December 26, 2000, 9:55 AM

The Struggle for Profitability

(Page 2 of 3)

The Boston Consulting Group report shows that online retailers spent $26 on marketing and advertising per order generated compared with $2.50 for traditional stores. Amazon.com spends 25% to 30% of sales on marketing and advertising whereas typical retailers spend around 5% and many spend even less. “If you adjust Amazon’s marketing expense to a 5% level,” says Haller, “they would have been profitable last year in terms of operating income as well as this year.” But last year Amazon.com had a negative operating income of $29 million and this year it’s projected to be negative $60 million. The rationale behind spending huge amounts on marketing and advertising, says Haller, is that by spending money to build and grow a brand, the company will generate bigger profits in the future. “And if the stock market is used as a gauge,” says Haller, “investors are agreeing.”

“We are investing in marketing, there’s no question,” says Egghead.com CEO George P. Orban. “If we didn’t invest in marketing, in the long term, we wouldn’t have a business.”

In fact, advertising is crucial to Internet stores as a way to drive traffic and develop credibility among potential customers. “The name of the game is who the customer trusts and wants to buy from,” says Rubin.

Smith likens the large amounts spent on marketing and advertising to America Online’s approach in its early years. Blodget agrees: “AOL lost money for years, a lot more than Amazon. But people bet on their long-term leadership. Now it looks like they were brilliant to invest the money and take the losses.”

In addition to spending large amounts on marketing and advertising, Amazon.com has also spent significant capital making numerous acquisitions to expand the business. In the past year, Amazon.com has bought Internet booksellers in the United Kingdom and Germany and an Internet movie database. The company also invested in human resources, more than doubling its workforce in 1998.

Blodget believes that the expenditures Amazon.com is making today are smart, and far from being penalized with lower stock prices for posting losses, he believes the company should be penalized if it did show profits. “They should be investing in the business,” he says. “It’s a smart management decision to do so now because in three years the barriers to entry will be too high.”

No worries

The retailers themselves do not seem to be worried about achieving profitability. “We have never forecast a date at which we will be profitable,” says a spokesperson for Amazon.com. “We are making decisions based on long-term business goals.” But Blodget believes that, based on current projections of sales growth and expense growth, Amazon.com will show profits by 2001.

Building the top line is of greater importance to most cyber merchants than having a positive bottom line. Says Kate Vick, chief financial officer at Cyberian Outpost Inc. in Kent, Conn., a seller of computer hardware, software and peripherals: “We’re investing money in the company right now, that’s what our shareholders are investing with us to do.”

In the future, says Haller, Amazon.com will continue to spend heavily, but as sales grow those expenses will be leveraged over a broader sales base, and the company will begin to post profits.

A grace period

Companies that transpire business just on the Internet have an advantage over companies that also conduct more traditional retailing, says Haller. “Investors in traditional retailers are not as willing to accept on-going losses of a new business venture in the name of developing brand awareness of the Web site as are investors in virtual retailers,” says Haller. But traditional retailers do not need to spend as much money to develop and grow their customer bases, Shop.org’s Smith argues. “Eddie Bauer,” he says, “is already ahead in the game, they already have a brand name, customer base, and infrastructure.”

Creating an e-commerce site is an added value function for established retailers says Smith. According to the Boston Consulting Group, multi-channel retailers such as Dell, Eddie Bauer and Lands’ End already account for 59% of online revenues and have better conversion and loyalty than purely virtual retailers where only 5% of unique visitors become customers, and only 1.6% of visits result in purchases.

However, some still question when e-retailers will become profitable. Some believe if investors demanded it, the companies would show profits. “Profitability,” says Haller, “is largely under the control of the company itself. If Amazon.com were being punished for not being profitable, in terms of their stock not doing well, then they would strive to be profitable sooner.”

Rubin believes virtual retailers that don’t stray from their original business model will become profitable in three to five years. Companies such as Amazon.com that changed their original concept to become a broader retailer-more like an Internet department store-will take longer, she says. “It’s clear that given the current growth that these companies are experiencing they will achieve profitability,” says Smith.

The downside

But even if they do begin to post profits some question whether the across-the-board run-up in e-commerce stocks is justified. “There’ll be a few successes and lots of failures,” says Blodget. But, he says, the successes will be huge with many new large companies created. “Given the potential of the Internet to change retailing, this will have as big an impact on retailing as Wal-Mart did. Investors are recognizing that there’s an enormous opportunity here,” he says.

But while the stock run-up has many people starry eyed, it may have created greater problems for Internet retailers. “The volatility created by people speculating in these stocks has made the business more difficult to manage,” says Orban.

For one thing, Orban says, high stock prices make it difficult for the company to find capitalization, because financial institutions believe the company is overvalued. And high stock prices make recruiting difficult. Stock options are a valuable compensation tool and they aren’t as appealing if recruits feel they are overvalued.

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