By Alexei Oreskovic

SAN FRANCISCO (Reuters) - When Google started testing a free same-day shopping delivery service in San Francisco last year, industry observers were surprised by the company's foray into a notoriously tricky and decidedly low-margin real-world business.

Others raised their eyebrows when orders of one or two items, such as toothpaste or a can of soda, sometimes arrived in a bag big enough to hold a week's worth of groceries.

It was a rookie mistake, one that underscores how Google is wading into unfamiliar territory -- a business, now contested by seasoned hands Amazon.com Inc and eBay Inc. that claimed many victims during the first dotcom boom.

For Google, which dominates the wildly profitable Web search advertising business, dispatching drivers and delivering packages seems like an expensive diversion with an uncertain payoff. One of the biggest disasters of last decade's dotcom crash, Webvan, bled hundreds of millions of dollars on just such a business until it failed.

Online shopping is an area that Google, which has ambitions to dominate every aspect of the Web, has traditionally had a limited presence in. Traffic lost to Amazon and eBay, which are using same-day service to lock in consumers for the main business, means customers lost for Google's other services.

As e-commerce grows, Google wants at least to get its hands on data about online shoppers, so it can expand and improve its main business, search advertising. Its successful foray into mobile phone software was driven partly by a similar philosophy to guard its search franchise. Now its Android system ensures Google search is on most smartphones globally.

After more than a year of testing, and hiccups such as on packaging, Google is preparing to expand its delivery service.

Unfazed by the ghosts of defunct home-delivery operations Webvan or Kozmo.com, Google is ramping up its Shopping Express with radio ads touting the service in the San Francisco Bay Area. It recently took its blue-and-white Priuses and vans to Los Angeles in a limited trial and is considering moving into New York, according to a person familiar with the matter.

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"Same-day delivery doesn't have to be a luxury. It's a convenience that everyone should be able to enjoy, and that means across lots of stores, across lots of cities and across lots of products," said Tom Fallows, director of product management for Google Shopping Express. Fallows wouldn't say when Google delivery cars might come to New York, but he confirmed that the company plans to enter more cities.

"We are eagerly starting to move forward on some of our next steps for expansion," he said. He declined to discuss the economics for Google.

Google is also experimenting with ways to deliver perishable groceries such as milk and eggs -- items that require special temperature-controlled storage and delivery gear, and which are already available through Amazon's rival Fresh service -- though Fallows said it's too early to say whether that might ultimately become part of the service.

Google has "tens of thousands" of users of the service in the San Francisco Bay Area placing thousands of orders a day, according to the person with knowledge of its delivery business.

"This is a play that will take many years before it turns in any way profitable. But it's something worth doing if they can establish the marketplace and the other hooks into the business," the person said.

THE LAST MILE

Google Shopping Express lets consumers buy products online from more than a dozen stores in the San Francisco Bay Area, including Staples, Costco, Blue Bottle Coffee and Toys R Us, and have the goods at their doorsteps that same day.

Couriers or contract drivers pick the orders up from retail stores throughout the day. Google collects an undisclosed commission from the retail stores for each sale.

For now, consumers pay nothing for the convenience, thanks to a free six-month membership trial offered by Google. Google will likely extend the free trial until it has perfected the service and is ready to charge a subscription fee, said Fallows.

With nearly $60 billion in cash, Google can afford to experiment with same-day delivery, similar to the way it is building out high-speed fiber networks in some cities.

Importantly, the ability to deliver purchases into buyers' hands on the same day closes the "last mile" between an online business and a customers' home. That removes a key advantage of traditional retailers today: instant gratification.

As Amazon spends billions on fulfillment centers and eBay contracts couriers around the country, the danger is Google may be left out of one of the hottest new areas of online growth.

The eBay Now service, available in the San Francisco Bay Area, New York, Chicago and Dallas, charges $5 per order and delivers goods within one to two hours. Amazon charges a $299 annual fee for Prime Fresh, which lets consumers order anything from fresh salmon to digital cameras, with free same-day delivery for orders more than $35. It's available in Los Angeles, San Francisco and Seattle. Amazon's separate Local Express service lets Prime members in 10 U.S. cities pay $3.99 per item for same day delivery.

Google's Shopping Express is being tested as a standalone delivery service, but many people expect the eventual goal is to integrate home deliveries as a feature in the search engine. A consumer doing research about camping tents on Google, for example, might see an ad that lets them order one and have it delivered to their doorstep the same day.

"It's just another way of to make search more powerful," says BGC Partners analyst Colin Gillis. And it gives Google more insight about users, such as valuable information about which visitors its website "convert" into buyers after clicking one of its search ads.

MAGIC WAND?

Amazon, eBay and Google have been mum on progress. But there's evidence to suggest that consumers may be taking to it.

Family-owned Palo Alto Toy & Sport, which Google identified to Reuters as a participant in Google Shopping Express, has increased sales by 15 percent, said manager Miguel Natario. The increase in sales has more than paid for an additional employee hired to pick the 30 to 40 additional daily orders from store shelves and prepare them for the Google driver pickup.

Among the most popular items? Helium-filled Mylar balloons, a party essential that sells for about $4 to $5 each. "I get inflated balloon orders every single day," said Natario.

The real test will come when Google asks users of Shopping Express to open their wallets and pay for home deliveries.

Google may need to put in place some restrictions if it hopes to make same-day delivery a viable business.

Paying drivers to crisscross town delivering packs of gum or tubes of toothpaste is not a sustainable business, said Kenneth "Skip" Trevathan, former chief operating officer of Kozmo.com, an online delivery service that expanded to several cities in the 1990s before going out of business.

"Unless they've got a magic wand of some kind that we didn't have, I just don't see how they can make money off that," Trevathan said. He predicts Google may have to impose a minimum order or tack on an additional fee for smaller orders.

Unlike many Internet businesses in which being first to grab market share is key to success, growing too big too fast can be fatal in the delivery game, said David Vernon, a Sanford Bernstein analyst. A small order that forces the delivery person to drive to the other side of town can do more harm than good.

"Last mile" economics are among the most complex metrics in the industry. Too much time between deliveries or poorly planned packing can inflate costs, especially for same-day orders.

A difference in the time between deliveries of just a few minutes can double shipping cost, according to an October analysis of Amazon's delivery service by Marc Wulfraat, a consultant who specializes in logistics networks.

"Getting a bunch of revenue that doesn't drive density in your routes is actually worse, because you're adding costs faster than you're adding revenue," said Vernon.

For Google, the key is to get that lag down. That's where mapping technology and a wide network come in handy.

"If you think about the fact that there are more than a billion people using Google maps to help them drive around town, we have a ton of information for optimal routes and traffic patterns," Fallow said.

Equipped with Android smartphones, Google couriers receive "step-by-step" driving directions. Deliveries per hour have increased by more than a factor of six since Shopping Express began, thanks to ongoing improvements in the software, and Fallow expects more improvements.

Orders for a single tube of toothpaste aren't ideal, but they are offset by the "broader basket" of customer orders and the annual spending of each customer. Google's delivery service is not so different from a traditional retail business, he said.

"Stores sometimes sell particular items as a 'loss leader' in order to over time earn the broader business of that shopper," he said.

(Additional reporting by Deepa Seetharaman. Editing by Edwin Chan and Douglas Royalty)