Why is pureplay online retail so rarely profitable?

I knew that this was doomed from the get-go. You thought that it was special, special.

Circles, Post Malone

Recently I shared a post on social media that essentially was asking this perennial question: why is pureplay online retail often a very marginal business proposition? Why, in reality, does online mostly only work as an omnichannel play? Which just goes to show that a physical environment is crucial to the profitability of omnichannel retail.

As we know, Amazon took 14 years to make a quarterly profit (in the meantime, it was effectively carried by its web engine services business.) The Iconic, a local business I admire, reported $370.5 million in revenue in 2018, a 38.3% increase from the previous year, while still recording a loss (though a narrower one) of $18.3 million.

Its sales growth has been impressive over the last eight years; its profitability less so.

For the larger players in online retail, it is a relatively slow burn to scale. These examples show it is not necessarily a panacea for the first 10 years and often longer.

Scale and capital are the enablers for these models.

For the smaller online-only retailers, conversely, it’s a very tough struggle. Cash flow may exist, however, as we know, profitability is another matter.

Which brings me back to my initial question, why is pureplay online retail generally unprofitable?

On average, over 30% of all product purchased online is returned to the retailer. For fashion retail, I believe it’s even higher. (For reference, physical stores have an average return rate of 8% to 9%.)

At the same time, a large number of online retailers offer free freight – even for returns.

According to Meero research, return deliveries in the US will cost US$550 billion by 2020. In Australia, that figure could be as high as $10 billion, factoring in the costs of packaging, resorting, storing, etc.

Online retail is a scale game with high pressure on low returns, distribution economics and margin growth. And when you add in the costs around staffing, equipment and premises (The Iconic now employs over 1000 people), you begin to see the challenge of running a profitable pureplay online retail business.

Here’s a hypothetical example:

This all adds up to $10,730 in additional costs, which is around 33 per cent of sales.

Now, this is a hypothetical example, assuming 100% sell-through and presuming familiar ratio of returns, etc. (we can debate the cyclical nature of returns). However, it is apparent that returns and the cost of servicing them is a significant factor in online profit.

We should expect advanced technologies like artificial intelligence, machine learning, adaptive technology and AR to make a difference in this critical area and contribute to the accuracy of purchase ratios and conversion rates, but it will take time.

Fashion and general merchandise conversion rates currently average around 2% to 4% online. A much fuller rate of sales at a fuller operating margin is only really achieved by a higher margin and a much lower return ratio than is currently the case in online retail.

Physical shops, which give consumers the opportunity to use all their senses to make a purchase decision, and deliver an experience beyond range and convenience, are fundamental to the profitability of most online retailers.

Expecting profitability in any other way is indeed circular thinking.

First Published in Inside Retail on 12 December 2019.

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– Brian and the team at Retail Doctor Group