September 27, 2007, 12:00 AM

Dollars and cents

Web retailers are growing both their top and bottom lines, but expanding organically rather than taking on outside risk.

Web retailers are feeling pretty bullish about their financial situation these days. But having made the transition from start-up operation to established business, web merchants are also keeping a close eye on their expenses and growing organically using their own resources rather than take on a big acquisition or too much outside financing, according to Internet Retailer’s latest monthly survey.

The survey-this one on profitability and business development-finds that 58.5% of merchants expect to grow their web sales by at least 20% this year, including 24.9% by more than 50%. The research also reveals that 83.2% of merchants are profitable and have been for several years. 28.6% of retailers have been operating in the black for at least five years, compared with 20.7% from three years to five years, 36.5% from one year to three years and 14.3% for one year or less.

Healthy bottom line

A big indicator of financial success is growth in net income and most retailers expect to end the year with a healthy bottom line. The survey was e-mailed in early September to all subscribers of IRNewsLink, the magazine’s e-newsletter, and all responses were collected and analyzed by Vovici Corp. (formerly WebSurveyor), which has partnered with Internet Retailer in a series of surveys on the e-retailing industry. The survey, which summarized answers from 27 chain retailers, 29 catalog companies, 97 virtual merchants and 9 consumer brand manufacturers, finds that 58% of web merchants expect their net income to grow by more than 10% this year, including 21.8% by more than 25% and 17.9% by more than 50%.

“More Internet retailers are turning a profit because they’ve hung in, survived a start-up and established a business model that’s generating recurring sales and net income,” says Paula Rosenblum, a partner with Retail Systems Research LLC, a Miami retail industry research and consulting firm. “They are profitable because they’ve figured out their market niche and what it takes to make consumers stick around and complete a purchase.”

The majority of companies participating in the Internet Retailer survey are small and most are privately held. For instance, 58.1% of merchants have annual web sales of less than $5 million and 85.5% operate privately or as a business unit of a non-public company. But regardless of their size, most retailers still rely on their own internal resources to grow the business rather than raise money from outside investors such as investment bankers and private equity firms. The survey finds that only 10.8% of retailers have raised money through a private placement. And of the companies that have sought outside financing, 44% have secured $1 million or less in funding, compared with 5.5% that have secured from $25.1 million to $50 million. “Smaller and profitable web retailers can fund their own growth because they are probably still running a lean and mean operation,” says Rosenblum. “For now they can leverage their present e-commerce platform and use it to launch a new venture.”

More online retailers are profitable, but the Internet Retailer survey finds many are operating on fairly tight gross margins and keeping a close eye on their expenses. Gross margins can vary widely by merchandising categories, especially online where price-conscious shoppers can conduct a detailed search for merchants offering the best deals. That ability to search makes online retailing highly competitive and forces merchants to price their merchandise carefully to attract customers and generate profitable sales.

Razor thin

Many web retailers are operating in niches and categories where the gross margin is razor thin. For instance, the survey finds that 33.3% of all merchants are operating on a gross margin of 25% or less, including 10.3% by less than 10%. At the same time, 23.6% of respondents operate on margins of 35.1% to 50%, and 13.4% have the luxury of margins above 50%.

Thin margins are the norm in many electronics and mass merchandise categories where online shoppers are using the web to search for the lowest prices on brand name products. Gross margins can be higher in some apparel lines where online retailers often charge higher prices for limited or exclusive supplies of designer fashions. But even if web retailers are profitable, a gross margin of 35% or less is an indicator that the merchant needs to keep an especially close eye on expenses. “With a margin of less than 35%, there is very little room for error in terms of operating or discretionary expenses like marketing,” says Mary Brett Whitfield, senior vice president and analyst with TNS Retail Forward Inc., a Columbus, Ohio, retail consulting and research firm. “After they pay their overhead, they must be prudent in analyzing how they can leverage profits to help finance growth.”

The biggest cost center for web retailers taking part in the research are general and administrative expenses, which include employee salaries and benefits and office overhead. The Internet Retailer survey finds that 19.9% of merchants are spending between 6.1% and 10% of their total e-commerce revenue on general and administrative expenses, compared with 15.1% between 10.1% and 25% and 8.5% more than 25%. A majority of merchants-56.5%-spend less than 6% of web sales on general overhead, which suggests that many small retailers are profitable, but run their operation as a sole proprietorship or with only a handful of employees.

Level spending

For the majority of merchants, their expenses are in line with accepted industry standards, say industry research firms. Many established web retailers typically spend about 10% or less of their total e-commerce revenue on such areas as marketing, technology, fulfillment and research and development. The Internet Retailer survey shows that only 7.5% of companies are spending more than 10% of their total revenue on new technology, while 45.6% are spending from 3.1% to 10% and 46.9% are expensing 3.1% or less.

With fulfillment and distribution, only 13% of web retailers spend more than 10% of total web sales on their picking, packing and shipping operations, compared with 47.2% from 3.1% to 10% and 39.8% less than 3.1%. A total of 20.5% of web retailers report spending less than 1% of Internet sales on fulfillment and distribution, which reflects the fact that many small companies may carry only a limited product assortment or rely on drop shipping to fulfill orders.

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