Store-based retailers, alerted by analysts’ predictions that on-line retail sales could account for as much as 10 percent of total US retail sales by 2003, are joining the rush to the Internet. As yet, these store-connected World Wide Web sites generate only trivial revenue. Many have suggested that the game has emphatically gone to pure Internet plays such as Amazon.com and eToys.com.

In fact, however, store-based retailers have a number of advantages over their Internet-only competitors, which can offer personalized search tools and links to related products and services but not the ability to see, touch, and try merchandise and to walk out with it. More generally, store-based retailers can leverage their multichannel advantage to give customers what they want, how and when they want it. So if store-based retailers make their sites as innovative and adaptable as those of their pure-play Internet rivals and at the same time realize synergies with their brick-and-mortar facilities, they may yet come in first after all.

Choose a winning business model

Building a thriving retail site on the Internet is every bit as hard as creating an exciting store environment. Like real-world retailers, on-line ones (pure play or not) must understand customer segments and shopping "occasions." But on-line retailers also have to address the complications arising from uncertainty about the behavior of Internet customers and the evolution of competitors’ sites in the future.

To deal with these problems, retailing incumbents moving into the on-line world must combine the three fundamentals of on-line retailing (or "e-tailing") and apply them to the business model that best suits the company and its category. The first fundamental is content—whatever appears on the Web site itself and on hot-linked Web sites—for if chosen wisely, that content can increase both the rate at which browsers are converted into buyers and their transactions. The second fundamental is community. Through site-to-user and user-to-user forms of interactivity (such as chat rooms), Web sites can generate a core of dedicated customers who become avid marketers of the site. The third fundamental is commerce, whether it involves offering goods and services directly or marketing those of another company for a fee, thus helping to cover the fixed costs of site operations and to offset customer acquisition costs.

These fundamentals can be applied to four main emerging e-tailing business models: channel supporter, category killer, auctioneer, and vertical portal (Exhibit 1).

Channel supporter

Some store retailers use the Internet more to support their existing channels than to generate additional sales. This approach is appropriate for categories, such as fast food, that have been slow to move on-line and for retailers, such as Tiffany, whose on-line channels may be at a competitive disadvantage to their traditional ones. American Eagle Outfitters, a retailer of apparel for teens, uses the Web to deliver product information and to share fashion updates through an on-line magazine (content), to offer user forums (community), and to sell an expanded range of products—for instance, bicycles and snowboards—and to refer customers to stores (commerce).

Beyond cross-channel promotions, many brick-and-mortar companies use the Web to increase their customers’ understanding of their products and services. Others harness the Web’s interactivity to improve their product development and product mixes by inviting customer responses on their Web sites and feeding those responses back into buying decisions at the store.

Category killer

Amazon, which began life as a bookseller, is the quintessential on-line example of the category killer approach, in which the retailer dominates a particular category of merchandise. By now, Amazon has evolved into a multicategory killer, and in every category the company has entered—music, videos, toys, and consumer electronics—it has blended content, community, and commerce by offering an extensive assortment of products supported by user reviews and information tailored to individuals.

The purchasing power and brand recognition of incumbent retailers make the category killer model in many ways the ideal choice for them: it leverages their strengths more than the other options do, and these are strengths the on-line competition must still acquire.

Auctioneer

Led by eBay, a number of companies are achieving success as on-line auctioneers. Sellers of goods and services provide the content; community comes from matching sellers with buyers and setting bidder against bidder; and commissions on sales and advertising revenue generate the commerce. eBay’s sheer level of presence has made consumer-to-consumer auctions the norm, but business-to-business possibilities abound as well. In reverse auctions, for example, a retailer puts out bids for tender on its Web site, thus expanding its universe of lower-cost suppliers. And the Internet’s unparalleled access to motivated buyers allows businesses to dispose of discontinued or excess inventory from their shops or warehouses at the best possible prices.

Vertical portal

The business model that may take greatest advantage of the Internet is the so-called vertical portal, which specializes in a particular industry or product category but, like Yahoo!, also offers personalized information and advice as well as access to a community with common interests. The Charles Schwab site is one example; another is boo.com, which seeks to become the one-stop fashion portal for hip 20- to 30-year-olds. Store-based retailers that use customer data adroitly and have brands the public trusts are in a good position to build demand for well-targeted new businesses and to attract to their portals customers who use more than one channel.

A new economics of e-business

To be successful on the Internet, incumbent retailers will have to do more than reproduce their off-line business models on-line, because these business models work only at considerable scale. Scale is certainly one route to profitability. Our own analysis suggests that an on-line computer retailer, for example, whose sales expand to $1 billion a year, from $100 million, moves from a loss of 3 percent return on sales to a profit of 9 percent. These figures hold true for product categories with smaller average transaction sizes, such as toys, sporting goods, and do-it-yourself equipment, as well as, to a lesser degree, for groceries and clothing (Exhibit 2).¹

But the margin for error is small. A 10 percent decline in the size of average transactions or an increase of 8 percentage points in annual customer churn would eliminate the profit margin of typical traditional apparel store retailers. Internet sales projections suggest that few retailers will sell $1 billion of merchandise on-line each year.

Even so, it is possible for an on-line operation to be profitable at far lower sales volumes if it exploits seven levers. Some merely bring on-line efficiencies to traditional retailing; others exploit synergies between on-line and store operations; while still others give an incumbent retailer with an on-line presence an enormous advantage over pure-play Internet retailers. It isn’t necessary to pull all seven levers perfectly; small improvements in key measures can make a great deal of difference (Exhibit 3).

Exploiting two channels to close one transaction

First, the Web offers customers two channels for closing transactions. Early winners on the Web belong to an exclusive club of Internet start-up companies, but established retailers could catch up and even overtake them by offering a choice of channels. Gap has tested a scheme giving customers an opportunity to preview and order goods on-line and then to pick them up at its stores. Barnes & Noble permits customers to search on-line for books that are not available in its shops, including titles no longer in print, which it can then often provide from its own or its affiliates’ inventory.

Maximizing the value of the whole transaction

The power of the double-channel model is apparent from the discovery by one store-based UK retailer that customers who buy both on- and off-line have increased their total purchases by 10 percent. The incumbent retailers that have done the best job of propelling themselves into the world of electronic commerce can boast on-line purchases that exceed the average off-line purchase by as much as 20 percent. Similarly—and intriguingly—the transactions of customers who use the Internet to purchase products in response to print and catalog advertising by store-based retailers are 30 percent larger than those of customers responding to on-line ads. Premium products, the bundling of products and services, and cross-selling all contribute to these higher average-transaction sizes.

Leveraging low customer acquisition costs

Traditional store-based retailers can use the Internet to exploit the fact that they have to spend somewhat less than $5 a head to bring their existing customers on-line, whereas Internet start-up companies must lay out an average of $45 a head to attract customers wholly from scratch. Furthermore, the print and catalog advertising, mentioned above, that appears to generate 30 percent higher on-line purchase activity costs the store-based retailers virtually no increment at all over the money they are already spending.

Exploiting alternative revenue streams

An on-line presence offers retailers a wider variety of sales opportunities. Many Web sites also sell advertising space on their sites. Peapod, a Web-based grocery service, generates more than $1 million a year from sharing customer purchase data with interested vendors. For Web-based retailers, acting as an agent on behalf of customers could become a revenue source in the future.

Purchasing scale at low volumes

Some retailers have been able to cut their purchasing costs by up to 20 percent and to shorten their procurement cycles by as much as 50 percent. They have done so by replacing electronic-data-interchange (EDI) tools with Internet-based ones that facilitate product comparisons, streamline logistics, and help business-to-business vendors, such as FreeMarkets and TPN Register, aggregate these retailers’ back-office purchases.

Keeping down customer churn

Given the high cost of replacing established customers, losing them is expensive. A Web presence supplies the personalized attention that could keep consumers loyal—though even some of the most successful e-tailers have acknowledged that working out operational kinks has, for the time being, taken precedence. E-tailers should transcend the usual imperatives of direct marketing (frequent high-sales, low-content marketing pieces) and build trust by providing information on the product and customer experience, as well as easy links to advisers, complementary vendors, and other customers.

Maximizing the pricing potential

Too many retailers believe that they must sacrifice the possibility of pricing up when they go on the Internet, a supposedly price-transparent medium. In fact, prices vary widely on-line. A 3Com Palm Pilot recently retailed for $399 at Insight.com, for $299 at circuitcity.com, and for $269 at BUY.COM. BizRate.com, an Internet consumer research company, found that buyers shop on-line more for convenience than for cost and that only 20 percent of on-line shoppers use "bots" (automatic-shopping agents) or other search engines to secure the lowest price. Another 20 percent simply buy at the first site that has what they want. In view of this relative indifference to price, e-tailers should work aggressively to capture some margin premium, at least in the early days of their sites.

Consider a carve-out

While the correct use of the seven levers should be enough to catapult any on-line retail operation into the realm of higher profits, traditional retailers taking their first steps on the Internet may yet suffer from cultural stress. Their struggle to keep up with fashion trends has not equipped them to move at anything like Internet speed, nor do they have experience building alliances. And while the top executives of a pure Internet company can focus solely on e-commerce, their counterparts at a traditional retailer too often want to pay only fitful, grudging attention to it—at least until the distant time when increased volume starts to deliver higher returns.

To promote speed and innovation unconstrained by such factors, retailers should consider carving out their e-tailing organizations into independent entities in which they retain equity stakes.² The new companies should have the full attention of the former parent’s CEO, who must show leadership, support, and patience in the face of often substantial losses that might well last for at least the first two years.

Moreover, such new companies should be judged by performance metrics other than earnings. During the lengthy period before profitability, incremental funding decisions must be based on indicators of the e-tailing business’s health. These include customer conversion rates (from "lookers" to "bookers"), customer acquisition costs, repeat purchase rates, and external site recommendations.

Finally, a successful new e-tailing venture must have an entrepreneurial culture. The excitement of building something new can itself energize employees to take risks. But all employees have heard stories about how struggling start-ups made fortunes for the people who contributed to their successes. In e-tailing businesses, the currency of the Web is equity.

Few store-based retailers can afford to ignore the Internet’s growth potential—or to spend the next five years losing money chasing on-line opportunities that might or might not realize their potential. An on-line business strategy that depends on synergistic skill rather than scale will permit such retailers to pull ahead of both their land-based and their on-line competitors.