June 3, 2013, 2:56 PM

8 ways to boost profits

Eric Roth, managing director at Lazard Middle Market, explains how retailers can boost their bottom lines.

Over the last 24 months of continued macro-economic uncertainty, investors in online retail have shifted their attention from companies focused on rapid revenue growth at the expense of profit to those generating profitable growth. As a result, it is critical that online retailers interested in attracting investors focus on generating healthy profit margins.

Recent deal experience and in-depth conversations with hundreds of online retailers and service providers suggest eight ways online retailers can increase and sustain profitability. These suggestions fall into three categories: improving gross margin, optimizing marketing spend and diversifying sources of traffic, and sculpting a leaner fulfillment operation.

Improving gross margin

There are two challenges with selling the same brands as your competitors: One, popular brands can dictate pricing, resulting in relatively low product margins, and two, consumers can price shop across retailers, which requires merchants to be very sharp on price points.

By contrast, private-label or exclusive products create a significant moat against price shopping and typically generate more than 1,000 incremental basis points of product margin, that is, the profit on the product itself without considering other revenue such as shipping fees. A retailer selling exclusive items may be able to boost associated product margin to 45% from 35%—when compared to similar third-party products.

Develop exclusive products. Developing proprietary brands, or working with brands to acquire exclusive products requires design capabilities and additional inventory, which can be challenging to justify for a primarily self-financed business. But such products enable a retailer to become a destination for products not available anywhere else. Even if only 5% to 10% of a retailer's offering consists of exclusive products it can materially enhance the retailer's profit profile, while building brand equity with consumers. Examples of online retailers with strong proprietary product offerings include those who offer only proprietary products (such as Warby Parker and Bonobos) and those whose proprietary offerings comprises a material portion of revenue (eBags Inc. and DermStore LLC).

Price products strategically. Retailers that typically sell several items per order have a significant, often untapped, opportunity to improve their profit margins through strategic pricing. Consumers rarely price shop more than one or two products in a given basket with those products often creating a halo effect that shapes consumer perceptions of a retailer's overall price competitiveness. For example, if a consumer finds the handbag she's been shopping for at a good price on a retailer's site, she's likely to assume that it also offers a good deal on a matching scarf and gloves. Pricing on the scarf and gloves offers an opportunity to enhance margin. Additionally, the ability to continuously test pricing to discern where incremental margin dollars may exist is a significant advantage for web-only retailers as compared to bricks-and-mortar-based retailers that can't as easily or quickly test prices. Recently, large retail chains have acquired service companies focused on pricing (for example, The Home Depot Inc. acquiring BlackLocus Inc.), underscoring the growing importance of strategic pricing.

Leverage Minimum Advertised Pricing (MAP). In product categories where a limited number of suppliers possess significant consumer mind and wallet share those suppliers often enforce MAP policies designed to prevent discounting. MAP programs, however, frequently are either inconsistently enforced or attempt to maintain pricing that is so high relative to the direct or wholesale cost of the product that the incentives to circumvent MAP are too powerful to overcome, even with strict enforcement. Nonetheless, when consistently enforced, MAP levels the playing field and enables online retailers that offer a superior shopping experience to make a more profitable sale compared to non-MAP, often discounted, products. Examples of online retailers selling in categories dominated by a handful of brands include Power Equipment Direct Inc. and CPO Commerce Inc.

Marketing Optimization

Cater to enthusiasts. Enthusiast customers readily consume, even demand, rich, engaging content and social community experiences. Retailers that cater to such enthusiasts can build a loyal and profitable following. Enthusiasts are brand ambassadors who pay full price and typically purchase more frequently, enhancing profit margins. Additionally, catering to an enthusiast customer base through content and community yields more balanced sources of traffic (e.g., increased traffic from natural search results), and less dependence on paid search. Examples of content-focused online retailers include Bodybuilding.com, part of Liberty Interactive Corp., and Ancestry.com Inc.

Social media marketing. The steady increases in pay-per-click costs have many online retailers seeking alternative marketing channels to paid search. While many online retailers struggle to crack the code of social marketing, several have utilized social channels, like Facebook, to rapidly acquire a significant base of enthusiast customers who purchase repeatedly and refer friends who also become good customers. Examples of online retailers with successful social strategies include Fab.com and Country Outfitter.

Sell high-consideration items. Consumers typically do more research when buying more expensive items, which often are technical in nature. Retailers that provide deep, engaging content help facilitate and validate consumers' decisions, which generate more sales. Rich content also generates better placement in natural search results, meaning less reliance on paid search. As a result, these high-consideration items typically generate elevated gross profit dollars. Examples of retailers who sell higher price point, considered items include Abt Electronics Inc. and OpticsPlanet Inc.

Leaner Fulfillment Operations

Encourage cluster buying. Merchandising strategies that encourage buying more than one item per order ("cluster buying") are less expensive to fulfill per item because the retailer can put multiple items in one package. Women's apparel retailers are particularly adept at encouraging shoppers to add complementary items to their order. These companies also can utilize strategic pricing, described above, to sell complementary products at higher prices. Examples of retailers who effectively employ cluster buying merchandising strategies include Vera Bradley Retail Stores LLC and Sundance Catalog Co.

Develop "hero" SKUs. Effectively merchandising high-volume items means selling more units of fewer SKUs, which requires less overall inventory and fewer warehouse employees. At the high end, some retailers generate 80% of their revenue from 20% of their products. These retailers turn inventory more quickly and generate more revenue per employee, which translates into the kind of favorable dynamics of working capital (that is, inventory plus receivables less payables) that appeal to investors. Examples of retailers who leverage "hero" SKUs include BikeBandit.com and Living Direct Inc.

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