E-commerce’s pesky little profitability problem

Online-only retailers have attracted huge amounts of investment capital during the past decade. Flash-sales sites such as Gilt and RueLaLa have collectively raised hundreds of millions of dollars. Rather small, but rapidly growing, specialty players like Bonobo’s, Warby Parker, One Kings Lane and Birchbox have all recently raised tens of millions of dollars and now have valuations approaching $1 billion or more. Net-a-porter, perhaps the strongest global fashion e-tailer, was purchased by luxury powerhouse Richemont for more than $500 million in 2010 and is reportedly being shopped for a multi-billion dollar price tag.

And on and on.

The pesky little problem–the seriously nagging and increasingly pressing issue, is that the vast majority of even the most established players don’t make any money and few have any prospect of doing so any time soon.

The bulls say that all trends point to the eventual dominance of e-commerce and that these brands must invest heavily in critical infra-structure, acquiring new customers and building their brands. Today’s heavy losses will yield category dominance and ungodly riches just a few years down the road. While I’m fairly certain that this will be true for a handful of today’s industry darlings, for most it’s likely to end badly.

Aside from consumer preference shifting toward online shopping, e-commerce seems to have important economic advantages, most notably avoidance of capital investment in physical real estate. In addition, by centralizing inventory in a few locations–or having a “buy it only when you sell it” model–the potential to streamline logistics costs and generate very high inventory productivity is significant. Digital-only marketing strategies also create the opportunity to serve customers more cost effectively than traditional sales and marketing tactics.

But here’s where reality starts to set in and why many e-commerce only models are profit-proof at any kind of reasonable scale.

While fixed costs are lower for pure-plays, marginal costs can be very high. Most hyper-growth companies find it initially fairly easy and cost-effective to acquire their “best fit”and most loyal customers. Consumers that are prone to gravitate to a disruptive business model often “get it” quickly and are great at spreading the word. They tend to return fewer items and aren’t as likely to need a deep discount to spur a purchase.

Unfortunately, growing beyond what I call the obsessive core, tends to be much more expensive and difficult. Acquisition costs rise dramatically. Big discounts are needed to drive conversion. Return rates are much higher. Assortments need to expand to create greater interest. Cost and complexity follows. Many of the new customers that contribute to higher sales, never have the potential to be profitable.

In fact, one of the reasons we are seeing many of these high growth brands now aggressively investing in physical stores is that they are finding it too difficult and expensive to acquire and serve new customers purely online.

So while it’s true that fixed costs are favorable in a pure-play model, it’s the dynamics of marginal profitability (and the associated variable costs) that ultimately determine the long-term viability of an e-commerce brand. And this will prove to be the Achilles Heel for many of today’s highly valued players.

It’s easy to extol the wonderful customer service delivered by Zappos, the incredible marketing and design from Bonobos or the overall awesomeness of Amazon. But lest we forget, it’s not that hard to be awesome if you aren’t required to make any money. It’s one thing to love these brands for the experience they deliver (which I do). It’s an entirely different thing to earn a return for the risk you are taking as an investor.

So far, the only winners from the advent and rapid growth of pure-play online shopping have been consumers and a small group of investors and entrepreneurs lucky enough to cash out at the right time.

Certainly Amazon could be profitable tomorrow if they wanted to (well, more accurately, if they could deal with a collapsing multiple). And a few e-commerce only companies ARE building strong brands and appeal to enough target consumers to eventually make real money. For this short list it is, in fact, just a matter of time.

But for the rest, don’t believe the hype. And proceed with caution.

 

 

 

 

 

Luxury Market Research Smackdown

A number of media outlets have picked up on the debate between Pam Danziger of Unity Marketing and Ron Kurtz of the American Affluence Research Center (AARC) concerning the future of the luxury market.  Let me boil it down for you.

In a recent AARC report Kurtz recommends that: “Luxury brands and luxury marketers should be focused on the wealthiest one percent because they are the least likely to be cutting back and are the most knowledgeable about the price points and brands that are true high-end luxury.”

Danziger fired back “This is just plain dumb advice for luxury marketers.” She goes on to suggest that “the top one percent of the market (about 1.2 million households with average incomes of $500,000 and above) simply can’t carry the entire weight of the luxury industry.” Instead, she recommends that the luxury industry cast a much wider net, aggressively going after the so-called HENRY’s (High Earners Not Yet Rich) to energize significant future growth.

So who’s right?  Well, neither one, exactly.

Kurtz is right that the most elite segment has the greatest capacity and willingness to spend on luxury. But for virtually all but the most rarefied luxury brands, it would be an unmitigated disaster to focus only on the top 1%.  As the former head of strategy and marketing at Neiman Marcus, I can assure you that customers outside the top 1% contribute a very significant percentage of sales and profits.   And if you are Saks, Net-a-Porter, Gilt Group, Louis Vuitton or Gucci, I doubt it’s much different. Most luxury brands need the truly rich and the merely affluent.

So Danziger is right that most luxury marketers need to attract a wider demographic. But she goes too far.  First, while there are many more of the HENRY’s–and their aggregate spending is significant–as you move lower in income the number of potential customers goes up, but their spending on luxury drops dramatically.  Trust me on this: I’ve seen actual, recent spending data by percentile, and the difference between a 99% percentile and a 90th percentile customer’s luxury spending is vast.

The second issue is one of positioning.  The more a brand’s target customer group becomes diffused, the harder it is to be relevant, differentiated and compelling across each distinct consumer segment.  As brands aggressively court a wider demographic they risk alienating their historically strong elite core.

Like most things in life, the answer is not black and white.  It is rarely true that brands need to focus on only one segment.  A compelling customer growth strategy can be built on multiple customer groups.  The needs and value of each segment must be well understood and segment specific strategies designed and integrated to create a powerful blend.

But the starting point is a solid understanding of your customer base.  And apparently that starts with sifting through what the facts actually say.

I’m reminded of the lyrics from the Talking Heads song “Cross-eyed and Painless.”

Facts are simple and facts are straight
Facts are lazy and facts are late
Facts all come with points of view
Facts don’t do what I want them to