E-Tailing Finally Hits Its Stride

As it gains popularity, online shopping transforms how all merchants operate

Bill Bass and Jon K. Stein are two very different kinds of Internet merchant. Bass runs Sears.com (S ), the online arm of the retail giant, where sales are up more than 40% this year. Stein owns Jake's Dog House in Cherry Hill, N.J., a chain of five pet-supply stores that gets about $250,000 of yearly sales over the Web -- and expects them to double in 2005. As different as they are, the Internet is at the heart of both their expansion plans.

As e-tailing heads into its 10th holiday season, it is coming of age. With more households shifting to faster broadband connections and online shopping increasingly friendly, Americans are purchasing ever more stuff on the Web. Analysts at Forrester Research Inc. (FORR ) say U.S. online sales will reach $145 billion this year -- or 7% of U.S. retail sales. While growth has slowed from last year's hefty 38% gain, that's still a 26% leap from the $114 billion racked up in 2003.

But the numbers tell only part of the story. Big changes are percolating through e-tailing -- and spilling over into the broader world of retailing. For one, giants such as Sears, Roebuck & Co. and Wal-Mart Stores Inc. (WMT ) have finally gotten serious about the Net. They are chasing new markets online and using their size to force down prices, just as they have done in the brick-and-mortar world.

NICHES UNLIMITED

At the same time, thousands of niche players like Stein are reaching a national audience through the Web. "I've got customers in all 50 states," he says. And while some outfits aren't much bigger than mom-and-pops, being a niche player doesn't have to mean staying small. A growing number, including e-jeweler Blue Nile, (NILE ) luggage site eBags, and shoe retailer Zappos.com, are racking up sales of $100 million a year or more. "There's an unlimited number of niche markets out there," says John Seely Brown, a director at Amazon and visiting scholar at the University of Southern California's Annenberg Center for Communication. "It's the new economic model."

Indeed, in the past couple of years, the increasing sophistication of search technology and comparison-shopping sites have allowed online businesses cheaply and effectively to market their products to millions of potential customers. Often, these innovations are bringing less-well-known brands and merchants to consumers' attention. People simply type what they're looking for into a search site, and they're instantly spoiled for choice. The forces being unleashed have not been lost on that icon of e-tailing, Amazon's Jeff Bezos. He recently told a New York audience: "We're going to see more richly varied products for people."

It also means a more richly varied network of suppliers. For several years, e-tailing was dominated by a handful of online merchants -- the likes of Amazon, eBay (EBAY ), and Lands' End. And while they continue to post strong growth rates, they are facing increasing competition. Much of it comes from a host of Establishment retailers that were late to the party and becoming increasingly Web savvy. Says Sears.com's Bass: "A number of really large companies are just getting started."

The big chains are harnessing the Web not just to sell more stuff but also to test new products. Gap Inc.'s Old Navy unit is testing plus-size women's underwear online, for example. Wal-Mart, meanwhile, is using its site to try out fancy merchandise its stores don't stock -- including such upscale products as baseball memorabilia, cashmere sweaters, and $6,000 plasma TVs. Says Wal-Mart.com President John Fleming: "We play in specialty markets where you wouldn't think of Wal-Mart playing."

FINGER PUPPETS

Even as the big guys muscle in, small fry are also proliferating. For several years, many smaller players have launched online stores under the aegis of eBay. According to the online giant, 430,000 people in the U.S. make all or part of their living as eBay merchants -- up from 150,000 in 2002. EBay's merchants now hawk everything from SpongeBob SquarePants finger puppets to classic Ford Mustangs.

The advent of search-related advertising -- the ads that appear next to search results -- has made it more cost-effective for online entrepreneurs to set up shop on their own. In the early days of the late 1990s, pioneer online merchants fruitlessly spent millions of dollars on TV and radio ads aimed at the mass market. Search-linked advertising has changed all of that. Nowadays, online companies pay Google (GOOG ) or Yahoo! (YHOO ) only when a customer clicks on their search ad. Blue Nile, for example, can get a prospect for a $5,000 diamond ring by paying Yahoo $1.12 per click. Search-based, targeted advertising helped make e-tailing a much less capital-intensive, risky business. Perfect for the small guy.

The Web's favorable economics don't stop there. Online merchants can offer a far broader array of merchandise than specialty brick-and-mortar retailers, since they don't have to keep the products on store shelves. Consider eBags Inc., the suburban Denver luggage purveyor. It easily dwarfs the selection a local specialty store can keep in stock. "We carry 12,000 bags; they have 250, most of them black," laughs Peter Cobb, eBags' vice-president for marketing.

It's too early to say how all of this will play out, but it may well produce a bifurcation of American retailing. At one end will be huge commodity sellers able to compete in an online world dominated by price comparison sites and consumers who do careful research and shop on price. Look for search engines and sites such as Shopping.com and Shopzilla to do to markets such as cameras and plasma TVs what Dell Inc. (DELL ) did to computers: Make it impossible for any but the most efficient retailers, online or off, to survive. At the other end, smaller players from gift site RedEnvelope Inc. to Stein's pet stores will fight to differentiate themselves. When Alison L. May became RedEnvelope's (REDE ) CEO in 2002, she refocused the strategy on selling goods designed in-house. "The way you protect brands is the same as at the mall," she says. "You sell things people can't get everywhere else."

The Internet promised an era of more choice, better prices, and greater customer satisfaction. And as the Web reaches adolescence, that's what's arrived.

By Timothy J. Mullaney in New York and Robert D. Hof in San Mateo, Calif., with bureau reports

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