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For some years department stores have been contemplating a less profitable future as costs increase and as they depend more every year on online retail. The Covid-19 pandemic has exacerbated the problem by accelerating our dependence on the online part of our business. In fact, we have been putting in place a number of channels and services for customers which we know are less profitable, and in some cases, loss-makers. So, the search for future profitability has become even more urgent.

The unstoppable growth of digital retail

For years now, bricks-and-mortar retailers have been battling with the issue of how to make the online part of their business profitable. Now, with the online share of business growing in the omnichannel mix, department stores are facing a future of less profitable retail – which they can ill afford. According to the World Economic Forum, e-commerce sales are expected to reach 40% of total revenue in the next seven or eight years. How can we remain viable when the fastest-growing channel is the least profitable? Is there anything we can do to prevent already thin margins being shaved further by demands for ever-speedier fulfilment, unrealistically broad assortment, and easy free returns?

The situation has become dramatic recently with the Covid-19 pandemic accelerating the development of online retail, the only channel left to many department stores to make any sales at all. These have not compensated for the loss of sales in stores, in spite of some very inventive solutions and admirable efforts to serve customers. Even efforts to concentrate on local customers and to use stores in novel ways as fulfilment hubs, for example, still leave stores with no better than 90% of “normal” sales. “Normal” being the level of sales required to keep afloat with the existing department store model. Needless to say, a future based on this level of sales will be short.

Online today is generally less profitable

Interestingly, the problem is not limited to department stores. Walmart, the subject of a recent IADS Exclusive, with its huge investments and the development of Walmart+, is actively trying to reverse the tide in its struggle with Amazon through the development of new models. But, according to some, it’s still far behind Amazon, and there are developing tensions inside Walmart. Last year, the company was apparently projecting losses of more than USD 1 billion for its US e-commerce division, on revenue of between USD 21 billion and USD 22 billion. Walmart does not disclose these figures publicly and declined to comment.

According to Forbes, TheRealReal, the marketplace, increased its previous year’s loss in spite of revenue up 51%. The digitally native fashion retailer Revolve, also announced a loss against revenue exceeding all expectations. Farfetch reported larger than expected losses despite a record revenue growth of 44%. “These results mirror a familiar pattern for retailers: improving year-over-year revenue while profits decline. Often these slides in profitability correspond to an outsized increase in e-commerce sales, highlighting the unfortunate truth that it’s very difficult to operate a profitable e-commerce business. And it’s only getting harder”.

And the issue is not confined to fashion or apparel retail. Indeed, as reported in the Financial Times, grocery shopping is also losing money online. A cited Bain consulting report estimates that grocers around the world are typically suffering a negative operating margin of about 15% on online orders. Even a USD 7 delivery fee does not lift that number into positive territory. The only operation which appears to be mastering the issue is Ocado which claims to have a list of one million people waiting to become customers once it has the capacity to serve them. And that is likely to come about since it is estimated (by UBS and Bain) that a majority of shoppers will increase their use of online shopping after the Covid-19 situation improves. Ocado sees itself less as a retailer than as an online service provider to retailers through huge investments in automation, robotics and technology.

What can department stores do?

On a positive note, a number of department stores are vigorously addressing the problem. Indeed, it has been at the centre of their strategies for some who have been acting decisively to transform themselves. One example is Falabella which now describes itself as “a digital retailer with stores”. It has been analysing online costs for some time, attempting to balance value to the customer, value to the store, and net operating cost of different solutions such as DC to customer, DC to store, and click & collect from store inventory.

Theoretically, the costs of fulfilment, for example, of DC to store will be lower than home delivery, which would be less than pick from store which would in turn be lower than ship from store. However, in reality, results may vary depending on the individual efficiencies of each process such as the incremental use of store labour, the efficiency of fulfilment centre pick-pack operations, the cost of real estate of click & collect counters, store pick efficiencies and much more. It is these variables which have to be analysed and in fact tailored to the operation in question and properly integrated. “A lot of these online channels were added as an afterthought to the brick-and-mortar channel”.

In general terms, whereas the physical store costs may be dominated by real estate and labour, those of online retail would be made up to a larger extent of marketing (in particular customer acquisition costs) and fulfilment. As the Harvard Business Review puts it, retailers need to find a way of creating a “digital-physical fusion” which will catch up with customer expectations, and importantly create a viable business model. “The greatest barrier to adopting fusion strategies is not skepticism about their promise but inexperience with their execution.”

What are the priorities in this process for department stores?

• There has been much debate about whether department stores should offer their entire assortment online, or a subgroup, or even in some cases extra items not available in store. Clearly fulfilment costs should play a major part in this decision: items that have difficult logistics and return logistics should be the first to come under scrutiny.
• For the rest, supply chain optimisation is crucial. For the average retailer, fulfilment costs have increased 12% over the last 12 months before Covid-19. Even Amazon saw shipping costs jump 23% at the end of 2018, reaching a record USD 9 billion. This is multiplied by the fact that customers are increasingly expecting free and fast delivery. On the other hand, there is evidence that customers are willing to pick up in store to avoid shipping charges.
• Linked to this is the pricing and promotion strategy: any difference between online and store price will be picked up immediately by customers. In this area, technology is almost indispensable (dynamic pricing and markdown optimisation).
• Technology in the form of either AI and machine learning, or robotic automation is also becoming standard. The Ocado example mentioned above is highly dependent on technology to offer affordable services. So much so that it is now building DCs for other retailers. There is some evidence that cost-conscious retailers are being pennywise and pound foolish when it comes to IT modernisation. However, research from Publicis Sapient revealed that IT infrastructure investments can pay back in 2-3 years while continuing to create long term value through increased conversion, affinity and loyalty.
• Finally, AI can also help with customer response and customer acquisition. Lifetime Customer Value (LCV) is sometimes used as an excuse to cultivate unprofitable customers. Technology can help us distinguish and cherish our best customers. Customer acquisition is generally acknowledged to be one of the big costs of online business. Targeting and reducing this cost can significantly contribute to profitability.

Conclusion

Foot traffic to stores continues to fall, while online retail has grown many times in the last ten years alone and has been boosted by the Covid-19 pandemic, probably with lasting consequences.

Many retailers must adjust their physical footprint to accommodate these changes. In today’s landscape, the strategy to open as many stores as possible is neither viable nor practical. Instead, retailers must focus on having effective stores. This may mean downsizing to smaller stores, moving to different, high-traffic, convenient locations, or reformatting to better accommodate in-store pickups. The measure is a difficult one since it means reducing the proportion of the traditionally more profitable part of the business. Recent examples of closures include Le Printemps, and John Lewis.

Therefore, in parallel, we need to consider each and every way in which to truly integrate our existing channels as well as ways of evaluating the true costs of what we are offering customers. The current pandemic has led to a innovative but unprofitable solutions for customers. How can we readjust, rebalance and integrate our physical and digital formats to recover a profitable department store model for tomorrow?

This is one of the tasks which will be set for the IADS Academy 2021: proposing a P&L for a truly integrated omnichannel business, and the related KPIs with which to measure omnichannel performance. It is a practical case of department stores dealing with disruption as discussed in the IADS Exclusive: responding to disruption in which How to shift in a company from the Incubation to the Transformation Zone. It can be done, but it requires strong leadership and purpose.

Credits: IADS (Dr Christopher Knee)