How E-Tailing Can Rise from the Ashes

Pure-play Internet retailers haven't made a profit and probably never will. The winners on-line will be experienced retailers that can execute a multichannel strategy. Retailing on the World Wide Web has alerted the general public to the Internet's potential for transforming business and everyday life. Yet so far, the financial performance of most Web-based retailers has been dismal. Their experience provides an object lesson for the new economy: businesses have to make money. As the Web continues to transform retailing, can retailers hope to generate profits on-line? The evidence is sobering. Our recent research into the underlying economics and competitive dynamics of Web retailing shows that it will be structurally impossible for most pure Web retailers --unless they hit Amazon.com-like scale--ever to turn a profit, let alone to take a dominant position. The clear advantage in retailing goes to big, highly skilled traditional retailers that use the Web to extend their already potent physical presence. So though pure plays may indeed be doomed, the demise of e-tailing has been greatly exaggerated for multichannel players. The problem Most e-tailers lose money on every transaction. Even the flagship e-tailer, Amazon, is losing about $7 an order on its nonbook sales after taking into account product, shipping, and fulfillment costs. (Its book sales generate about $5 an order.) Fogdog Sports, a sporting-goods outlet, loses $5 an order. For others, the losses are even starker: Drugstore.com loses about $10 to $15 an order (Exhibit 1). Three weaknesses lie at the core of this problem: 1. Many product categories, such as toys, start off with a big disadvantage-- they are difficult to pick, pack, and ship; they attract only small orders; or both. 2. Plain inexperience and lack of scale are inflating fulfillment costs to as much as $12 to $16 an order for many pure plays. 3. Inexperienced merchandising and sourcing organizations, intense price competition, and problems with inventory management and product returns give pure plays particularly poor gross margins. Established retailers in categories like apparel and drugs enjoy an advantage of 2,000 to 3,000 basis points in gross margins. They are thus in a much stronger position to make profits and prosper. To post comfortable contributions on each transaction, e-tailers would need efficient order fulfillment, average order sizes of at least $100, and gross margins of at least 25 percent (Exhibit 2). Since money generally vanishes with each order, it follows that almost all e-tailers are losing money on every customer, for those customers generate too few orders or too little profit per order to cover the cost of winning them. Soaring acquisition costs of $50 to $100 a customer, generated by the difficulty of building virtual brands without stores or catalogs, put pure plays in a deep hole. In addition, many of them have relied on scattershot marketing campaigns using high-profile ads that generate buzz among investors but don't bring customer accounts to the servers. This combination of low repeat buys, high acquisition costs, and small orders explains why pure plays are destroying value with every customer. Retailers with established brands and marketing engines are relatively insulated from such problems, for these retailers can leverage their traditional marketing mix to acquire on-line customers more cheaply. In highly brand-sensitive categories like apparel, multichannel retailers can spend as little as one-third or even one-fourth of what their pure-play rivals pay for that purpose. Fixed costs come unfixed The lower costs per order and per customer of multichannel retailers help them break even. But contrary to the early business plans of many players, e-tailing doesn't amount to a free new channel where established retailers can test new product categories, reach new customers, and increase revenue. …