Ocado’s full year results demonstrate the two key features of internet grocery retailing – excellent growth and the difficulty in making a profit.

Ocado’s full year results demonstrate the two key features of internet grocery retailing – excellent growth and the difficulty in making a profit.

There is seemingly relentless growth in internet grocery retailing, with sales growing by around 15% or £1bn per annum. In a market with no volume growth overall, this channel is winning share from large store formats and is one of two growth areas, along with convenience retailing.

The second feature is low profitability. Ocado has finally made a profit (albeit a small one and a loss after exceptional items) but it has taken many years and a lot of hard work and investment. Ocado though, is not alone in low profitability.

We question if any of the majors are profitable on a fully costed basis, particularly if cannibalisation is taken into account. The lack of transparency from Tesco and its competitors shows retailers are unwilling to discuss profitability in any depth. With turnover in excess of £2.5bn, Tesco’s internet grocery business is bigger than some quoted non-food retailers, yet shareholders are not even given the true turnover level, let alone insight on profitability. At least Ocado provides transparency.

So why do the retailers persist in pursuing this channel? The answer is that they are damned if they do and they are damned if they don’t. Five players – Ocado, Tesco, Sainsbury, Asda and Waitrose – are sitting at a high stakes table and the stakes are rising – participation in a market that will grow to £10bn, £20bn, or £30bn and higher. The biggest reward though, could be long term survival. That is if this channel keeps growing, and there is every sign it will.

Mobile technology is improving and becoming more widespread. Each development, whether wi-fi on the underground, new apps, or 4G, effectively adds more capacity, as does every sale of a new smartphone or tablet. But capacity without demand growth is destructive - just look at the falling returns on investment for large stores as the majors have kept opening space in a flat market.

Growth is provided by consumers who are increasingly switching to this channel and we can see this switching gathering pace. Long term, a generation will grow up that regards this channel as the norm, as one of the unequivocal features of technology, is that once something has been invented and accepted, you can’t go back. The future will be family shoppers using the internet for main shop and convenience for top up shops, supplemented with an occasional visit to an old cavernous superstore.

Weak profitability is a result of retailers not charging the full economic price for the service. They are subsidising internet operations, either from existing large store operations, or from shareholders (in Ocado’s case). No-one wants to charge the consumer the real cost of home delivery unilaterally (estimated at £15-£20 per order) as high cross price elasticity would lead to customers leaving in droves. Think what a 15% price increase would do to sales. And no-one wants to leave the table while the pot in the middle is growing with the end prize becoming greater by the day.

In the medium term, the internet will keep growing, cannibalisation will increase and large store returns will fall. Ocado may not have a large store legacy, but it suffers from a lack of scale and may face issues if click and collect develops as a popular channel. Sir Terry Leahy once likened Ocado to a charity for not charging commercial rates. It now seems the whole industry is more charitable than ever, with the internet shopper being the real winner.

Dave McCarthy is analyst at Investec