Image courtesy of Renjith Krishnan at FreeDigitalPhotos.net

I’m convinced that e-commerce is one of the toughest businesses in the Internet world. And it is especially tough in Latin America. Let me clarify that I’m referring to e-commerce of physical goods. Digital goods (music, movies, digital books, travel reservations, etc.) do have an advantage over physical goods in e-commerce.

I have seen that many entrepreneurs starting e-commerce startups fail to see the challenges they will experience. They believe that any new e-commerce site will attract hundreds of thousands of customers who will prefer to buy online rather than offline. The reality is very different.

I use an analogy to explain how an e-commerce business works. When you open an online store, it is similar to opening a store in the middle of the forest where nobody lives. So, you get few visitors and customers because you are not located where they live or work and your location is hard to find.

Then, you need to advertise to let people know you exist and bring them to your store. Most sites use Facebook or Google for that. With Facebook you target segments of potential customers (i.e., gender, age group, preferences) and with Google you target potential customers that are searching for something in specific, that you could provide to them. Of course you have to pay for that service to Facebook and/or Google. They bring potential customers to your store at a price, which depends on the characteristics of the universe of potential customers you are targeting and what amounts are other businesses spending on targeting the same group.

Now, only a few of the visitors to your site will end up as customers buying something (typically around 1% “conversion rate”). If you divide that marketing spend by the number of actual customers, you get the cost of acquiring each customer; what the industry calls “customer acquisition cost” or CAC.

As you can see, an online store behaves differently than an offline store, lets say in a shopping mall. There the visitors go to the mall and walk in front of your store. A number of visitors decide to go into your store. You pay rent and services for being in the mall but you don’t hire somebody to bring you people. In the online store, you save on rent and some other expenses, but have to pay to bring potential customers.

Also you can generate organic traffic, which is a fancy way of saying that you didn’t pay for it. In most cases this comes from searches in Google (which is the overwhelming leader in search engines). When a user searches something, Google produces a long list of results on every search. Links shown higher on the list get clicked much more often than the rest, so every site wants to rank high on a Google search. Internet sites spend significant effort tweaking their sites looking to rank higher in a Google search, what is called Search Engine Optimization or SEO.

Online stores face additional challenges in Latin America (which probably also happen in other emerging markets). It is estimated that there are only 90 million e-commerce users in Latam (of which 31m are in Brazil) out of a population of 605 million. So penetration is still very low although is growing quickly.

There are three main challenges e-commerce faces in Latam: low penetration of payment methods, lack of trust, and lack of perceived convenience. Let me explain each one:

Low penetration of payment methods: This could sound shocking to a US-based online retailer, but Latam has a relatively low penetration of credit cards, estimated at less than 20% (although could be higher in some countries, specially Brazil). Debit cards are more available, however the issuer banks tend to restrict online transactions (i.e., around 70% of debit cards in Mexico are restricted from doing online transactions).

Potential clients that do not have credit/debit cards need to use other payment methods. So online retailers need to offer cash based payment methods, which are provided by third parties. Essentially payment processors offer that customers pay in cash through a network of collection points (typically, convenience stores, large retailer chains, etc.). Some retailers can have up to 40%-50% of their customers using offline cash payments. The issue is that customers lose convenience if they have to pay offline, so even if they place an order, a large percentage of those sales are never collected as the customer does not go to a payment point and then the order has to be cancelled.

Lack of trust: The Latam online customer has a generalized lack of trust. Many fear that their credit card can be “cloned” or fraudulent charges applied. But some also fear that they will not get the product or that the product they will get is not what they ordered. Some people even call customer service before putting an order to ask if the company is real and to get assurance they will get the product they order. It seems some people have much more trust in an unknown real person on the phone than on a website. The Latam customer behavior is more than 10 years behind the evolution in the US.

Lack of perceived convenience: Normally a person wants to see, touch and try a product before buying it. Unless a customer already knows exactly what he/she wants, the buying experience tends to be superior at a physical store. Also, e-commerce for physical goods (not the case for digital goods) lacks instant gratification. You buy something and have to wait several days to get it. When you buy something in a physical store, you get it instantly. You can even use or wear it before leaving the store.

Some people could argue that there is convenience on having the items you purchase arrive directly to your home. Sure that could apply for very large items. Or if you leave far away from physical stores; but the reality is that most of the affluent and middle class population who are the target for e-commerce in Latam lives in the large population centers which tend to have a broad and deep offline retail offering. It is very uncommon that mid to high income people live far from good retail offerings.

In addition, offline retail don’t face the obstacles described above. The customer can pay with cash or credit/debit cards with lower fraud risk. And the trust is higher as he/she knows exactly what he/she is buying and taking it. In order to overcome the three issues described above, an online retailer needs to have a differentiation or a competitive offering to the offline retail world. Basically there are three ways to differentiate:

• Price: a retailer needs to consistently offer lower prices than the offline world (minimum 10%-15% price differential) to attract clients on price. At the same price point that offline retail; most customers will prefer the advantages of a physical store. The best performing online retailers in Latam are flash sales sites, where limited amounts of a product is offered during a limited amount of time at prices 30%-50% below market.
• Selection: e-commerce has to offer products that clients want but can find easily or a more extensive selection than in physical stores. This could be tough because most manufactured products in Latam are imported from China or other Asian countries by wholesalers or distributors. It is almost impossible for an online retailer to import differentiated products without having scale.
• Customer service: in general Latam customers are not used to US-type customer service. In many instances you can’t exchange, much less return any purchased item in an offline store. The implication of this is that users do not expect to be able to return anything they buy from an online store (again, another barrier for e-commerce). The differentiation then has to come from providing better information on the products (including other users ratings), and ideally information on related or other products that the client might like (exactly what Amazon does best and my opinion the reason for their retailing success). The client doesn’t have this information at a physical store and is where the online store can be much superior.

I have focused here on the issues with customer adoption of e-commerce. There are other issues on the economics of running an e-commerce operation, where normally margins are razor-thin and working capital needs are very high even if you some scale is achieved, but I am not going to discuss that in this post. Even the largest e-commerce players in Latam are not making money today.

On a macro view, the e-commerce potential in Latin America is huge based on where the region is and the penetration that we can observe in more developed regions. However, entrepreneurs trying to capture that potential have to develop a clear differentiation to offline offerings and achieve great execution in order to be successful. And they should plan on having sufficient capital to sustain the business until scale is achieved, which could take several years.

An interesting link here: Latam E-commerce Insights from the European Travel Commission.

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