By Geoff Wissman
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.
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.
According Amazon.com executives, free shipping is successful at driving site traffic, bolstering conversion rates and enticing customers to buy more per order.
While it’s been repeatedly proven that free shipping can influence consumer behavior, distribution-related expenses can also become prohibitive. For e-retailers, the primary economic model trade-off is lost shipping and handling revenue (and/or higher shipping costs) vs. additional gross margin dollars. One reason free shipping is economically feasible for select e-retailers is that product prices and, hence, gross margin ratios are higher today. For example, a few years ago, about every product could be purchased for less at Barnes & Noble.com compared to a Barnes & Noble superstore. Today, this is no longer the reality, with mass market paperbacks no longer featuring a discount and bestsellers typically featuring a similar discount online as in stores.
The majority of retailers see free (or reduced) shipping as a temporary promotion, particularly useful during the holidays and other important shopping seasons or special occasions. With regard to Amazon.com’s free super saving promotion, it’s telling that neither partner, Target nor Toys R Us, agreed to participate in the promotion.
Going forward, e-retailers will continue to prominently feature shipping and handling promotions, quite simply because they can quickly impact site traffic and the top line. However, e-retailers will do so with a bottom-line mentality.
Closing thoughts
In the past 12 months, e-retailing has moved significantly up the profitability continuum. With Amazon.com eking out a small profit and others producing black ink, the industry is well on its way to legitimizing its existence from a profitability perspective. While questions and challenges remain, the channel will solidify its reputation as a profitable distribution channel if players are able to produce the same amount of progress during the coming 12 months compared to the prior.
Geoff Wissman is vice president of Columbus, OH-based consultants Retail Forward. E-Retail Economics - The Next Evolution is an excerpt from “The Ongoing Evolution of E-Retailing,” a Retail Forward Intelligence Program publication. More information about the E-Retail Intelligence Program and this special report is available from Katherine Clarke, 614-437-1021, ext. 109.
