Co-authored with James Hankins
The outbreak of Covid has had an undeniable effect on businesses worldwide, creating all kinds of new problems to be solved. For the companies that had to close physical stores, the answer appeared obvious: escalate and expand ecommerce efforts.
In the UK, online retail in relation to total retail saw the equivalent of 10 years’ growth in just three months at the onset of the pandemic. Online grocery sales doubled almost overnight, albeit on an admittedly low base.
The headlines that followed were entirely predictable; if you are not pivoting to online sales, you are about to get forever overtaken by the competitors that are. However, few seemed to consider whether this was actually true or merely evidence by citation to drive an overall narrative – what psychologists would call a Woozle effect.
As it turned out, lacking amid the analysts falling over one another in endless attempts to come up with new forms of hyperbole, was a fundamental economic understanding of the unavoidable challenges that online and direct-to-consumer (DTC) sales brings.
By and large, moving retail sales from a physical store to a digital outlet is equivalent to taking purchases from where they are most profitable to where margins are lowest, yet few supposed experts appeared to take note.
We therefore decided to analyse the true commercial nature of ecommerce – its upsides, downsides, inherent risks and potential opportunities.
In a forthcoming white paper, the highlight findings of which you will be able to access in three summaries exclusively here in Marketing Week, we will dig deep into the aspects of ecommerce that marketers often fail to take into account.
The first part details what we call the final mile – new business models and optimisation processes in supply chains. The follow-up will delve into the world of fintech, algorithms and software. Finally, this autumn, we will look at the future of physical retail and real estate.
Iceberg, dead ahead
As the pandemic hit the world, companies scrambled to move their outlets online, either by choice (optionality) or effectively lack thereof (obligation). Many marketers found themselves in unfamiliar waters and had to quickly get up to speed on ecommerce.
Unfortunately, this led to an industry-wide issue of veneer knowledge; thin layers of understanding that drive context-free decision-making and the application of generic solutions to specific problems. Put simpler, many only saw the tip of the proverbial iceberg – the website, the mechanisms of purchase or the ad unit – but numerous fundamental commercial, strategic and operational elements remained hidden from view beneath the surface.
Over time, the market should stabilise, but as of right now, winning the final mile means winning full stop.
The lack of insight is problematic. While we are now heading towards less obligation and more optionality as restrictions are relaxed, it appears unlikely that ecommerce take-up will revert back to pre-Covid levels. That is not to say take-up will remain where it is currently are, but what we saw was, as alluded to earlier, not a new trend as much as an acceleration of existing ones. Combined with a wider consumer adoption across multiple demographics and the psychological consequences that come with corporate investments, we are looking at a potential self-fulfilling prophecy of sorts in the short- to medium-term.
Nike CEO John Donahoe provides one example out of a myriad we could have chosen, being quoted as saying “simply put, consumer behaviour is shifting fundamentally during this pandemic and we don’t think it’s going to flip back”. It still may, of course, but clearly there will be efforts made to prevent that from happening.
Understanding what makes ecommerce succeed or fail will continue to be a very important aspect of many marketers’ jobs. So, let us start with the basics.
In the traditional commercial operation, the physical store provides a centre of consumer gravity. It is a many-to-one model; buyers (the many) incur the cost of traveling to the store (the one) to purchase. Ecommerce inverts this relationship. Consumer gravity is replaced by fragmented demand fulfilment and near-endless consumer choice. The company (the one) therefore has to incur the cost(s) of taking the product the final mile to the buyers (the many).
In our research, we found that understanding this fundamental shift was practically a prerequisite for profitability. Although Covid drove customers online and revenues followed, the pattern was obvious: profits were scarcely seen as organisations grappled with improving their fulfilment operations under the significant stress of rapid channel penetration growth.
A significant reason why profitability is so difficult to obtain in ecommerce is that the one-to-many model forces companies to pay what one might call a distribution tax. In the past, companies could load up their vans knowing they could minimise marginal costs by maximising delivery size and taking it to fulfilment centres at fixed delivery days. In the new reality, they have to go to a plethora of places at all times – and quickly and cheaply too due to the expectations created by actors such as Amazon. The metaphorical van becomes more difficult to fill and marginal costs go up.
Then, there is the matter of reverse logistics. Although non-applicable to some categories, and less impactful in others, returns generally increase in frequency with online purchases, particularly within the highly coveted younger demographics. This, of course, compounds costs further.
As a result, retail category pre-tax profit margins have dwindled across Europe. Recent research by Alvarez & Marsal echoes our finding of an inverse relationship between share of sales online and margin; as ecommerce penetration rises, margins fall.
To illustrate, widely hailed DTC success story Made.com recently hit a £1bn cumulative revenue over a 10-year period. However, during its biggest year in terms of revenue (2019), it also posted its largest loss. Its consistent failure to produce profit led to a recent IPO flop.
Nike, featured heavily in industry press of late, has been boasting about its rapid growth in Nike Direct while reducing exposure to third-party resellers. Yet despite a direct sale contributing 66% more to revenue than a comparative wholesale sale, the overall impact on gross margins has been negative. Of course, many things can affect margins at a global level, but it is nonetheless telling that Nike Direct struggles to provide a positive contribution.
Many categories, few exceptions
The importance of final mile optimisation and fulfilment efficiency was consistent throughout our analysis. Ecommerce is a commercial area with precious little room to manoeuvre; the fulfilment engine requires significant and carefully considered capital expenditure (CapEx) over a sustained period of time in order to support profitability, but it is a task easier formulated than carried out.
Tesco, the UK’s leading supermarket at 27% share, is a vertically integrated business with one of the largest supply chains in the country. It is responsible for £1 in every £10 spent in UK shops, employing some of the best buyers around and enjoying all the economies of scale that one could hope for. And yet, despite recently announcing that its £6.3bn ecommerce branch contributed positively to the overall net profit, the company did not divulge any numbers. Given the obvious financial and PR gains of good figures, the fact it chose to avoid public scrutiny leads us to suspect that the contribution is close to zero. By comparison, Ocado increased its revenue by 30% year on year (to £2.3bn) with a big shift in grocery EBITDA (+265%) yet made a loss of £148m before tax and exceptionals in its 2020 financial year.
While it is demonstrably clear that revenue can be created through digital, profitability is another matter.
In order to combat the supply chain issues, a number of retailers in our analysis had chosen to form partnerships with third-party suppliers and delivery service providers. However, this is far from a guarantee for success. In fact, among the verticals that were struggling the most to make a profit were those that specialised in delivery.
Despite Amazon’s deal to purchase a part (16%) of the company, Deliveroo’s recent IPO was publicly deemed the worst in London’s history. This was perhaps somewhat unsurprising; the business had seen nine figure losses in each of the past three years despite an overall revenue growth of more than 100%.
UberEats follows a similar pattern. Obfuscation with published accounts aside, the business tripled its gross bookings during the pandemic, leading to a reported 179% year of year growth in revenue (to $3.9bn). And yet, at 20-30% cut of orders, the company has never posted a profit. Its most recently reported $873m adjusted EBITDA loss is also likely higher – we discovered that the figures hid some $3.3bn of cost. Contrary to popular belief, the company appears lightyears from making money.
Just Eat Takeaway was initially just a marketplace matching users with restaurants that provided their own delivery and, by historic accounts, profitable. In 2019, Takeaway.com purchased the company and shifted it to a delivery marketplace. At 60 million active users, 588 million orders and a claimed gross merchandise value of €12.9bn, the company saw a loss of €185m. The list, as they say, goes on.
That is not to say it cannot be done. General merchandise powerhouse Next has increased its online revenue by more than 50% over the past five years by consistent CapEx into fulfilment operations.
Given half of all online purchases are click-and-collect from the store, and 70% of returns are too, reducing and incorporating the cost of fulfilment within existing cost structures allows the company to drive efficiency. When customers are in-store, they are also more likely to browse the assortment, leading to further incremental sales.
This stands in contrast to John Lewis, the supposed jewel at the heart of the high street (and much of adland). During our time period of study, its CapEx was significant, but its reported return on invested capital declined from 10.1% (2017) to 6.7% (2021) with a low of 5.8% in 2020. Compared to Next, it is clear the company has efficiency issues.
The worrisome consequences
It is evident in our research that the final mile problem is unescapable. Unfortunately, what is equally clear is the problematic ways in which some companies have gone about attempting to handle it.
Firstly, there is the push for a zero hours culture, commonly labelled the ‘Uberification’ of jobs. By removing human capital (and the responsibility thereof) from the balance sheet, companies can shift employment risk to the individual. While this route appears to be (finally) closing through legal means, Amazon’s treatment of its workers remains notorious, as are its attempts at fighting unionisation.
Gymshark, one of few profitable companies in our analysis, also shifts risk, albeit of the financial variety. Through the means of so-called negative cash conversion, the organisation takes over 160 days to pay its suppliers, which effectively means the suppliers finance the business through credit.
Then there is the complexity of supply networks. In a globalised world, supply chains are complex adaptive systems that are inherently impossible to control and optimise. Efforts, particularly in fast fashion, to therefore create local, vertically integrated models have been disastrous, as demonstrated by the recent Boohoo scandal. The modern-day slavery conditions discovered were a direct result of the paper-thin margins.
Carefully consider the shift
Covid has accelerated the customer migration to online for better or for worse. With profit margins already in decline – and further pressure added with every increase in ecommerce penetration – it is apparent companies need to carefully consider their approaches as the model shifts from the traditional many-to-one to the new one-to-many.
While it is demonstrably clear that revenue can be created through digital, profitability is another matter. Technology and automation certainly help, but the crucial factors our research unearthed are supply chain management, final mile optimisation and fundamental economics. This goes counter to the popular trade media narrative.
The strategic implications are evident: fulfilment and distribution are of crucial importance particularly in the short- to medium-term. Over time, the market should stabilise, but as of right now, winning the final mile means winning full stop. Consequently, its optimisation should be a focus for any brand affected by the ecommerce revolution.