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The High Cost of Free Shipping


Just as online retailers are finally starting to make profits, a price war is breaking out that could send them back into the red. The recent flurry of promotions started last month, when Amazon.com Inc. (AMZN) lowered the order limit eligible for free shipping to $49 from $99. Then Buy.com Inc., which sells everything from consumer electronics to books and CDs, did away with shipping charges on many products and began undercutting Amazon's book prices by 10%. Not to be outdone, Circuit City (CC) and Best Buy (BBY) jumped in with their own free shipping offers, while Barnesandnoble.com (BNBN) began shaving 30% off books published this year.

It's all about revving up sales. Last year, amid the recession, online sales growth slowed to 25% from triple-digit growth in previous years, as e-tailers slashed marketing and raised prices. Now, the heat is on for companies to grab a greater part of this year's online sales, expected to rise 30%, to $39 billion. "Everyone is under pressure to increase revenue," says David Dowhan, vice-president for marketing at Drugstore.com Inc., which in May began offering 5% discounts to some customers who spend more than $200 a year.

It's a risky strategy. The online retailing industry has just started to become more profitable. About 56% of the 109 largest online retailers had operating profits last year, up from 43% in 2000, according to a survey by Boston Consulting Group Inc. and Forrester Research Inc. for Shop.org, an arm of the National Retail Federation. Deep discounts and wide-open free shipping offers could harm e-tailers' performance, especially if they drag on for months or become permanent. "Companies had made great strides toward profitability, and I worry we're stepping backward again," says analyst Ken Cassar of Jupiter Research.

The key company to watch is Amazon.com. The largest player in online retailing, with more than $3 billion in annual sales, introduced free shipping in January on orders of $99 or more. The key goal was to stimulate sales. The offer came with strings attached: The shipments took three to five days longer than normal. It worked. In the first quarter, Amazon's books, music, and video sales rose 8%, to $410 million, up from a 5% increase in the fourth quarter and a 14% dip in the third. Meanwhile, the company was able to narrow its overall loss to $23.2 million in the first quarter, from $234 million.

Now, in lowering the free-shipping threshold to $49, Amazon is betting that it can stimulate more sales, increasing gross profits and offsetting shipping costs. More than half of its book, movie, and video orders are under $50, often in single-item shipments that Amazon loses money on, says analyst Mark Rowen of Prudential Securities Inc. If Amazon can get a customer to buy three books instead of one and wait a little longer for delivery, it can save on postage and ship orders more efficiently.

The key is increasing sales enough to make up for revenue lost in giving away shipping. On a $60 order, the company used to make a gross profit of about $15. Now, with free shipping, it's about $12, estimates analyst Safa Rashtchy of U.S. Bancorp Piper Jaffray Inc. If sales don't get a lift, Amazon could lose as much as $152.5 million this year on sales of $3.7 billion, estimates Rashtchy, instead of the $92.5 million loss he is still forecasting. "The question is at what point do lower margins not get made up with increased sales," says Prudential's Rowen. "I don't think they know the answer to that."

Buy.com's aggressive discounting could interfere with Amazon's plans. Buy.com is in the midst of a turnaround. Founder and CEO Scott Blum says cost-cutting, including an 82% cut in staff from the peak level in 2000, improved business so much that Buy.com earned its first net profit in the first quarter. "We have been focused internally, not externally," says Blum. "Now, we're prepared to compete." With its free shipping and 10%-off offer, Buy.com is hoping to increase orders for books, which typically have 20% to 25% margins. In contrast, consumer electronics, which make up most of its sales, have 10% margins. Although Blum expects gross margins to tighten to 12% from 15% now, he is betting he can pull in more revenues and increase profits.

So far, Amazon.com hasn't responded with deeper discounts. It enjoys an enormous size advantage over Buy.com, with 10 times Buy.com's $380 million in revenues. It figures Buy.com, which has only $5 million in cash, won't be able to sustain its promotions long enough to take much business away. Market analysts say that unlimited promotional offers typically generate a flurry of excitement, but interest quickly tapers off, making it difficult to cover increased costs. Blum, however, is adamant that he'll be able to boost sales profitably at Amazon's expense. In the three weeks since he slashed prices, Buy.com's average daily sales have increased to $1.2 million, up 50% from about $800,000, Blum claims.

Other retailers are eyeing Buy.com warily. "We watch the competitive environment, and we know it's important to the customer and to us," says Scott Bauhofer, senior vice-president at BestBuy.com Inc., which on July 2 began offering a free shipping offer for the first time in two years. If more aggressive discounting works for Buy.com, its competitors, including Amazon, may have to stick with their promotions or even expand them--even if they're not paying off financially.

The danger is that deep discounts and promotional gimmicks will once again become standard operating procedure for e-tailers. The last time online promotions spiraled out of control, it contributed to 325 e-commerce companies going out of business in 2000 and 2001. If history repeats itself, a good thing for shoppers could again have dire consequences for this still-fragile industry. By Heather Green in New York


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