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Stock Strategist Industry Reports

Where Are All the Profits in Online Retail?

In the online market share battle, customers benefit, but retailers lose profits.

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During the last 15 years, the demographics of online shoppers has shifted from the early adopters to nearly all Internet users. Along the way, there have been numerous failures (such as Webvan and Pets.com) for every success story (such as  Amazon.com (AMZN)). Despite these failures, the growth in online retail is undeniable, as 4.2% of all retail sales were transacted online in 2008, up from just 1.3% in 2000. Although the industry should continue to benefit from secular trends, we think industry dynamics and a slowdown in consumer spending will keep profitability low at the firmwide level. Therefore, we would only invest in the strongest companies at attractive valuations.

There are several reasons for the strong growth in online retail, including consumers becoming more comfortable making online purchases, the convenience of home delivery, and the ability to easily compare products from multiple retailers. In addition, advances in technology have improved the experience via quicker-loading Web sites, better search functionality, and better images and videos for product descriptions. According to the U.S. Census Bureau, online retail sales have increased at an average annual rate of 22% since 2000, compared with just 5% for total retail sales.

Although not all players have participated equally in this growth, most online retailers have benefited directly from these secular tail winds. The bubble in consumer spending during the last several years has also contributed to industry growth. Now that this bubble has burst, we expect consumer spending to be challenged for some time. Therefore, we think consumers will be more selective, choosing online retailers that provide value, convenience, vast selection, and a compelling user experience.

We think this reality favors the larger players who can afford to keep investing in their business. For example, Amazon can outspend its smaller rivals on technology (leading to a better user experience), inventory (better selection), and marketing (more traffic). In addition, Amazon's scale allows the company to sell its products at a low price and still earn an adequate profit margin. Although some strong niche sites will continue to thrive, we think the largest players will become more dominant. We've already seen this trend start to play out. According to Internet Retailer, the top 500 online retailers accounted for 65% of total online retail sales in 2008, up from 61% in 2007 and 2006.

Despite the industry's solid revenue growth in recent years, profitability has been weak. Even Amazon, the most successful online retailer (we exclude  eBay (EBAY) because of its unique business model discussed below), continues to post thin operating margins (4.4% in 2008 and 2007) despite its scale advantages. The only other publicly traded online retailers in Internet Retailer's top 50 that sell a wide variety of products
( Overstock.com (OSTK) and  Drugstore.com (DSCM)) continue to lose money. The low profitability of these large companies leads us to believe that most of the smaller, privately held players are also struggling to turn a profit.

We expect profitability to remain weak for most online retailers. Although we think it requires a considerable amount of capital to succeed in this industry, the barriers to entry remain low. In addition, traditional bricks-and-mortar retailers continue to invest more in their online offerings. Therefore, we think the large Web-only retailers will have to keep spending generously on technology, marketing, and customer service while keeping prices low to fend off rivals, resulting in meager profits, if any, for most online retailers.

Below, we discuss four of the online retailers that we cover. As we've outlined above, profits remain elusive for the smaller companies.

Amazon.com
Amazon's initial foray into selling commoditylike media products (such as books, movies, and CDs) forced the company to provide a superior customer experience by focusing on low prices, generous shipping terms, and great customer service. Because of this strategy, Amazon's brand has come to represent low prices and quality service, a rare combination among retailers. This strategy has also resulted in thin operating margins, but returns on capital remain high because of the asset-light nature of online retail. Although we think Amazon will remain a dominant online retailer, the evolution of media, potential for margin expansion, and uncertain prospects for Amazon's new offerings create a wide range of possible outcomes for the company's future cash flow.

eBay
EBay is unique among online retailers in that the company doesn't actually buy and stock inventory, but rather it simply provides a platform that allows buyers and sellers to meet. This business model results in robust operating margins and high returns on capital. However, this strategy also means that eBay cannot directly control many aspects of the consumer experience, including pricing, selection, and shipping. To counter this head wind, eBay has revamped its platform and provided an incentive to sellers to provide buyers with a better experience. Although we don't think eBay will ever fully shed its flea market image, we think the firm's financial resources give it a good opportunity to transform the site into a more attractive e-commerce platform.

Overstock.com
We believe Overstock's use of the Internet is an effective way to bring together buyers and sellers of closeout merchandise. Overall, we think Overstock has done a respectable job of providing a good customer experience: low prices, good selection, solid customer support, and a user-friendly Web site. However, because the company sells mainly closeout, discounted merchandise, the company's gross profits are too low to cover its operating expenditures; Overstock has lost money every year since its inception. Because of management's unproven record, we don't trust that the current leadership will turn Overstock into a profitable company.

Drugstore.com
In addition to selling prescription drugs (10% of sales) and contact lenses (15% of sales), Drugstore.com sells everything a consumer would find in a traditional bricks-and-mortar drugstore including personal-care products, packaged food, and nonprescription medication. This over-the-counter segment (the company's largest, representing about three fourths of sales in 2008) directly competes with larger online retailers, such as Amazon.com and eBay, that offer a larger selection of products. In addition, Drugstore.com's goal of providing convenience to its customers is mitigated by the fact that the majority of products sold by the company can also be found at any local drugstore. Lastly, Drugstore.com primarily sells low-ticket items, thus, any cost savings will generally be lost on shipping charges. For all of these reasons, we don't think Drugstore.com succeeds in differentiating itself in regard to its stated goals of convenience, selection, and value. Therefore, we remain skeptical that the company will ever turn a profit.

Larry Witt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.