August 12, 2002, 12:00 AM

The State of the Industry: The Next Evolution

(Page 2 of 3)

There are multiple similarities across the e-retailers that recently made money. One is specialization, an exclusive focus on a niche product category, which limits distribution and other overhead expenses. Another is strong top-line growth, which reduces fixed expenses as a percentage of sales. A final is being quicker: Many realized the new emerging e-retail economic model before others, and had sufficient time to make the necessary adjustments, such as containing expenses, improving site shopability and leveraging multiple channels.

These characteristics made it possible for a reported 56% of retailers to generate profits from online operations in 2001, up from 43% in 2000, according to Shop.org. The sizable percentage of retailers making money in 2000 suggests that the niche and cost containment strategies have been present throughout the industry’s evolution. They just have not been the focus of the leading players until recently.

Leveraging existing assets

Throughout e-retailing and the retail industry it has become imperative for companies to do more with less to succeed.

A core competency is imperative for e-retailers as it creates a raison d’etre while producing scalable economies for the business. Perhaps more importantly, a core competency helps drive key company decisions regarding strategic initiatives and economic performance, such as labor allocation and capital investments. For a select group of e-retailers, a core competency can drive an additional aspect of the economic model, namely the ability to become an outsourcer and offer value-added services to other companies. Amazon.com is the prototypical example, having entered into strategic alliances with a number of multi-channel retailers (Borders, Circuit City, Target, and Toys R Us) and other companies (CarsDirect.com, Drugstore.com, Expedia.com, and Hotwire).

From an economic model perspective, service revenue has the ability to significantly impact profitability. The services division at Amazon.com, which includes revenue from auctions, zShops, strategic alliances with companies and other marketing agreements, generates a significantly higher gross margin ratio compared to the rest of the company. A significant portion of this revenue falls straight to the bottom line, as minimal new operating expenses are created. In these instances, additional profit dollars come from referral fees and commissions, not managing more inventory.

However, the reality is that only a select number of e-retailers have the competency and resource base to leverage assets outside their own supply chain In addition, services are more vulnerable today compared to a few years ago as the industry’s growth rate has slowed, giving potential customers more leverage at the negotiation table, as well as making fewer potential customers available as prospects.

e-ROI - consider more than greenbacks

While services can aid a select number of e-retailers in their pursuit of profits, it’s necessary to analyze the economic viability of online operations in a slightly different context than a traditional capital investment. The multi-channel nature of the business challenges the traditional Return on Investment calculation. Online shopping sites generate some difficult to quantify benefits that can include additional foot traffic and sales at stores, increased visibility for catalogs and promotions, the ability to develop a closer relationship with customers, i.e., an enhanced level of customer service, and basic brand building.

A quandary exists because consumers shop at multiple channels, but only transact at one for any given purchase. Sales that transpire in one channel are often influenced by experiences across channels. According to a recent Retail Forward survey, the category with the highest shopper retention in terms of online research at a site leading to a subsequent store trip is consumer electronics, followed by clothing, computers and toys.

It’s imperative that a retailer’s e-ROI calculation take into account difficult to quantify benefits, and in some cases, strictly qualitative issues when evaluating online operations. Today and in the coming years, it will be fairly common for multi-channel retailers to lose money online, yet deem the channel an unbridled necessity and success.

In the industry’s early days, many consumers became enthralled with e-retailing solely based on the prolific number of free or near free product purchasing opportunities. E-retailers were literally giving away products, all in the name of building brand awareness. While brand awareness was the goal, the outcome was the reputation and eventual expectation by online shoppers that e-retailers only sold goods at rock-bottom prices.

While coupon proliferation and coupon generosity have been significantly reduced in recent years, product prices, while generally higher than a few years ago, remain very attractive compared to other channels. While select e-retailers have been able to bolster gross margin ratios in recent years, opportunities for future gross margin increases will be minimal.

For e-retailers, the problem of a low price strategy is that a company must generate sufficient gross margin dollars per order to cover expenses related to taking orders, shipping and handling, and customer service. For e-retailers that have a low-price strategy-an applicable description of Amazon.com, Buy.com and others-it’s imperative to operate flawlessly on a consistent basis as well as have the capability to be the low-cost supplier. This is one reason Amazon.com has been focused on operational efficiency in recent years.

For low-price, low-gross-margin players to prosper, cost containment and cost-cutting initiatives must be prevalent. For this reason, e-retailers will continue to reduce advertising and marketing expenses (both offline and online), focus heavily on (cost effective) e-mail marketing tactics, and leverage existing supply chain infrastructure or go the outsourcing route to reduce the asset base.

Free shipping & handling-the norm, with caveats

In reality, it’s not appropriate to analyze gross margin ratios (i.e., pricing strategy) without considering shipping and handling simultaneously. Consumer surveys have found that most online shoppers expect a basic trade-off between lower product prices (compared to other channels) and shipping and handling charges.

Many e-retailers employ free shipping and handling promotions as a basic marketing tool. While the evolving e-retail economic model features a plethora of free shipping and handling promotions, it often does so with strings attached. Recently, Amazon.com debuted free super saving shipping for (most) orders exceeding $49. The permanent promotion, which lowered the threshold from the $99 set in January, is akin to a slow-boat-to-China option, taking an additional three to five days to arrive compared to standard shipping, hence, reducing distribution expenses for the e-retailer. Buy.com followed suit with a similar promotion, but is also being somewhat cost conscious, as the offer does not apply to clearance items or products weighing more than 20 pounds.

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