Retailing: What's Working Online

NEW YORK - Online retailing has come a long way since the go-go years of the 1990s: It generated $90 billion in revenue for U.S. retailers in 2004 compared with just $8 billion in 1998.

To study how the online strategies of today's successful retailers reflect this maturation, McKinsey analyzed the 100 largest direct retailers in North America. We found that direct retailers with physical stores captured 52% of Internet sales in 2003, while those without stores garnered just 31%. For each group, two broad strategies appear to be most successful. Together, the four models we identified have lessons for all retailers.

Retailers without stores do well as either "efficiency machines" or "niche leaders." The first approach is best for sellers of relatively low-margin products such as CDs, books or computers, because the Web provides the global reach these companies need to gain scale. Efficiency machines--such as Amazon (nasdaq: AMZN - news - people ) and Dell (nasdaq: DELL - news - people )--invest heavily in brand marketing, innovative Web sites and highly efficient sourcing and fulfillment processes. These investments create massive fixed costs, often running into the hundreds of millions of dollars, so efficiency machines must generate annual revenue of at least $750 million to be profitable. Such retailers, once successful, tend to generate strong cash flows, however. Amazon invested more than $400 million in marketing and technology in 2004, for example, while generating $477 million in free cash. The largest efficiency machines drive repeat business by offering deals to customers (for example, Amazon's $79 annual membership, which includes unlimited two-day shipping). Of the top 100 direct retailers, only seven are efficiency machines, yet they account for a quarter of total online revenue.

Niche leaders, such as L. L. Bean and Ross-Simons, sell higher-priced, higher-margin products (like apparel or jewelry) primarily through catalogs and over the Internet. Niche leaders build a loyal customer base by offering quality merchandise, exceptional service or both. The ability to acquire and retain customers is crucial, since most niche leaders are too small to afford expensive brand marketing and must rely instead on targeted online or direct-mail campaigns. The most innovative niche leaders coordinate their channels by making products from their catalogs easy to order online, for example, or by using their Web site to display a wider selection of products than a print catalog could accommodate profitably. The 28 niche leaders we studied generated nearly $15 billion in revenue--17% of which came from the Internet--and account for 6% of total online revenue.