August 12, 2002, 12:00 AM

The State of the Industry: The Next Evolution

A new emphasis on profitability—measured both in the web channel and in the web as an influencer of offline purchases—characterizes the next stage of e-retailing.

Throughout e-retailing’s existence, one of the leading distractions has been the industry’s blatant disregard for profitability. During the industry’s boom period, retailers, primarily those of the pure-play variety (but some multi-channel retailers also participated) spent money like it was growing on trees. Long term, this behavior did little to propel the industry forward, while raising red flags about e-retailing’s long-term potential as a viable distribution channel.

Over the last few years, the outlandish outlays and unrealistic business models have been amended, often by a combination of employee layoffs and other difficult cost cutting initiatives, updated go-to-market strategies, and/or companies shuttering online operations. The landscape is littered with a rash of e-retailers that spent lavishly on advertising and marketing as well as supply chain capabilities, and ended up as little more than mere “lessons learned.”

Lessons were taught by eToys, Kozmo, OurHouse.com, Pets.com, Priceline.com’s WebHouse Club, and Webvan, among others. Originally, many actually envisioned e-retailing with a higher profitability threshold than traditional retailers due to a smaller asset base, specifically no store network. However, the pure-play model has several deficiencies from a profitability perspective, most notably a lack of consumer visibility that necessitated significant advertising and marketing expenditures and substantial fulfillment and service-related costs. As multi-channel e-retailing emerged as the preferred model, other key challenges remain.

Today, the major question marks surrounding e-retailing’s reputation as an important and viable distribution channel have largely subsided. However, questions remain about the industry’s ultimate potential, and whether it can take the next step in its maturation process from a legitimate to a lucrative channel of distribution. Key issues that must be addressed for e-retailing to evolve to the next level include:

- What’s the optimal way to leverage existing assets and expertise: outsource services to other companies or sell more products?

- How should retailers think about and most accurately calculate ROI for online operations?

- Are low to moderate gross margin ratios a long-term reality for the industry? Or posed another way, can the industry minimize its reputation as a channel that features “rock-bottom” prices?

- Can/should free shipping and handling remain a basic expectation of online customers?

Before addressing some of these issues, it’s appropriate to take a moment and congratulate the industry ringleader, Amazon.com, on generating a positive return for its shareholders for the first time. Despite the company’s consistent, bordering on obstinate, focus on pro forma operating income, Amazon.com generated profitability at the net income level during the fourth quarter of 2001. This occurrence represented a turning point for the world’s largest e-retailer, and more importantly, the industry as a whole. Overnight, the image of e-retailers doing little more than giving away products at deep discounts and burning large piles of cash vanished.

In reality, Amazon.com’s encouraging fourth quarter profitability announcement was less clear cut. While the company made money, the amount was very small-a minuscule $5 million- compared to an aggregate deficit of $2.85 billion during its seven years of operation. Also, Amazon.com benefited from a gain of approximately $16 million due to a reevaluation of its euro-denominated debt at the end of the fourth quarter. More importantly, the company does not expect to make money during any of the first three quarters of 2002, or in fiscal 2002 at the aggregate.

One primary driver of the company’s recent financial improvements has been a focus on inventory management and supply chain efficiency. As a result, while the company’s top line nearly doubled from 1999 to 2001, inventory declined 35%, an unheard of occurrence in the retail industry. Key economic model implications include skyrocketing inventory productivity and reduced fulfillment expenses, helping bring the company closer to long-term profitability.

Others clearing the bar or getting closer

In addition to Amazon.com, other major players, such as Barnes & Noble.com, Drugstore.com, and ToysRUs.com, have reported improved financial results. Similar to Amazon.com, major drivers include a relentless focus on cost containment and operational efficiency, coupled with bolstered conversion rates due to a more efficient and easier online shopping experience. E-retailers that have made money include U.K.- based Tesco and a fairly large number of small U.S. e-retailers:

-During the fourth quarter of 2001, Tesco.com became the first major online supermarket in the U.K. (and likely around the globe) to make money, after online food sales reached profitable levels in the prior quarter. The result excludes Tesco’s investment in an online joint venture with U.S. supermarket retailer Safeway.

- Catalog and online gift retailer RedEnvelope was profitable during the company’s third quarter (ending Dec. 31, 2001), and expects to be profitable on an annual basis in 2002. In fiscal 2001, total sales increased 71% to $56 million.

- Jewelry e-retailer BlueNile.com made $1.1 million in operating income during the fourth quarter of 2001, representing an operating margin of 6.5%. Ice.com, another jewelry site, also has reportedly obtained profitability.

- Online accessory e-retailer eBags.com posted its first-ever profitable month in December 2001, when sales were up 45% compared to the same month a year earlier. The company was reportedly profitable in January 2002, too, and expects to make money for the year.

- Electronics Boutique said that its e-commerce operating subsidiary, which features ebgames.com, achieved profitability for the first time in 2001. The site was launched in August 1997.

- According to a company executive, Overstock.com posted profits of between $300,000 and $400,000 in December 2001. However, the company lost $2.7 million at the operating income level for the quarter ended December 2001, and will likely produce more red ink in 2002.

- Multiple online flower and gift retailers as well as travel sites produced black ink in 2001.

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