Webvan’s unsustainable business model

This case study looks in detail at online grocer Webvan's business model to understand why the company went under.

Why was it that so many dot.coms were unable to survive? For many, the business model was simply not economically viable. Some sold bulky bags of pet foods, delivered to the consumer’s door for prices far less than the cost of the delivered product. Others spent more on acquiring customers than those customers would ever be worth. Perhaps the most striking example of a dot.com business model that simply was not viable was Webvan, whose demise would cost investors more than $1 billion.

Webvan’s idea

In 1997, Louis Borders, a successful entrepreneur in book retailing, saw what he thought was an opportunity to revolutionize American grocery retailing. Borders believed that by using automated warehouses and computerized scheduling software, he could let customers order groceries on the Internet and have them delivered to their doors at no more cost than if they picked them up at the supermarket.40 Given his previous track record, Borders was able to attract investment capital from a star-studded roster of blue-chip investors, including Benchmark Capital, Sequoia Capital and Goldman Sachs.

In June 1999, Webvan took its first grocery order in the San Francisco Bay area. The company offered customers access to 24-hour-a-day, seven-days-aweek online grocery ordering. Webvan promised to deliver orders within a 30- minute window, allowing customers to pick a convenient time to receive groceries. For consumers, the story was attractive. No more weekly trip to the grocery store. No more waiting in long lines at the checkout. No more fighting the crowd to select the freshest peaches. Let’s take a look at how the business model matches the criteria for economic viability.

Revenue in relation to capital investment and margins

Webvan’s initial capital investments were enormous. The company’s 300,000-square-foot distribution centres were the most automated in the world. ‘Infrastructure is everything’, said David Cooperstein, an analyst with Forrester Research in Cambridge, Massachusetts. ‘To do online sales the right way rather than the rushto- market way, they need to develop a very complex distribution system.’ In groceries, profit margins ‘are so tight you need to figure out where the leverage is’, said Cooperstein, adding that Webvan had determined that the leverage was in distribution. To make these investments pay, Webvan would need either large numbers of customers spending large amounts per order or great margins.

Margins in the US grocery business

In the American grocery business, returns on sales of 2 to 3 per cent were considered healthy. One per cent returns were not uncommon. The business works on very high volumes at razor-thin margins. Unless customers were willing to pay substantially more for Webvan’s convenience – an unlikely prospect – or unless customers would spend more online than they spent the old-fashioned way – also unlikely, given America’s traditional weekly trips to the supermarket – then the only route to economic viability would have to be through significant productivity advances. Hence, the highly automated warehouses.

Obtaining customers at affordable cost

With all the fanfare surrounding the dot.com boom, everyone knew about Webvan and other online grocery retailers. But would customers switch? Would they trust Webvan to deliver only ripe peaches, not hard ones? If the green beans weren’t fresh, would they arrive anyway, instead of perhaps broccoli for tonight’s meal, as one might decide in store? Would one out-ofstock item render tomorrow’s dinner plan unworkable, necessitating a trip to the store anyway?

From Webvan’s perspective, would enough customers switch their shopping to Webvan to make the huge investments worthwhile? Webvan did $13 million in sales in 1999, its first half-year. By the end of 2000, its San Francisco customer list had grown to some 47,000 households, with fourth-quarter sales totalling $9.1 million. But orders averaged only $81, short of the $103 Webvan’s plans required. And sales volumes were far short of what an ordinary high-volume supermarket would generate, despite the far higher capital investment. Online grocery retailers like Webvan had to overcome die-hard shopping habits and a preference among some people simply to squeeze their own melons. In addition, price was a factor for many budget-conscious consumers, who liked shopping for specials. Worse, it was costing Webvan about $210 to acquire each customer.

Gross margins compared with cost structure

As we have seen, Webvan needed either huge sales volumes or significant operating efficiencies to make its model work. Operating the facilities, marketing the company, and delivering the orders were all more costly than Webvan anticipated, however. The process of fulfilling customers’ orders was particularly expensive.

Order handling and fulfilment cost the company approximately $27 per order, $18 of which went directly on the delivery process. In ordinary supermarkets, the customer does this work at no cost to the retailer. The company charged a $4.95 delivery fee for orders under $50, a threshold it increased to $75 in November 2000, as delivery expenses exceeded budgets. As Paul Malatesta, a University of Washington finance professor, said later, grocery delivery can work in densely populated areas where grocers offer delivery without building expensive and complicated distribution systems. ‘If you have a relatively low-wage delivery person who is pretty much packing grocery boxes and riding elevators, you don’t have a large capital investment. But if I have to run $100,000 trucks through the suburbs and pay a driver $25–$35 an hour, when they spend part of the day idling in traffic, that just isn’t going to work’.

Webvan also lacked the buying power of Kroger, Safeway and other large chains. Without the enormous economies of scale its competitors enjoyed, Webvan could not easily keep its costs of goods low.

Operating cash cycle characteristics

Of the four keys to economic viability shown in the table above, the first three looked gloomy indeed. Only the fourth key posed no real problems. Webvan got the same payment terms that other grocers received, and its customers paid when they placed their orders. Inventory turned at a respectable rate. But these cash cycle characteristics provided little comfort to offset the significant economic disadvantages Webvan faced in the first three arenas.

Results

By July 2001, after just two years in business, Webvan had spent just about all of the $1.2 billion put up by investors. Its audacious plan to reinvent grocery retailing was not going to work. Instead, on 9 July, the company closed its doors. As Miles R. Cook, a vice president at Bain Consulting, said, ‘They’ve got an approach that’s profit-proof’.

On the outside, Webvan looked like a new-economy company. On the inside, it was very old economy, with its high-cost warehouses, its fleet of vans and its labour-intensive delivery system that couldn’t compete. As we’ve seen – and some might have foreseen – its business model simply wasn’t viable. The Webvan model wasn’t the only way to run a dot.com grocery business, however. For another model that’s worked much better, see the Tesco story below.

How Tesco did it differently

While Webvan’s business model was perhaps poorly conceived, Internet grocery retailing was alive and well in the UK. Tesco, the leading British grocery chain, ran its Internet business model quite differently from Webvan’s. What was different?

• No expensive infrastructure: groceries were picked and packed in the company’s largest stores.
• Customer acquisition costs: no expensive marketing campaigns, given Tesco’s already broad awareness in the UK.
• Margins: pre-tax profit margins for grocery retailers typically ran at 6 to 8 per cent in the UK, versus 2 to 3 per cent in the USA.49 Tesco also found that shoppers bought a higher-margin mix of groceries online than in stores, since they were less likely to pick up sale-priced goods. These higher margins, plus a fixed delivery charge on every order, helped offset the costs of picking and delivering orders. And the fixed delivery charge encouraged customers to place larger orders to make the delivery expense worthwhile.

Will Tesco’s approach work in the long run? By 2001 Tesco was already making money on its Internet operation. By 2005, online and other non-store retailers were taking nearly one-fifth of total Uk retail sales.

Lessons learned from Webvan

Put simply, if your business model doesn’t add up, your business won’t last. If it costs you too much to do what you want to do – regardless of how innovative you are – then your business will die. Webvan's sums did not add up.

Poor execution probably hastened Webvan’s demise. Given its model, however, its case history suggests that its demise was probably inevitable.