The Big Cheese Of Online Grocers Joe Fedele's inventory-turning ideas may make FreshDirect the first big Web upermarket to find profits.
By Erick Schonfeld

(Business 2.0) – My dinner party began at 6:30 p.m. with shrimp cocktail and mushroom pizza triangles. Next came the grilled prime rib and seared peppered tuna with sautéed haricots verts and salted vine-ripened tomatoes. By 9, my guests were enjoying a cheese course of aged Spanish manchego with some custardy cherimoya pear. At that point the dark chocolate double layer cake seemed superfluous, but we ate it anyway.

This meal wasn't just self-indulgent gorging: I was testing how well the new online grocer FreshDirect stacks up against some of the food shops in my Brooklyn neighborhood. After all, FreshDirect CEO Joe Fedele claims that his operations offer "a better product at a better price." So I asked my guests whether they could taste the difference between the food delivered in a truck and the stuff I had to schlepp home. The consensus was that FreshDirect pretty much held its own against everyone except Staubitz Market--my Brooklyn butcher that has been around since 1917--and that's no small achievement.

But the true test is whether FreshDirect can make any money off my $59 order. After Webvan blew through more than $1 billion on its way to bankruptcy two years ago, most people relegated online grocers to the long list of dotcom-era pipe dreams. Since then, a crop of second-generation Web grocers has popped up around the country, claiming to have learned from those spectacular failures of the past.

Big supermarket chains like Albertsons, Safeway, and Royal Ahold, which bought first-generation online grocer Peapod in 2001, have replaced the Webvans and WebHouse Clubs. They dominate the $1.6 billion online grocery sector with a simple business plan: Supermarket clerks in stores and warehouses fill orders. The companies hope to cover the added costs through delivery fees, but rarely do. "Those other people picking off store shelves are yesterday's business model," sniffs Jim Manzi, the former CEO of Lotus Development and now FreshDirect's chairman.

Although it's part of the second generation, FreshDirect went another route. The company borrowed the no-store concept from Webvan and even picked up the leases for some of that company's refrigerated delivery trucks. But that's pretty much where the similarity ends. "I do not believe in looking at failed business models," says the gruff Fedele, who made his name in the notoriously rough-and-tumble New York City grocery trade by helping to start Fairway Uptown, a gourmet supermarket in Harlem. He's raised about $140 million and cadged ideas from Dell, FedEx, and Wal-Mart to develop a better plan: Start by dealing directly with farmers, fishermen, and slaughterhouses and build a single superefficient distribution center to hold down costs. That keeps gross margins high enough to cover the added costs of reliable delivery, which is offered only in densely packed neighborhoods. Kenneth Boyer, an associate professor at Michigan State University's business school who studies online grocers, says a visit to FreshDirect "really blew me away." His question is whether Fedele can produce fatter net profit margins than regular grocers.

To see how FreshDirect is doing it--and to check on my dinner party order--I went to the company's 300,000-square-foot facility in an industrial section of Queens. The action begins after midnight in this giant refrigerated food factory. That's when online orders are cut off and a customized SAP manufacturing application marries every customer order in an Oracle database to a production schedule for every department. FreshDirect eliminates waste by making everything to order. If 400 people each order a pound of Malawi coffee, only 400 pounds are roasted that night. "The computer tells me how much I sold for the whole day," says Victor Kalokola, the manager of the coffee and tea department. It tells each butcher, baker, and veggie-quiche maker--through touchscreens at their stations--what to prepare that night and when to do it. Six miles of conveyor belts zip bins through various departments as steaks are sliced, bread is baked, and fruits are selected. Packers know which bin to toss the Stilton cheese into after they scan the label because a green sign flashes "Here."

Dean Furbush, the newly hired chief operating officer, thinks of the food in terms of data. Every coriander-and-peppercorn-crusted tuna whizzing by is an information packet being sent from node to node in the warehouse network. Furbush wants to eliminate any node that is a choke point because, he says, "buildup at that node is inventory." And the No. 1 rule in retailing? Don't hold on to inventory.

FreshDirect is onto something big. "Think Dell and the whole inventory story," Furbush says. The company does as much business as two large supermarkets, but needs only a fifth the inventory. Even more remarkable, its inventory of perishables--about 70 percent of its business--turns a head-spinning 197 times a year, compared with only 40 at a typical supermarket.

The hard-charging Fedele--he interrupted an interview to scream into his cell phone, "Why don't you call me at night? Because my day is a nightmare!"--keeps the company's 650 employees focused on improving margins. FreshDirect uses its website, a virtual Larousse Gastronomique with tutorials on coffee blends and goat cheeses, to steer customers away from packaged goods and toward meat, fish, and prepared meals, where it has higher gross margins of 45 percent.

The warehouse design also plumps those margins by keeping food fresher. The meat departments are kept at an optimal 36 degrees, while bananas and tomatoes are kept in ripening rooms set at 60. In contrast, when a grocery store keeps everything out in open chillers at room temperature for the shoppers' comfort, the meat eventually turns gray and fruit overripens. "Ever keep your refrigerator door open for three days?" Fedele asks. "That is what you just bought your food out of."

While the facility could pump out as many as 20,000 orders a day, after a year of making deliveries around New York, FreshDirect, with just 150,000 customers, processes only about 3,300 a day. But it may soon boast something the first-generation online grocers never had: profits. With an average order of nearly $97, the company is bringing in almost $100 million in annual revenue. Fedele claims that profitability "is inches away."

To get there, he needs volume. If only he could find more customers as obsessed as David Lee, a Columbia University grad student. FreshDirect doesn't yet deliver to his neighborhood, so he sometimes orders delivery at his girlfriend's apartment downtown and drives the groceries uptown himself. "I am ashamed to admit it," he says. But then, that mushroom pizza is pretty darn good.