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.






Don’t confuse members with customers

Thanks to the so-called flash-sales sites we now have a distorted definition of what being a member means. Before Gilt, RueLaLa and the myriad “private” e-commerce business wanna-bees, gaining membership in something typically meant you needed to actually do something more than have an email address and a pulse.

By now it should be clear to everyone that membership to these sites is simply a marketing gimmick. And an effective one at that.

But beyond semantics, the key issue is really how many of these members are actually customers? And of the actual customers, how many have bought more than once in the last year and how many are actually profitable (or have the potential to be)? You don’t have to tumble too many numbers to realize how shallow the customer base for most of these sites must be.

With competition heating up, and overall core sector growth flattening, it won’t be long before some investors become quite unhappy indeed.

Competing with yourself

One of the biggest mistakes companies make strategically is failing to compete with themselves.

The only reason Sears is no longer the leader in the retail home improvement industry–and now on a slow slide into oblivion–was their unwillingness to build or buy an off-the-mall response to Home Depot when they had the chance. Having personally participated in 2 separate strategic studies in the early and mid 1990’s, I can tell you that the big hang up in making the plunge was leadership’s fear of sales diversion from the “core” mall-based department stores.


So it was refreshing yesterday to see Nordstrom’s acquisition of HauteLook, one of the leading flash-sales sites.

The luxury/fashion off-price market has exploded in the past 3 years with upstarts like HauteLook, GiltGroupe, RueLaLa, et al creating a $1 billion+ (and growing) sub-segment through daily online sales. And it’s clear that a lot of that business has come at the expense of traditional players like Nordstrom, Neiman Marcus and Saks.

It remains to be seen whether the price Nordstrom paid was sensible. And time will tell how well they will be able to leverage their capabilities and customer database to accelerate HauteLook’s growth and profitability. But one thing is clear. The other industry incumbents have been slow to react–or have responded with utterly unremarkable tactics–and have let many start-up companies steal market share and attract new customers in a space they could have easily dominated.

Retailers are pretty good at firing people when they don’t make their seasonal sales plan or manage their budgets well. When they let hundreds of millions of dollars of potential shareholder value slip through their hands by failing to act on business that is rightfully theirs, you rarely hear a peep.

That needs to change.

And you need to be willing to compete with yourself. Last time I checked you don’t any credit for your competition’s sales.


The Private Flash Sales Sites Jump the Shark

On April 19 I posted about my belief that the luxury off-price market was about to hit the wall, largely owing to a squeeze between a growing customer base seeking out great deals, and a diminishing supply of first quality branded merchandise.   I suggested that the various players in the space were going to have to evolve their winning formulas substantially to sustain their growth.

Well this seems to be playing out with the various high-end flash-sales sites (Gilt Groupe, RueLaLa, HauteLook, Ideeli and BeyondTheRack and the myriad wanna-bees).   In fact, what made these new concepts so great–and allowed them to gobble up market share–is rapidly being watered down.  Whether you call this “jumping the shark” or “nuking the fridge”, it’s a cause for concern.

All these companies have grown rapidly, attracting both legions of members and significant investment capital.  Their original value proposition was simple: offer well-known, high end brands at unbelievably low prices, and make them available in limited quantities during a short sale period.   This was an innovative re-imagining and up-scaling of QVC–or a blatant ripoff of Europe’s Vente Privee–depending on where you sit on the cynicism scale.  Regardless, during late 2008 and well into 2009, customers signed up in droves and feasted on high demand fashion brands at steep discounts.  Of course the rocket fuel during this time was the substantial amount of surplus inventory that both manufacturers and retailers were desperate to turn into cash.

A review of the flash-sale sites’ offerings today reveals quite a different story than even six months ago.

The first obvious thing is the paucity of true high demand luxury brands.  Tomorrow’s sale on RueLaLa features one true luxury brand (Pratesi), but also Andrew Marc, L. Spaace, Tailor Vintage and Cuddlestone.   BeyondTheRack has some Gucci, Prada and Robert Cavalli–though it’s sunglasses and wallets–not ready-to-wear or handbags.  The rest of their offering is Jonathan Marche, Ninety, SpyZone Exchange, CC Skye and Italgen.   Not exactly household names.  A check of Ideeli and Hautelook reveals the same smattering of brands you have heard of, while the rest is decidedly second tier or no-name.  Gilt Groupe, on the other hand, does seem to consistently have a much broader offering of true high end and fashion brands.

The second item of note is that the discounting is not nearly as extreme as last year.  And this is not surprising.  Last year, when manufacturers were stuck with mountains of unsold inventory, they were often willing to sell first quality product below their production cost.  Today, more and more product is not distressed, but rather made specifically to be sold in these channels; and that means the manufacturer needs a mark-up.  If your product acquisition cost goes up, the retail price goes up (i.e. the lower % discount to the consumer).

The other noteworthy change is the growing mix of product that is not fashion merchandise.  All these sites are starting to feature travel, wine and even bicycles.  On the one hand, this is a smart growth strategy: find more things to offer to your existing clientele.  For others, it smacks of desperation.

All this adds up to a model that, despite being barely two years old, is rapidly evolving and will likely look quite different by this time next year.  My guess is that by then several of these sites will be gone, bought out or struggling mightily, while a short list will leverage deep customer insight and new capabilities reinvent themselves and thrive.  Given that the big guys–Neiman Marcus, Saks and Nordstrom–have yet to do anything meaningful in this arena (and really why is it taking them so long?) we can only expect the competitive environment to become even more intense.

Any guesses on who will be standing tall versus who will become chum?
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