Sunil Gupta is the Edward W. Carter Professor of Business Administration and Chair of the General Management Program at Harvard Business School. He is also the co-chair of the executive program on Driving Digital and Social Strategy.
In this final guest post, Professor Gupta shares his thoughts on the third key area of the digital economy: Online Retail
2014’s Black Friday sale set a new record at $89 billion. If it were a country, it would rank 64th in the world by GDP, just ahead of Oman. Much of this was fuelled by online and mobile commerce, and the relentless growth of these retail channels has become an accepted fact of the connected world.
As online retail continues its growth, driven significantly by mobile, the challenge of generating sustainable margins and cashflow returns for investors will loom larger.
Amazon – the company that defines the sector – has reported slowing revenue growth rates for four years, and is expected to slow further in 2015. Many of the industry’s largest, most successful companies have invested to build infrastructure and customer bases in the expectation of future profitability; to deliver this, their business models must prove themselves durable in the face of pressure on margins from both retail competitors and brand owners.
Behind the healthy headline growth statistics, a major transition is underway as online retailers, offline retailers, and brands jostle for primacy in rapidly evolving value chains.
Omnichannel distribution that allows brands to engage with their customers on many different levels is in the process of breaking down the simple, vertical divide between producer and retailer around which retail value chains have been built. Retailers must adapt to their new, more complex roles as part of their brands’ multi-channel distribution strategy and deliver demonstrable returns on the margins brands allow them – effectively, brands’ investments in retailers as a distribution channel.
In parallel both retailers and brands must also react to the continuing evolution of ecommerce; as the channel has matured and overall growth has slowed to a relatively sedate 11%, mobile commerce has accelerated, growing at 44% in 2014. Both brands and retailers will therefore continue to invest in their omnichannel capabilities, whilst striving to deliver cash returns from their existing desktop channels.
Growth driven by large scale players; industry concentrating as it matures
Economies of scale weight online retail heavily towards its largest actors. Of $293 bn. spent online in the US in 2014, $44 bn. or a sixth was spent with Amazon (around double the share of UK offline retail [x] Tesco enjoyed in its hayday), and as its growth continues and it explores more innovative and convenient delivery mechanisms (drones, one-hour delivery slots). The power of these scale economics means that the industry may well concentrate further.
Although impressive in absolute terms, the growth of online retail as a whole is slowing. Amazon, a bell-weather for the sector and an out-performer in terms of growth, has recorded declining annual revenue growth for three years, which is expected to slow further throughout 2015.
Mobile ecommerce traffic reached a new high over the 2014 holiday season; 47.6% of the total. As we saw earlier in this series, this growth in mobile will tend to cement the position of the incumbent e-tail giants because of consumers preference for app-based shopping.
Brands & retailers building more complex relationships
The inefficiency inherent in historical retail distribution models built on a single, relatively inflexible margin on each unit sold is clear; the cost to the brand of each sale is the same, whilst the value to the brand of acquiring a new customer is many times greater than that of simply supplying an existing customer.
Omnichannel retail and granular customer data allow brands to measure and understand the value to them of each sale more accurately than was ever possible through traditional retail channels. With this understanding brands are able to manage the cost and effectiveness of their retail distribution by controlling the marketing, promotion, and supply through an array of channels. Reducing distribution costs by migrating existing customers to direct or low-cost distribution, whilst continuing to use the high-cost retail channel for customer acquisition is a strategy followed by many brands.
At the extreme, the massive marketing support payments now being made by leading consumer electronics firms to high street retailers are an acknowledgement that they provide an essential customer-acquisition service – a showroom for brands’ high-value, high-involvement products – whilst a large proportion of the sales they generate will ultimately be fulfilled by competing online retailers.
In parallel, some brands have chosen to develop directly operated retail networks in order to both secure this high-street presence, and develop direct relationships with their customers. Direct models such as this, both physical and online, inevitably create some tension between brands and their retailers. Whilst in the short term these conflicting interests are addressed to a degree through coordination of pricing and promotion, if brands continue to expand their estates these conflicts will inexorably grow.
Online retailers fighting margin compression
The inexorable pressure on margins, particularly in categories such as electronics poses a challenge even to the largest, most efficient online retailers. As it becomes increasingly apparent that the industry is maturing, promises of future profitability will no longer satisfy investors; online retailers will have to start delivering meaningful net margins.
In search of a durable competitive advantage to support sustainable margins, online retailers of all scales are implementing strategies seen in other areas of technology.
Some have sought inspiration from Netflix and Hulu by becoming brand-owners. This strategy seeks not to generate a sustainable ‘retail’ margin, but to incorporate the brand’s margin into the retailer’s. It has thus far been applied largely to commodity products with little brand equity; categories that can be entered at low cost.
To successfully develop private labels in higher-margin categories would require significant product expertise and investment in marketing. Whether or not retailers will succeed in this, I predict that we will see further private label or ‘captive brand’ launches over the next 18m.
Become the platform to capture the value
The largest online retailers have the opportunity to ‘be the platform’, which has an inherent value to consumers that will support a margin premium. Amazon’s marketplace model and outsourced fulfilment business are both revenue streams in their own right, and protect the economics of its core business by reducing the incentive for consumers to shop around.
The outperformance of mobile as a channel combined with the prevalence of app-based mobile commerce and the practical limit on each user’s portfolio of frequently-used apps will reinforce this trend by concentrating usage, and value in a small number of platform retailers. Leading platforms, such as Amazon and eBay, have recognised this by investing heavily in their mobile apps in order to secure valuable ‘real estate’ on their users’ mobile devices.
For retailers who do not enjoy either the category authority to launch private labels or the scale to make margin simply as platform aggregators, the traditional route to retail success – adding value through differentiated product expertise and customer service – is the strategy that has proven durable.
Single-category retailers in vertical markets that require either specialist product knowledge or more complicated logistics continue to succeed. Operators who find themselves caught between these models will need to rapidly refocus their businesses to be successful; I would expect that, over the next couple of years, a number of large retailers will quietly slim down as they focus on the verticals in which they can achieve sustainable margins.
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