Why It's So Hard to Make a Profit in E-Commerce

By Markets Fool.com

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It's become clear to retailers big and small that e-commerce is the way of the future.Amazon.com(NASDAQ: AMZN), the undisputed leader in online shopping, continues to tighten the screws on brick-and-mortar players, having already leveled sectors from bookstores to electronics stores, and now department stores.

Wal-Mart's(NYSE: WMT) just-announced $3.3 billion purchase of e-commerce start-up Jet.com is a reminder of how urgent it is for companies to boost their competitive position in online retail.

Brick-and-mortar giants seem to have accepted the need to prioritize e-commerce, but there's a problem: profits. Physical retail is notorious for narrow margins, usually in the low-single digits, but it seems that e-commerce profits are even slimmer, and many online retailers are operating at a loss.

Apparel and accessories retailer Michael Kors(NYSE: KORS) confirmed such speculation earlier this year when CEO John Idol told analysts that the online channel currently delivers lower margins than brick-and-mortar sales due to investments in fulfillment centers, extra staff, free shipping, free returns, and appeasing an increasingly demanding customer that does things like buy multiple sizes of an item just to return all but one.

Nordstrom(NYSE: JWN) acknowledged a similar trend, and Costco(NASDAQ: COST)has resisted basic e-commerce additions like in-store pick-up as its model works better by getting customers to shop in its stores.

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For pure-play e-commerce companies, profits are even harder to come by. As the chart below shows, stand-alone e-commerce companies are almost all struggling to get past breakeven.

AMZN Profit Margin (TTM) data by YCharts

eBay(NASDAQ: EBAY) is the exception to the rule here, as all of its sales come from its marketplace, where it charges sellers a fee to operate on its website. It also benefits from a history nearly as old as the internet, as it's the go-to site for online auctions.Etsy(NASDAQ: ETSY) and Groupon (NASDAQ: GRPN) also operate through a marketplace, though neither one has reached the scale where it can deliver solid profits. Their struggles also show that even the marketplace model is more difficult to profit from than it might seem as it requires substantial marketing expenses to build a stable of buyers and sellers.

The other three companies, Amazon, Overstock.com(NASDAQ: OSTK), andWayfair(NYSE: W) are all struggling to turn a profit despite having been around for 14 years or more. Amazon's recent uptick in profit margin has been supported by its cloud-computing division. In its e-commerce unit, operating margin has also expanded, but was still just 4% in North America in its most recent quarter and -1.4% internationally.

There is no simple explanation for why profits have proven so elusive in e-commerce, but three reasons stand out.

1. Amazon calls the shots

Amazon founder and CEO Jeff Bezos' pricing strategy can be summed up by his famous quote: "Your margin is my opportunity." Bezos' focus on long-term value has meant he's been willing to forgo profits in order to build out a loyal customer base and grow sales to drive leverage. Time and again the company has ruthlessly undercut competitors on price. Amazon pressured Diapers.com-parent Quidsi, which it eventually bought, by lowering its prices on diapers by a third. It made enemies with several major publishing houses by refusing to respect industry pricing norms, artificially lowering the value of books and pushing out competitors.

Recently, thanks to the strength of its Prime membership program -- a $99-a-year program that includes two-day shipping -- Amazon has begun competing on convenience rather than price alone, but its tactics have influenced the entire industry. Consumers have been trained to shop for the lowest price, and Amazon still carries that perception for many. The zero-margin philosophy has instilled a cutthroat sense of competition in the industry.

2. Little opportunity for differentiation

Brick-and-mortar stores often distinguish themselves above all else by their location. Consumers will choose to shop at a certain store because of its proximity to their home or its overall convenience. A physical location also allows brands to differentiate themselves through shopping experience, customer experience, and things like store layout and decor.

The ability to do so online exists to a much smaller extent -- price remains the key differentiating factor. Price comparison apps and Google searches can also help shoppers quickly determine the cheapest option for the product they're seeking in a way they couldn't before the internet.

Barriers to entry are low in retail and even lower in e-commerce. It takes little investment to sell online, especially when operating through a marketplace like Etsy or eBay. That ease of entry means the level of competition in e-commerce will remain high.

3.Consumers have high expectations

Credit Amazon again here for continuously raising the bar for customer expectations: The company offers free two-day shipping on millions of items, and with Prime Now customers in more than a dozen cities can get some items within an hour.

That has forced other competitors to play catch-up. Many have lowered their free shipping minimums to allow customers to avoid that onerous charge. Free shipping, however, is not free for the retailer, and can be one of the most costly items in e-commerce. In its last four quarters, Amazon spent more than $13 billion on shipping, and net shipping costs, or shipping costs minus shipping fees collected from customers, were nearly $6 billion.

Idol's point about excessive returns illustrates another quandary. Consumers want the benefits of brick-and-mortar shopping, like free returns, included in online shopping, even though those costs can be excessive.

As more companies are recognizing the importance of e-commerce, investment will increase, and so will competition. Sales should continue to grow at the roughly 15% clip they've been at recently, but profits are likely to be muted. With the internet in their pocket, consumers have all the power in online shopping, and high volume and high competition will continue to mean low profits for online retailers.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com, Costco Wholesale, eBay, and Wayfair. The Motley Fool owns shares of Etsy and Michael Kors Holdings. The Motley Fool recommends Nordstrom. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.