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Why growth online shopping may end

Many people might assume that online stores make a lot of money, without all the expensive bricks and mortars

But the reality is somewhat different. Many e-commerce activities are, in fact, not profitable; if people have to pay the true cost of what they buy online, they might buy less. In fact, we think there is an approaching turning point, when consumers have to pay more for online purchases or end up with fewer products and services to choose from.

Let’s start with Amazon’s online retail leviathan, which recorded record profits and revenues in 2018. This is good news for Amazon shareholders, but more in-depth supervision reveals a different picture. To begin with, most of the profits are not from retail activities. Amazon Web Services, a cloud hosting business that is not related to e-commerce, generates more operating income than all North American retail operations – and with margins more than five times higher.

Even then, this is a far better performance than the retail division than in 2017, when North American operating income was fully offset by the loss of international retail. That year, Amazon’s positive operating income was fully thanks to the cloud hosting business.

Push profit

Amazon’s retail increase in 2018 comes behind a boost in profitability, much of which involves increasing consumer e-commerce costs. For example, Amazon increases the annual membership fee from Prime prime customer service by 20% to US $ 119 (£ 94) in the US, along with comparable increases in other countries.

According to one estimate, this US increase accounted for almost a third of the Amazon North American operating margin in 2018. But not all of this extra profitability looks sustainable: Amazon now sees shrinking growth in Prime membership in North America and declines in some countries as customers at the margin decide to go.

Amazon has also targeted its CRaP products, which means “cannot generate profits”. The product line ends in this category due to small margins or logistical challenges such as weight or size. Bottled water, soft drinks and snacks are examples.

Amazon has been pressing the manufacturers of these products to reduce sales costs. It is impossible that this will work as a whole, because in many cases there is little room for improvement. This will force Amazon to choose between setting higher prices for these products or eliminating them, which will result in higher prices for consumers or narrower choices on the site.
Not all Amazon initiatives sacrifice consumers, it must be said. The company recently reported a 4% reduction in the cost of fulfilling orders, mainly because it had built fewer new warehouses and increased throughput in existing locations instead.

This is a welcome development for companies, because the cost of fulfilling orders and shipments increases as a percentage of sales every year between 2010 and 2017.

In its warehouse network, Amazon handles its own branded goods and many of the other vendors sell through the platform. These vendors have the choice between paying Amazon premiums to fully handle their distribution and prices, giving them full access to the Prime customer base; or have looser relationships that can involve Amazon payments or independent logistics companies to use warehouse networks.

Amazon has succeeded in growing these types of loose relationships – they now make up more than half of total retail sales. Developing a third-party logistics flow is creating a new revenue stream and reducing working capital, because it means that the Amazon bears less of the cost of fulfilling overall sales. This resembles the business model of China’s Alibaba e-commerce giant. However, savings on working capital do not represent inherent efficiency, because the dismantling of some distribution costs is likely to be passed on to consumers in the end because of higher prices than costs incurred elsewhere.

Competitor

Walmart’s main rivals have their own techniques to try to make online sales more profitable. The new approach to CRaP products is to hide it from view in Walmart’s consumer search results, showing run out of stock in addition to a more profitable alternative for the company.

Interestingly, Walmart also drives free next day shipments from its stores in the US without customers having to become members of services that are equivalent to Perdana. The wrinkle is that this offer is limited to high volume products and higher margins. In both of these examples, Walmart therefore cuts consumers’ choices in their search to get more profits online.

Walmart is also one of the many big retailers that offer food delivery on the same day, but this doesn’t seem to be all.

An experienced grocery store manager has told us that an online grocery store is needed as a leader who loses marketing but is “impossible” to make money. Such delivery offers are only possible, he said, because online stores are only 2% of the total market, because most consumers do not buy these products online. A recent study agrees with this idea, finding that online wholesale orders have a negative margin of around 15%. This reminds us of old business jokes about losing money on every sale but making it in volume.

To understand the mindset of retailers such as Walmart and other small competitors who are not purely online, supply chain consultants told us last year that they put priority on the speed of change before profitability, amid pressure to stay competitive with people like Amazon. “This is a logic of despair as much as it is a strategy,” he said.

We can see the consequences in an interesting survey that found that in 2017, 61% of supply chain executives reported an increase in product lines due to e-commerce, up from 55% in 2013. When asked about the impact on distribution, 26% said they implemented smaller warehouses and more localized, up from 20% in 2013. These changes unavoidably lead to higher costs, which will again be continued, at least in part, to consumers.

Viewed as a whole, the turning point in online shopping that we mentioned earlier can be even closer. We may have reached peak comfort and low prices, and now may enter the world of more targeted offers, with less geographical coverage, variations in order turnover and maybe even higher prices – all of which will slow down the growth curve. At least for high-street retailers who have lived in freefall that seems endless, this might be the best news in a very long time.

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