The Online Grocer Version 2.0 Forget Webvan, say the founders of FreshDirect. Their business is about food--and that's why they're sure it's going to succeed.
By David Kirkpatrick

(FORTUNE Magazine) – Joe Fedele thinks the food industry is ripe for revolution. He has raised $120 million to try to get one going. In September the company he co-founded, FreshDirect, launched a new kind of high-quality food preparation and delivery service. From a 300,000-square-foot plant in the New York City borough of Queens, just a block from the Midtown Tunnel, FreshDirect's brightly decorated trucks fan out every evening across the densely populated East Side of Manhattan. Their cargo--meat, fish, cheese, fresh-baked breads, produce, and other foods--sells at prices about 25% below what most New York grocers charge.

Higher quality at lower prices--it sounds like every implausible grocery-store advertisement we've ever seen or heard. But CEO and food-industry veteran Fedele and his partner, ex-investment banker Jason Ackerman, swear they can perform this seeming miracle profitably. They say they can do it by restructuring the food-delivery supply chain and using cutting-edge technology to gain unprecedented efficiencies. Fedele claims his company's gross margins are already several points higher than those of Safeway, the $34-billion-a-year California giant.

A few days spent exploring FreshDirect's sprawling plant, talking with customers, and ordering and eating its food suggests that these guys are onto something. So far, the startup's sales volume remains minuscule, though Fedele projects he'll get revenues of about $100 million his first year and about $225 million by 2004. But FreshDirect does deliver specialty-store-quality fresh food and prepared food at strikingly low prices. A basket of 25 items at FreshDirect sells for 28% less than at Garden of Eden, a high-end New York grocer, and 12.5% less than even the sale-circular products at grocery chain Gristede's. The minimum order size is $40, and delivery prices are fixed at $3.95 (no tipping). Drivers come only at night and on weekends, which keeps the trucks out of the heaviest New York City traffic.

Cindy Palicka has bought just about all her groceries from FreshDirect for the past five weeks. The director of children's education for a Manhattan church, she lives in a Midtown high-rise and cooks almost every night for her husband and three boys, ages 6 to 17. Says Palicka: "I've ordered fish, chicken, and meat. It looks good and tastes good. It's packaged beautifully. You lose a little control over how your fish is prepared, because you're not standing there watching. But the salmon is about half the price of Food Emporium [the supermarket where Palicka used to shop]." Discussions on online bulletin boards at two large housing complexes where FreshDirect delivers also find impressed customers shouting down skeptics who call the company just another web scam.

Though FreshDirect has heretofore been secretive, food industry experts learning about its operations are almost uniformly dumbstruck at its apparent sophistication. Well-respected Lehman Brothers supermarket-industry analyst Meredith Adler, who recently spent time talking with company executives, was blown away by FreshDirect's profitability: "If they can maintain anywhere near the numbers they say they're maintaining, they've got something that works." Bruce Axtman, CEO of the Perishables Group, which consults with the food industry about fresh foods, pronounced what he heard about the company's operations "amazing."

It's a measure of the times that Fedele and Ackerman refuse to call FreshDirect a dot-com. And while they admit that the company could not exist without the web (orders are placed on for delivery the following day), they insist that efficiency, not technology, is the point. "Our idea was to build the ultimate food company that could scale," says Ackerman. "The only reason we chose the Internet was that it helped us reach people at a lower transaction cost. It allows us to do for food what Michael Dell did for computers." One of the great unfulfilled promises of the Internet has been that it would enable manufacturers to sell directly to consumers. But few companies other than Dell have actually done it.

And of course Webvan failed spectacularly. That first great Internet grocery scheme spent more than $1 billion on huge distribution facilities in seven cities before closing shop in July 2001.

Why should these guys do any better? It's a question they are asked constantly. Fedele and Ackerman insist Webvan was merely a distribution company that missed the point. Says Fedele: "This is a company based on food people, not dot-com people." FreshDirect's motto: "It's all about the food."

There's already evidence that they're on the right track. Despite Webvan's demise, some online groceries have thrived, notably those run by supermarket chains. Forrester Research calculates that the U.S. online food-and-beverage business will generate $2.4 billion in sales this year. Safeway, for example, delivers in many parts of Southern California; its product selection is broader, and its prices and delivery charges are considerably higher than FreshDirect's.

The startup doesn't try to deliver items like light bulbs or kitty litter. Though it has a limited selection of dry goods, it concentrates on impeccably fresh perishable foods because that's what consumers want, says Fedele. Adds Ackerman: "Our ideal customer orders twice weekly and also goes to Costco once a month." Americans have shifted their food buying dramatically over the past 30 years. In the 1970s about 70% of food was purchased in packaged form, vs. 30% fresh. Today, following dramatic growth in prepared and specialty foods and even farmers' markets, the percentages for East Coast urbanites have roughly reversed.

Yet supermarkets were literally built around the old product mix. Says analyst Adler: "Most supermarkets don't even think of themselves as perishables retailers." Ever noticed that supermarkets are often uncomfortably cold? That's because so much of the food people now buy--all that fresh stuff--is displayed in open refrigerators.

So FreshDirect aims to make the store unnecessary. Instead it has built what Fedele calls the "most automated plant in food processing." In many ways the plant resembles a gigantic restaurant kitchen more than a grocery. It butchers meat from whole carcasses, makes its own sausage, cuts up entire salmon, roasts and grinds coffee, bakes bread, pastries, and desserts from scratch, ripens fruits and vegetables (in seven special ripening rooms), and cooks meals.

Fedele has not stinted on implementing extreme measures to ensure quality. "We want to create a new standard in the processing and handling of fresh foods," he says. The entire building is a refrigerator. From the moment foods enter, they are kept at 36[degrees] F or below--all the way through production, packing, and shipping. Only when the delivery person removes an order from the truck is the food exposed to warmer air. This contrasts greatly with the repeated "hot/cold cycles," as Fedele calls them, that foods typically go through as they pass from wholesaler to truck to grocer to customer cart and home. Says Fedele: "If I get it to you faster with better temperature control, it's a better product."

Cleanliness is another obsession. All food-preparation areas--and the equipment in them, including computers--are bathed in antiseptic foam at the end of each day, hosed with water, and given a final antibacterial coating. The company even maintains a laboratory to test incoming and outgoing shipments as well as food-preparation areas for contamination. A 32-year veteran U.S. Department of Agriculture inspection supervisor named Walter Rickman manages the lab. "We put this place together to USDA standards," he says. Explains Ackerman: "We're trying to set a safety bar we don't think other retailers can ever reach, and then make that a standard of expectation for all consumers."

FreshDirect's systems take advantage of the centralized processing that online delivery affords. The plant is designed to handle up to 16,000 orders per day, far more than the 600 or so the company was getting in early November. Fedele hired industry veterans for each food category--the head baker, for instance, was previously at Ecce Panis, an expensive baked-goods chain. These experts supervise daily production, and their knowledge is also programmed into the SAP manufacturing-software system. That way FreshDirect can fill the ranks with inexpensive, relatively inexperienced hands. The system combines, say, incoming swordfish orders so that a fish guy can cut them all at once.

The SAP software may tell a low-wage baker to make 500 sourdough baguettes. It will print out a list of ingredients and measures, and check the worker's decisions using readings from scales and bar-code scanners. SAP sets the distilled-water temperature and the mixer's speed and intensity. It tells the baker when to put the dough in the oven, where it sets temperature and humidity. High tech pervades the plant. On a recent tour Jim Manzi, former CEO of Lotus Development and a FreshDirect investor, looked at a tankful of lobsters and joked, "These were grown from stem cells."

Fedele, 50, is a cigar-chomping tough guy who co-founded and ran Fairway Uptown, a now legendary New York supermarket anomalously located on a riverfront in Harlem. People thought he was crazy, but when the store opened in 1993 it became a sensation for its low prices and ultra-fresh produce and meats. Customers flock to it even from the suburbs. Ackerman, 35, was a Donaldson Lufkin & Jenrette investment banker specializing in supermarket mergers and acquisitions. He sought out Fedele because he saw him as the industry's most visionary retailer, and he proposed jointly starting a chain of fresh-food stores. "But we realized," says Fedele, "that we wouldn't be able to manage the quality after we got to five stores." The two also saw that they could take their ideas about fresh food even further using online ordering and central distribution.

That was before the dot-com bubble burst, and the two were able to raise money from Ackerman's uncle, Peter Ackerman, once a top deputy to Michael Milken at Drexel Burnham Lambert. He now runs a private investment firm and owns more than half of FreshDirect's stock. (An iconoclast, he recently co-authored an article on nonviolent resistance to Saddam Hussein.)

FreshDirect is eager to avoid the Webvan mistake of overreaching. It delivers in only five zip codes, mostly in Manhattan, and is adding new ones slowly as it fine-tunes its systems. It has no immediate plans to expand beyond New York; the longer-term goal is to open one or more additional plants in the region before expanding to four or five other East Coast cities. It seeks densely populated areas because that keeps delivery costs low. He wants to sell raw, semi-prepared, and prepared food to institutions as well. Fedele thinks eventually he can get about 5% of the New York food market, which he calculates would give FreshDirect revenues of about $2 billion. Executives say the company can be profitable within six to eight months, once it hits $60 million or so in sales; they won't consider an IPO until the business is solidly in the black.

The final piece in the profit formula at FreshDirect, say its founders, is the unique relationship they believe they can establish with suppliers. The grocery industry is fraught with conflict between increasingly powerful supermarket chains and the manufacturers of food. Slotting fees and other forms of trade allowances often require food companies to pay heavily to guarantee positioning on store shelves. FreshDirect doesn't accept such payments. Instead it plans to provide suppliers with invaluable market research based on its direct contact with consumers, and to encourage them to put their own brands on what are normally commodity items--things like beef, fish, and vegetables. Fedele tries to buy directly from growers or producers that normally sell through distributors. He also says he pays suppliers in three or four days, vs. the 35 days or so typical for the industry.

For all these reasons, Fedele claims, suppliers charge FreshDirect significantly lower prices than they charge supermarkets. "The game here," he says, "is a real partnership with manufacturers." Whether he has achieved that is anybody's guess--not a single supplier would talk to FORTUNE about its dealings with FreshDirect. The resulting prices, however, are there for all to see.

Ordering from FreshDirect at our Manhattan household was a pleasure. The delivery arrived when it was supposed to--between 8 p.m. and 10 p.m. While a few glitches were apparent (our frozen food was delivered to the wrong apartment), the food was impressive. The fresh-baked peanut-butter cookies were fabulous, as were the cheese, prosciutto, two different types of FreshDirect-made frozen pizzas, precooked antibiotic-free herbed chicken, and shrimp that were fresher than we'd ever seen. The produce and meats really did seem to last longer than when purchased at the disheveled Gristede's downstairs. And who can complain when a box of Post Shredded Wheat sells for $2.99, vs. the obscene $4.69 Gristede's charges?

Lehman's Meredith Adler suggests that much of my satisfaction stems from being a New Yorker. "New York has a unique problem. Perishables here are really bad," she explains. "You have to be careful not to extrapolate too much from the New York market." Forrester online retail expert Christine Overby is similarly cautious: "Online grocery is a very difficult thing to do profitably. And perishables are the most difficult part of the market because they have such a high spoilage rate." Adler, meanwhile, wonders if FreshDirect will be able to maintain its fastidious quality control if and when it scales up, and whether suppliers will still give Fedele those great deals if FreshDirect becomes an industry power. It's still too early to know if this business will succeed. Yet Adler, herself a New Yorker, notes that she and her husband have quit buying perishables at supermarkets. Our conversation ends with her asking if FreshDirect delivers to her neighborhood.