Tech giants Google and Amazon.com are offering it in some major cities, and so are upstarts such as Instacart, Postmates and FreshDirect. These newcomers are battling with more established businesses such as Peapod, which has been delivering groceries for more than 20 years, and services from companies such as Wal-Mart that allow customers to place orders online and pick them up at a nearby store.

It's a business that everyone seems to want in on, even though new data shows it's awfully hard to do profitably.

In some ways, the enthusiasm makes sense: According to a report from IBISWorld, a market research firm, online grocery sales grew at an annual rate of 14.1 percent from 2009 through 2013 and are expected to grow at a rate of 9.6 percent from 2014 through 2018.

But a closer look at the report reveals the major challenges these companies will face as they try to make these fledgling businesses viable. IBIS World estimates that the online grocery business collectively brought in $10.9 billion in sales in 2014. Profit, it estimates, was just $927.1 million, or 8.5 percent of total revenue. By 2018, the researchers project that profit margins will slip to 6.9 percent of sales. In part, that's because these operators will continue to contend with the high distribution costs associated with getting perishable items to customers.

The report also predicts that big players, particularly AmazonFresh, will play a role in compressing margins for the whole industry. Amazon has often sought to vanquish its competitors by undercutting them on price, and the report suggests that the company might use that tactic in the grocery business, dropping their prices as low as possible and, in doing so, pressuring their competitors to make similar price cuts. (Jeffrey P. Bezos, the founder and chief executive of Amazon, owns The Washington Post.)

Even though it's a tough business model right now, report author and industry analyst Will McKitterick says companies of all stripes think they can't afford not to take a chance on it.

"For larger companies, it's definitely a process to build the infrastructure, develop the delivery networks," McKitterick said. "All of that takes a lot of time, and if they miss the boat now, then they're going to be in a pretty bad position" later if throngs of consumers take to online grocery shopping.

For all the speculation about how potentially disruptive these businesses are, IBISWorld's report reveals that they so far have a low penetration in the overall grocery market. Online grocery sales were only 1.9 percent of total grocery sales last year; by 2018, even given the rapid growth researchers anticipate, online sales are still expected to equal only 2.9 percent of grocery sales.

In the broader retail industry, online purchases account for 7 percent of sales, which suggests that shoppers have been less willing to go digital with their grocery-shopping routines than other shopping routines. The report says that may have to do with shoppers' concern about quality and freshness of produce and meat, something that would not be a factor in buying apparel, electronics and other goods.

It may be that online grocery shopping hasn't been widely adopted in part because the services are available only in major cities; some shoppers that might want to buy online but don't have the option. But experts say it is difficult to imagine a profitable scenario in which grocery-delivery service is available outside dense urban areas, meaning the customer base is always going to be somewhat limited.

The extent of their challenge in luring customers is evident in the mix of products they're selling. For online grocers, about 30 percent of sales come from nonfood items, such as cleaning supplies and beauty products. At bricks-and-mortar grocery stores, the share of sales from nonfood items is much lower, just 14 percent. This suggests that even when people are using online grocery services, they're not using them for the fresh products that make these grocers distinct from, say, a traditional retailer, such as Target, that could simply send you some paper towels or toothpaste via FedEx or United Parcel Service.