Study: Pure Plays Lose Money on Each Sale

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In their quest to acquire customers, most major Internet-only retailers lose money each time they make a sale, according to a new study by McKinsey & Co. and Salomon Smith Barney.


The study found that first-quarter 2000 sales for orders accepted by Internet-only retailers were below the cost of acquiring and distributing products sold to customers. Per-order losses -- before overhead, marketing and Web site development costs -- ranged from $2 to $12.


Even reaching a break-even point while selling low-margin products online is difficult for retailers, according to the McKinsey/Salomon Smith Barney E-Tail Economic Study released last week.


To wit: Even if a pure-play Internet toy retailer generates an $11 per-order contribution to gross income -- an ambitious target, according to McKinsey -- it needs more than $1 billion in annual revenue, or about 5 percent of the overall toy market, to support $120 million to $140 million in fixed warehouse, Web site, overhead and marketing costs.


"It's very hard if you're a pure play to say, 'Let's improve our gross margin,'" said Joanna Barsh, a director at McKinsey and part of the firm's online retail practice. "That has to do with merchandising and your purchasing clout and scale, which most pure plays tend to have very little of."


The study looked at two to three Internet companies in each of five categories: books, groceries, apparel, pharmacy and toys. After developing a study model, both consulting firms interviewed 100 people, including their own employees.


"We looked at specific players and literally created a simple model on a per-order basis of product revenue, plus shipping revenue, minus cost of product, minus cost of shipping, minus our estimation of fulfillment, to get what we were calling a contribution per order," Barsh said.


"When we had done that, with very few exceptions, almost everybody was losing money on a per-order basis," she said.


Barsh cited several reasons for this cash burn. There was heavy discounting during last year's holiday season with evidence of negative gross margins. Fulfillment costs per order also were very high because the players were not equipped for efficient fulfillment.


"They just really were learning, and, as we like saying here, they were short of trying to paint the airplane in flight," Barsh said.


To keep a lid on costs, she said, Internet-only retailers should look at the transaction size and how price points can be changed and discounting slowed; gross margins, which are closely linked to buying scale -- a strength of multichannel retailers; and fulfillment cost per order, linked to discounting.


Thus, pure plays can profit on each sale if they increase their average order size, curb discounting and sell high-margin products. McKinsey suggested that online retailers ramp up their average order size to at least $50 and sell products with margins that exceed 35 percent.


In fact, the frequency and size of each order are more critical to the Internet-only retailer's profitability than large customer accounts, the study showed.


Take groceries, for instance. While the average online grocery order generates only $9 in gross income, the typical Internet customer will buy groceries on the Web up to 30 times a year. The study's data showed that this order frequency boosts the net present value of an online grocery customer to $909 in a four-year time frame.


After groceries, online retail categories that showed the highest customer net present values over seven years were prescription drugs, at $434; specialty apparel, $384; department store apparel, $283; direct mail apparel, $190; pure-play books, $50; off-price apparel, $39; and pure-play toys and pure-play apparel at $9 each.


The lifetime value of a customer is a key factor for online retailers to bear in mind, Barsh said.


"We're fairly conservative to begin with, but we say, on average, only four years [for the customer's lifetime value to the online store]," Barsh said. "Our retail experience is that it's hard to hang on to people for a long time and particularly online, where it's so easy for that customer to find a better deal.


"Plus, you get the effect of a lot of people that are still trialing the Internet," she added. "They're doing this more for their own learning and being part of the revolution, and you can get a huge number of customers coming in for a one-time offer."


On the whole, the study concluded, retailers that sell across multiple channels, such as bricks-and-mortar stores, catalogs, private-label house brands and the Internet, are the ones that stand to gain sizable returns and victory in the online retail shakeout.


"[Internet-only retailers'] best bet is to go out and find the strategic investors who can bring scale in purchasing, merchandising know-how and promotional strength to help build their brand name," Barsh said.
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