December 26, 2000, 9:55 AM

When the bag breaks

Are Internet grocery services headed for the clearance aisle? Peapod, the pioneer in the business, was saved from the compost heap by an 11th-hour bailout from international food giant Royal Ahold, which bought a 51% stake worth $73 million. Yet some analysts took Peapod’s trouble as a sign that the entire category is headed for disaster. “It’s not a business model amenable to the Web,” says Kevin Murphy, a research director for the Gartner Group, Stamford, Conn. “One’s going under, and there are questions whether even one can survive.”

Peapod’s trouble began in March, when investors withdrew an anticipated $120 million in funding after CEO William Mallory resigned for undisclosed health reasons. The company, which has steadily lost money despite building a customer base of 100,000 in eight markets since 1989, had counted on the financing for ambitious expansion plans. Last year, Peapod lost $28.5 million on revenue of $73.1 million.

Peapod aside, expect to see new business models emerging for Web grocery services. “The online grocery market cannot go it alone,” says Alice Richter, national industry director of KPMG Peat Marwick’s food and beverage practice, Minneapolis. “The pure-plays are going to have trouble, which we’re already seeing. The smart ones will partner with brick-and-mortar grocers.”

The problem, says Murphy, is a costly business model-a lethal layering that begins with distribution centers, trucks and teams of employees picking, packing and delivering. Add to that discounted shipping and other deals being offered to attract customers, plus already-scant grocery margins. Grocers used to make money on non-perishable goods, until superstores siphoned off that business.

Richter sees survivors taking a hybrid tack: Continue targeting high-income shoppers who’ll pay for convenience, combine groceries with delivery of dry cleaning and other errands as Streamline has done in Orange County, Calif., and combine Web shopping with brick-and-mortar stores. Shoppers could order “drudge” goods like cereal and paper towels on the Web, pick out their own bananas and meat in the store, then drive to the loading dock to pick it all up. “I don’t see any other way beyond a built-in formula for making money.”

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