Pure Plays Face Trouble in E-Commerce Shakeout

E-tailers who sell to their customers across multiple channels — through stores, catalogs, and online — significantly increase their chances of generating impressive returns and emerging victorious amid the growing e-tail shakeout, according to a study by McKinsey & Company and Salomon Smith Barney.

In their race to gain market share of customers, most major online retailers lose money every time they sell anything, according to the McKinsey/Salomon Smith Barney E-tail Economic Study. However, online retailers can profit on every sale if they drive up their average order size, hold the line on discounting and sell higher-margin products, the study found.

“The notion of a ‘pure-play’ is turning out be the wrong play,” said Joanna Barsh, a director at McKinsey & Co. and a leader of the firm’s e-tail practice. “To be successful, online retailers need to exploit other marketing channels simultaneously, such as in-store and catalog sales, as well as private labels. A number of apparel e-tailers are already doing this successfully. Our study shows that multi-channel players can increase their share of wallet, as many consumers are already browsing on the Web before buying in the store.”

The study found that first-quarter sales for orders taken by online retailers were below the cost of acquiring and distributing goods sold to customers. Resulting per-order losses before marketing, overhead, and Web site development costs ranged from $2 to as much as $12.

The study also pointed to the difficulties online retailers face in reaching a break-even point while selling low-margin products over the Internet. For instance, even if an online pure play retailer could generate an $11 per order contribution to gross income (which is extremely ambitious given high fulfillment costs) it would need more than $1.0 billion in revenues (approximately 5 percent of the total toy market) to support the $120 million to $140 million it would have in fixed warehouse, Web site, marketing, and overhead costs.

Despite these findings, most online retailers and catalog merchants can generate significant profits. The frequency and size of each order are much more important contributors to an online retailer’s profitability than large customer counts, the study found.

For example, while the average online grocery order generates only $9 in gross income, the typical online customer will buy groceries on the Web up to 30 times a year. Thus, order frequency drives the net present value of an online grocery customer to $909 over a four-year time period, according to the study.

The McKinsey/Salomon Smith Barney E-tail Economic Study analyzed five industries, focusing on specific sectors within those industries. Following groceries, online retail categories showing the highest customer net present vales were: prescription drugs ($434 over a seven-year period), specialty apparel ($384), department store apparel ($283), direct mail apparel ($190), pure-play books ($50, off-price apparel ($39), pure-play toys ($9), and pure-play apparel ($9).

“Shrewd e-tailers need to drive up their average order size to at least $50, hold the line on discounting and move to products with margins over 35 percent,” said Blair Crawford, a principal at McKinsey & Co. “Together with maintaining high ticket sizes and decent gross margins, driving order frequency is the way to bypass today’s costly market-share wars.”

Research by Bain & Company and Mainspring found that few segments of online customers are profitable. For example, that research found that only 24 percent of consumers, those buying based on brand or convenience, generated all the profits; in online groceries, the same two segments (known as “Brand Buyers” and “Convenience Shoppers”) accounted for only 31 percent of customers but 65 percent of profits. Other segments identified by the survey (“Casual Buyers,” “Relationship Seekers,” and “Bargain Hunters” are considerably less profitable or money losing. The study found that customer segmentation is critical to a retailer’s economics, and companies can target profitable segments, for dramatic gains, both in their choice of advertising channel and business model.

“Many online retailers are focused on trying to swell their revenues by attracting any and all possible traffic to their sites,” said Darrell Rigby, a director at Bain & Co. “Instead, online retailers should take a more focused approach because all customers are not created equal. It’s more important to have a loyal group of the right customers than to have lots of the wrong ones.”

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