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Is Pure Play the Wrong Play? Yes, Says New E-tail Study

By Beth Cox - July, 2000
A number of big e-commerce sites have fallen by the wayside recently, and no doubt that's of concern to you if you're running a small- to medium-sized site. Perhaps you've noticed that the revenue stream is no longer growing much, or the average profit per sale is on the decline. Could it be time to consider adding some other sales channels? The answer is more than likely "yes," at least according to one new study. E-tailers that sell across multiple channels -- through stores, catalogs and online -- will significantly increase their chances of emerging victorious amid the growing e-tail shakeout, says the new industry report.

The E-tail Economic Study by McKinsey & Company and Salomon Smith Barney found that in the race to gain market share, most major online retailers lose money every time they sell anything. 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 says.

"The notion of a 'pure play' is turning out to be the wrong play," said Joanna Barsh, a director at McKinsey & Company who works in 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," she said. "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 often 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 pointed to difficulties that 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 toy 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.

Those are some sobering numbers and the reality is that we can expect to see more fallout in e-tail before the market approaches equilibrium.

Despite these findings, most online retailers and catalog merchants can generate significant profits, however, the study says. 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 instance, 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 study data.

The study analyzed five industries, focusing on specific sectors within those industries. Following groceries, online retail categories showing the highest customer net present values 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. "Together with maintaining high ticket sizes and decent gross margins, driving order frequency is the way to bypasstoday's costly market-share wars."

"The e-tail shakeout now under way doesn't mean the industry is economically unsound," Barsh added. "Winners will be those who focus on making their current transactions profitable while stopping the suicidal race to acquire unprofitable customers at any cost."

McKinsey & Co. is an international management-consulting firm; Salomon Smith Barney is the well-known investment banking and securities brokerage firm.

To read more articles relating to e-commerce, click here: The E-Commerce Guide

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