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Think Big. Move Fast.

Since my earlier post on “Three ways to build an online media business to $50m in revenues” was well received, I thought I’d examine the e-commerce industry as well.

The margin structure in most (physical) ecommerce businesses is dramatically different from that of online media businesses. Whereas online media businesses can enjoy gross margins of upwards of 90%, and net margins (at scale) of 50% or higher, many ecommerce businesses have gross margins in the 20-40% range and net margins (at scale) in the 5-10% range. As a result, ecommerce companies have to grow to a much bigger top line to achieve the same value. We’ll target $500m in revenue to get to net income in the same range as a $50m revenue online media business.

There are three ways that an ecommerce company can get to this scale:

1. Build up $500m in sales in a single vertical. You’ll need to ensure that the vertical that you’re addressing is large enough in online sales to accommodate your size – books, music, consumer electronics, shoes and groceries are all good examples. You’ll likely need to be number one in your category, which implies industry leading cost structures. You’ll probably be holding inventory and operating multiple distribution centers, dealing with returns and generally operating a very large scale business that gives you certain margin advantages because you’re one of the largest retail channels for your suppliers.

You’re probably able to spend on building a brand (vs performance based marketing only) and you likely think about customer lifetime value. Hence you may be willing to pay more to acquire a customer than you’ll realize from your first transaction since you sell a product that is bought frequently. As a result, you obsess over customer service because you need your customers to have a great experience and have confidence and recall to buy from you again in the future – ideally by typing your URL in directly into their browser.

$500m in a single category is a lot. In 2005, according to Internet Retailer, only four pureplay ecommerce companies exceeded $500m in online revenues (Amazon, Newegg), Overstock and Netflix. The remaining 22 companies who had sales over $500m online were very large multi-channel retailers like Office Depot, Gap, Dell, Circuit City and Walmart.

Other companies who likely have already reached this revenue level since then, or will soon, include companies like Zappos, Freshdirect, Drugstore.com and Buy.com

2. Build up $50-100m in sales across each of 10-5 verticals. This could be by being a smaller player in a larger category (such as the verticals discussed above), but you’re likely number one in a smaller category. Say Ski gear, nutirtional supplements, autoparts or power tools; smaller categories than books or shoes, but still pretty big. (Note – the links are to examples of companies that are at or could get to $100m in sales, but they are not parts of companies with multiple verticals each doing $100m in sales).

Since in many cases there are not that many synergies across categories (little or no ability to leverage supplier relationships for example) you may be a result of a rollup to get to critical scale. You may see some ability to leverage your distribution infrastructure, but in many cases the pick, pack and ship needs of different products are quite different and may not support shared infrastructure (small vials of pills looks very different from aftermarket auto parts). You likely hold inventory and operate your own distribution centers, but if you are in a category with large and unwieldy items that often get built to order, you may be able to dropship from your manufacturers.

In 2005, according to Internet Retailer, only 155 companies exceeded $50m in online revenues, and only 45 were pure play etailers, including Blue Nile, Redenvelope.com, Shoebuy and Furniture.com. However, there are a number of companies who are taking this approach, including Musician’s Friend, Provide Commerce/ Liberty Media, and Blue Lava

3. Build up less than $5m in sales in each of 100+ categories.
According to Internet Retailer, there were 479 ecommerce companies with sales over $5m in 2005, including Batteries.com, Junonia (plus sized activewear for women), iGourmet, artbeads.com and thinkgeek.com. As you can see, even relatively small niches can sustain $5m in sales. You may be able to rely on your manufacturers to drop ship, and you may need lower levels of dedicated resources against each category with less depth of industry merchandising expertise.

Rather than building a brand, you can rely more on performance based marketing, particularly paid and organic search and shopping engines. You may not even need to be number one in your verticals – if they are big enough you can still win some share of the market to get to $5m.

What is hard is getting to this level of sales across so many verticals. To be able to do this you need a level of shared technology and processes that can be applied across many stores. Winning becomes less about any one store, and more about applying best practices across all the stores. The challenge is in being able to enter a category cost effectively, and to run a store against low volume in a very low cost way. Processes and cost control become paramount because any sub optimal practices get magnified across 100 stores. Although no one has hit $500m in revenues through this approach yet, there are a number of companies who are taking a shot at this approach, including Mercantila (a Lightspeed portfolio company)CSN Stores, Netshops, Niche Retail, and others.

All these models are viable. As in most cases, the first $20m in revenues are the hardest! I’d love to hear from people on any of these paths.

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