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E-commerce

Photo: Getjustin

 

E-commerce has disrupted a number of large categories, including media, electronics, apparel, and home furnishings. If you’re shopping in these categories, there’s a strong and rapidly growing chance that you’re going to buy them online. But that’s not the case for the largest retail category: grocery. For the vast majority of people, filling the fridge still means rolling a cart down the aisles at the local grocery store.

As I outlined in a previous post, groceries are among the last huge e-commerce opportunities. Online penetration of groceries is extremely low. It’s not that innovators haven’t tried—it’s that they haven’t enjoyed significant success. To date, virtually all of the digital efforts to attack the grocery vertical—i.e., the brick and mortar franchises—have followed a very similar model: by building out e-commerce grocery businesses end-to-end, including warehouses, inventory, and trucks. They’ve essentially replicated the grocery store supply chain at great cost and complexity. During the first wave of Internet startups, we saw this centralized approach most famously with Webvan, but also at Peapod, FreshDirect, and more recently Amazon Fresh.

But now a new wave of digital companies is going after the grocery business with a very different approach. That’s why we’re thrilled to announce we’re backing Instacart.

The proliferation of mobile devices is enabling what I call “People Marketplaces”: two-sided marketplaces that connect consumers with people providing specific services.From finding a ride with Lyft, to getting your house cleaned with HomeJoy, home-delivered restaurant meals from DoorDash and Caviar, and instant pet-sitting from DogVacay, the variety and usage of People Marketplaces are exploding. It’s really becoming a thing!

People Marketplaces couldn’t really exist before the smartphone; the efforts of all these people couldn’t be efficiently managed or optimized without that supercomputer-with-GPS that’s now in everyone’s pocket. Today these devices can run sophisticated software that orchestrates tasks like order placement, driver location and logistics, delivery timing, and payment.

Instacart offers same-day delivery from your favorite grocery store via an army of local contractors, often within the hour. The service is expanding rapidly and is already available in the San Francisco Bay Area, New York City, Chicago, Boston, Washington D.C., Philadelphia, Los Angeles, Seattle, and Austin. Instacart is doing this by taking what I’d term a “virtual” approach that requires negligible infrastructure investment relative to other more centralized models; they leverage the existing grocery store infrastructure with a workforce enabled by digital tools.

I know what you’re thinking; I’ve written extensively on how brick-and-mortar retailers will be disrupted by e-commerce companies, and how they’re at risk of becoming dinosaurs in many retail categories. Yet Instacart is partnering with these same brick-and-mortar grocery stores in the delivery of their service. Have we cast our lot with the dinosaurs?

Not. Traditional brick-and-mortar retailers have a large advantage relative to e-commerce companies (if they can figure out how to harness it): Each of their stores is essentially a mini-warehouse with inventory widely distributed throughout the country. So we’re making a bet that Instacart’s partnerships with brick-and-mortar grocery stores will be the winning play in grocery delivery to the home, with the ability to fend off competition from e-commerce companies that build out their own infrastructure.

Here’s why we think the virtual model wins in this case:

  • It’s capital efficient – Instacart’s virtual approach to delivering groceries is extremely capital efficient relative to the approach of e-commerce grocery players like Amazon Fresh, Fresh Direct, and Pea Pod. Instacart’s leveraging of existing infrastructure obviates the need for physical capital investment. To put a point on it, Webvan raised $1.2 BILLION  largely for cap ex in their unsuccessful attempt to build a centralized grocery e-commerce business back in the day.
  • Faster to market – Instacart’s virtual model lets them expand to new cities quickly; their market entry strategy requires them to digitize local grocers’ inventory, hire drivers, and acquire consumers. Contrast this with the centralized e-commerce players and their need to build warehouses, buy trucks, buy and receive inventory, hire both warehouse workers and drivers… For these same reasons, Instacart should also be able to service smaller cities more efficiently.
  • Offers potentially superior operations – Instacart’s model is much more simple operationally; an order on Instacart results in a shopper going to the grocery store you selected, picking the items on your list, and delivering them immediately to your door. This should enable them to provide service that’s both high quality and FAST (remember that Instacart is often able to deliver groceries within an hour). By contrast, centralized e-commerce approaches have significant operational complexity. They need to buy, store, and pick inventory that’s often fragile and/or perishable (e.g., fruits, vegetables, meat, dairy) and keep it fresh and undamaged inside their trucks that run around the city all day making multiple deliveries.
  • Capitalizes on well-known brands – Instacart leverages the brands of the physical grocery chains, which typically are well known to the neighborhoods they serve. These chains know and carry the SKUs that people in their community want to buy. In the Bay Area, this already includes national chains like Whole Foods and Safeway as well as iconic local brands like Rainbow Foods and Berkeley Bowl. Centralized e-commerce businesses, on the other hand, need to build a brand from scratch and optimize for the tastes of an entire city.

We’re not alone in thinking that grocery will develop differently than other e-commerce verticals.  Fred Smith ,the founder of FedEx — which re-invented the delivery business — had this to say about the delivery of groceries (as part of a 1999 InternetWeek interview):

 “A lot of retailers are coming to the conclusion that well, maybe the best thing is not a total inventory-less environment but maybe what we do is use the Internet in concert with our bricks and mortars. And that’s what I think will happen, because you have a lot of things that have very low value, and they don’t lend themselves to e-commerce and fast-cycle distribution.

Groceries are the best example of that. Now, maybe there’s an example where you have an e-commerce interface and home delivery of groceries, but those groceries are not going to be delivered from across the country, and they’re not going to be built on demand for your order.”

FedEx was the pioneer of the centralized approach to delivery,jet planes and all. And even back in 1999, he thought the virtual approach in partnership with brick-and-mortar grocery stores was the future of online grocery distribution. Fast-forward 15 years and throw in the smartphone — and we think he just might be right.

I see lots of analogies between Instacart and OpenTable, the business I ran for four years before joining a16z. They are both local, requiring city-by-city rollouts. They both provide convenience to consumers. They both drive incremental business for their retail partners, providing those retail partners with an incentive to promote the service. They both have the potential for network effects. And FWIW, they both involve food!

In addition to these strategic advantages, we as always are making a bet on the founder. In this case, it’s Apoorva Mehta, a former Amazon programmer who is the founder and CEO of Instacart. Apoorva and the team have made extremely impressive progress, leading Instacart to strong early results on very modest resources. This round will give them a deeper war chest to rapidly bring the convenience of Instacart to cities across the country. We look forward to supporting their efforts to revolutionize grocery shopping. Your fridge awaits!

The news around shopping during the holiday season was dominated by two separate stories. One talked about how traffic to brick-and-mortar stores was well below expectations, and that these retailers were forced to discount tremendously to drive sales. The other talked about how an enormous late surge in packages coming from e-commerce companies overwhelmed the capacity of UPS and, to a lesser extent, FedEx, and caused many of these packages to arrive after Christmas.

But, to me, these two stories are not at all separate, they simply reflect different sides of the same narrative: We’re in the midst of a profound structural shift from physical to digital retail.

The drivers of this shift are simple:

  • Online retail has strong cost advantages over its offline counterparts and is rapidly taking share in many retail categories through better pricing, selection and, increasingly, service.
  • These offline players have high operational leverage and many cannot withstand declining top-line revenue growth for long.
  • The resulting bankruptcies of physical retailers remove competition for online players, further boosting their share gains.

So, how has this shift been playing out? Recent data suggests that it’s happening faster than I could have imagined.

The U.S. Census Bureau publishes what I consider to be the most accurate figure on e-commerce penetration in the U.S. It reports that e-commerce penetration of total retail sales in the U.S. was around eight percent in 2012. But, as I’ve blogged previously, this aggregate figure seriously underestimates the impact of e-commerce in large sectors of the retail landscape. Let’s unpeel the onion and look at the next level of reporting from the Census Bureau, where it segments the retail landscape into six large categories of goods. It’s at this level that things start getting more interesting:

The data suggests that there are two very different patterns going on with respect to e-commerce penetration. The two largest categories — “Food and Beverage” and “Health and Personal Care” — show e-commerce penetration well below the overall average. These categories essentially are the domains of grocery stores and drug stores, and e-commerce (at least to date) has achieved only modest penetration of these massive categories (but Amazon Fresh has designs on changing that).

The other four categories are what I would consider to be the domains of traditional specialty retail categories, the ones that are transacted in the malls of America. All of these demonstrate e-commerce penetration well above the overall average, ranging from a low of 12 percent for “Clothing and Accessories,” up to 24 percent for “Media, Sporting and Hobby Goods.” It’s in these specialty retail categories where e-commerce to date has had its strongest impact.

One additional observation is that the pace of online share gain in the specialty retail categories shows absolutely no signs of slowing down. All of these charts are “up and to the right.”

So it’s clear that a growing share of the retail pie in the specialty retail categories is being captured by e-commerce. Now let’s throw in one more massive complication for brick-and-mortar retailers in these categories: The total retail sales in these markets have been extremely sluggish, and have barely recovered back to pre-recession levels. This is a toxic combination — physical retailers in these categories are losing share of a total retail pie that isn’t growing. The inevitable result is that the portion of the pie left available for physical retailers is shrinking rapidly:

And that’s just what’s happening. The Census Bureau reports that the four specialty retail categories representing total sales of just over $600 billion grew by only $5 billion between 2007 and 2011 (the last date that this level of detail was reported). That’s less than one percent over four years. The e-commerce players increased their cumulative sales in these categories by $35 billion over the time period. This means that the cumulative sales of brick-and-mortar retailers shrank by $30 billion in just four years!

The result of these macro shifts is a Darwinian struggle playing out in the malls of America among physical retailers. Some recent retail news:

  • It’s getting hard to find a physical bookstore, music store or video store these days. In books, Borders has closed, and Barnes & Noble has reported continuing declines in comp store and total retail sales in its second quarter. All major music retailers are out of business. And the Dish Network recently announced that it would close its remaining 300 company-owned Blockbuster stores in early 2014.
  • Office-supply retailers are under pressure, as the paperless office is finally arriving. Office Depot and OfficeMax recently completed their merger, and will likely consolidate stores. Staples reported a four percent decline in comp store sales in their most recent quarter, and has closed 107 stores in the past year.
  • Electronics retailers are facing enormous pressure. Circuit City has closed. Best Buy recently declared that “show-rooming is dead,” as it offers to match the prices of 19 online retailers and all offline retailers. The next day, it warns of potential profit shortfalls from the hot promotional environment. And all of the computer superstores are long gone.
  • Apparel retailers serving the youth market are facing big headwinds. The “Three A’s” (American Eagle, Abercrombie & Fitch and Aeropostale) are all performing poorly, with declining sales and stock prices. It feels pretty likely that a key factor in these declines is early-adopter teenagers turning to online alternatives like Nasty Gal and Stitch Fix.
  • The general-merchandise department store is under siege. Sales at Sears have declined for 27 straight quarters (for you keeping score, that’s almost seven years). And it just announced that it is spinning off its Land’s End subsidiary, following its divestitures of Orchard Supply Hardware and Sears Hometown and Outlet business. Says Brian Sozzi, chief executive of Belus Capital: “Sears is in a steady state of decline. … They’re essentially selling their body parts so they stay alive today.” J.C. Penney continues to be in the intensive-care unit, with declining sales and substantial losses, and the SEC just launched a probe “requesting information regarding the company’s liquidity, cash position, and debt and equity financing.”

The stark reality for brick-and-mortar retailers is that there currently are just too many stores. Remember, these retailers have very high levels of operating leverage, and a meaningful decline in sales can quickly render them unprofitable and eventually unviable. And $30 billion in lost sales is most definitely a meaningful decline in sales. It’s not surprising that few retailers are opening new locations, and that a large number are shuttering existing ones.

The retail world is changing, and we’re seeing creative destruction play out before our eyes. And the speed at which it is happening is absolutely stunning. UPS and FedEx had better start building out their fleets, big time — these trends are only accelerating.

This post originally appeared in Re/code.

I’ve had Amazon on my mind lately, part of which is due to my reading Brad Stone’s very interesting book, The Everything Store: Jeff Bezos and the Age of Amazon.

I’ve described in earlier blog posts how Amazon is a brutal competitor for brick and mortar merchants due to their large and growing cost advantages and a maniacal commitment (at least most of the time) to having the lowest prices anywhere.  (You can read more about it here.)  These same drivers also make Amazon a heavyweight competitor for e-commerce companies as well.

Much attention has been paid to the concept of “show-rooming” in the context of brick and mortar stores, where customers use their smart phones to compare the cost of a product on a physical store’s shelf against online competitors—typically Amazon.  But show-rooming is also a fact of life for e-tailers due to the ease of comparing online prices.  As a result, Amazon is a monster competitor for online merchants as well.

Amazon enjoys scale economies far beyond that of their online competition that they can use to support hyper-aggressive prices and fast, cheap shipping.  Here is a simple illustration of their scale, using data from Internet Retailer:

top 50 e-retailers

Amazon is larger than the next dozen largest e-tailers—COMBINED!  Its resulting scale advantages are staggering.  And they aggressively re-invest the benefits of this scale into even lower prices and faster, cheaper shipping that in turn lead to growth and further scale advantages.  When we consider an e-commerce investment at a16z, we always strive to carefully evaluate the risk of competition from Amazon.  They’re not just a heavyweight—they’re the heavyweight champion of the world!

So how do you compete with Amazon?  Here are some strategies that we’re seeing in the market from both offline and online retailers.  Not all are mutually exclusive—i.e., many companies deploy multiple strategies:

Sell differentiated product:

Amazon’s sales skew very heavily towards “hard-lines”, things like media, electronics, home & garden, and toys.  Most best-selling hard-line products are produced by large manufacturers who market them heavily and distribute them broadly through multiple retail channels.  They are essentially commodities, identified by a standardized Universal Product Code (aka, U.P.C.).  An example is a Canon digital camera; once Canon’s ads convince you that you might want a Canon camera, you know you can shop for it pretty much anywhere.  And for most commodities, price is the key differentiator.  Consumers know that Amazon almost always has the lowest prices, along with free and fast shipping.

Many retailers try to “hit ‘em where they ain’t” and sell in categories where Amazon is less dominant.  Soft-lines is an obvious one; while Amazon is trying to build up this business, they have not achieved anywhere near the dominance that they have on the hard-line side.  Online companies like NastyGal and Zappos (before their acquisition by Amazon) and offline companies like Nordstrom and Neiman Marcus have successfully pursued soft-line strategies and have managed to weather competition from Amazon relatively well.  Another example is home improvement retailers, where a combination of products that “I need today” and/or bulky or heavy items are less suited to online distribution.

A related strategy is to feature products from companies that typically are not distributed or searched for on Amazon.  a16z has two investments in companies that primarily sell goods from a long tail of designers that lack extensive national distribution.  zulily does this in kids’ and moms’ apparel, and Fab does this in design.  These designers’ unique products are typically not found through Amazon’s search engine as they lack broad awareness.

Develop your own products:

Many retailers seek to compete with Amazon by developing their own products.  These products can be largely insulated from direct price comparison as they are proprietary and the producing company can elect not to have them sold by other online retailers.  A number of the best performing offline chains pursue this strategy including Lululemon and Victoria’s Secret.  It is also being pursued by a new breed of online retailers such as Chloe & Isabel in jewelry, Julep in cosmetics, ShoeDazzle in women’s shoes and Poppin in office goods (note: Andreessen Horowitz is an investor in Julep and ShoeDazzle).  While it’s clearly much more work to design and source your own product, retailers who do are often rewarded with higher gross margins as they both cut out expensive middlemen and avoid head-to-head price competition.

Merchandise product differently:

Amazon.com at its core is a search engine for products.  They are strongest where consumers know pretty much exactly what they are looking for, and the predominant way to find that on Amazon is the ubiquitous search box.  Merchandising on Amazon is almost completely algorithmic—things like others searching for ‘x’ also looked at ‘y’ and ‘z’.  I know of very few folks who browse Amazon in the traditional merchandising sense of the word.

One tactic a number of companies are employing to compete with Amazon is to build a great browse experience, showing consumers a targeted assortment of attractively displayed products. Offline retailers historically have done this through beautiful window displays and their in-store end caps.  And a new breed of online merchants is doing this, too, although it’s often referred to as “curation”.  And price is not typically top of mind during these impulse purchases.

Deploy alternative distribution strategies:

A number of online retailers are trying to put themselves directly in front of consumers before they think to consider searching for that product on Amazon. “Flash sales” companies like One Kings Lane and The Clymb send a daily email that merchandises a compelling assortment of goods at attractive prices.  Other companies like Birch Box or Trunk Club are employing a subscription model that sends you a highly curated selection of product, typically on a monthly basis.

Leverage unique advantages:

Brick and mortar retailers are disadvantaged with respect to costs relative to Amazon due to higher real estate, labor and inventory costs.  But a number of merchants are trying to flip this disadvantage on its head and leverage their network of local stores.  Wal-Mart for a while has enabled consumers to pick up online orders at their local store on the day it was ordered.  Last holiday season, they launched a test of same-day delivery for online orders from their stores in a number of cities.  Both take advantage of Wal-Mart having inventory in geographically dispersed stores.  And in a creative twist, they are considering crowdsourcing their local, same-day delivery to their customers, who would receive discounts on their shopping bill in exchange for their efforts.  Alternatively, Williams-Sonoma has used both their store locations and their catalogs to aggressively build their online business.  They have been willing to cannibalize themselves, believing rightly that someone else will do it if they don’t.  Over 40% of their revenue now comes through the online channel.

It’s clear that e-commerce is highly advantaged vis-à-vis offline retail and will continue to gain share.  The more interesting question to me is how e-commerce companies will compete with the heavyweight champ Amazon.  Amazon will always be able to pummel other e-tailers on price and probably on shipping as their scale advantages are virtually unassailable.  Companies that hope to compete with them successfully have to adopt different tactics.  Similar to when Cassius Clay (now Muhammad Ali) prepared to fight the then reigning heavyweight champion Sonny Liston, they’re going to need to “float like a butterfly, sting like a bee”!

Amazon and Google are on a collision course.

When I was at eBay, we had a belief that no one was going to compete with us by replicating exactly what we were doing.  We had first mover advantages and network effects.  Amazon and Yahoo! both launched auction marketplaces in response to eBay’s strong growth, and both businesses were essentially DOA.  What did concern us was that someone would compete with us with a new, disruptive approach—a completely different take on the business.

Early on, we came to believe that Google’s emerging search business was the biggest threat that eBay faced.  eBay helped users find hard-to-find, unique products.  Google’s goal of organizing the world’s information also helped users find hard-to-find, unique products.  The mechanisms and models were different, but the overlap was clear and we came to view Google as our top competitive threat.

This thought was validated after the fact by then-Google executive Sheryl Sandberg.  We both were guest speakers at the same Intuit event a few years back, and I stayed after my talk to listen to Sheryl.  In response to a question, Sheryl said something along the lines of, “We knew early on at Google that our key competitor was eBay.”  I almost jumped to my feet shouting, “I knew it!”  It did not make me feel any better that eBay was one of Google’s very top advertisers at the time, and that we were paying them tons of money that they were in turn using to compete with us.

In Google’s case today, I am becoming increasingly convinced that their most challenging competitor isn’t another search engine like Yahoo!, Bing, Baidu or Yahoo! Japan.  It’s Amazon, which is bringing a completely different take on search—in this case, product search.

Amazon is a vertical search engine focused on helping users find products.  The overwhelmingly dominant way to find things on their site is the search box.  Users enter a keyword phrase and are presented with results that match his or her query.   The order of the search results is determined by algorithms that seek to optimize relevance and monetization.  Sound familiar?

In my personal website use, I increasingly find myself searching for products on Amazon instead of Google.  Shopping on Amazon is a superior user experience and it runs the table on the magical retailer formula of selection, price and convenience.  It has an increasingly comprehensive product assortment, with their ever-expanding direct sales supplemented by third-party merchants who sell on the platform.  Prices are almost always extremely competitive, so much so that I have pretty much stopped using Google to comparison-shop at different merchants.  And it offers the fastest and most cost effective shipping solutions, particularly in Prime (which has the interesting impact of making me want to buy goods on Amazon to make sure I get the most out of my $79/year Prime membership).  I can buy an item on Amazon in a minute, secure in the knowledge that I’m likely paying the lowest price while getting free shipping and fast delivery.

Contrast that with the shopping experience on Google.  Shopping on Google is work.  It has infinite selection…if you can manage to find what you’re looking for amidst the forest of search results.  You have to work to find the best price, typically by pogo-ing in and out of different search results to check both prices and shipping costs.  And when you find a product you want to buy from a new merchant, you need to enter all the payment and shipping information from scratch.  Buying on Google takes chunks of an hour, not an Amazon minute.

Apparently, lots of consumers are behaving like me.  Amazon is on a growth tear and is rapidly gaining share of e-commerce.  A quick calculation suggests its $35 billion of 2012 net sales in North America represented a whopping 16% market share of total North American e-commerce.  And this probably understates their true position.  Amazon’s revenue recognition policies allow them to record only the commission and shipping fees on sales by third-party merchants as revenue.  If you were to consider the actual consumer spend (comparable to eBay’s Gross Merchandise Volume number), then their share would be substantially higher.

E-commerce merchants now also have a very viable advertising alternative to Google: they can list their products for sale on Amazon through the Amazon Marketplace program.  Amazon is currently generating billions of dollars in sales for these merchants, and these third-party sales are growing significantly faster than Amazon’s direct business.  Merchants typically migrate to where customers are, and the customers increasingly are on Amazon.

This has to be a very big deal for Google.  Virtually all of Google’s revenue comes from advertising ($44 of $46 billion in 2012, excluding the Motorola acquisition), and the majority of that comes from search.  And possibly their largest advertising category is shopping.  Google doesn’t release information on their largest advertisers, but it’s become a sport for third parties to reverse-engineer the results.  Take a look at a recent effort by Wordstream in the chart below.  They report that four of Google’s largest 10 categories are different segments of retail in which Amazon competes, and that many of Google’s largest advertisers are retailers:

Wordstream

Given this context, it’s not surprising that Google has been hard at work on product search.  They recently completed a revamp of their product search results and have significantly enhanced its prominence.  Check out this search for a Canon EOS 7D, a high-end camera.

They have also announced new initiatives that at first blush appear atypical for a search company:

  • In the past few months, Google has launched a test of a same-day delivery service called Google Shopping Express in San Francisco.  It’s free for the first six months, and already includes merchants such as Target, Staples, Toys-R-Us and Walgreens.
  • Through Google BufferBox, Google has plans to place secure boxes in convenient locations throughout a city to which you can have parcels shipped to for easy pickup.  They just launched their first location in San Francisco, with many more likely to come.

These initiatives are not about organizing the world’s information, they’re about enhancing the shipping experience on products bought through Google.  It’s part of Google’s effort to shore up their start-to-finish shopping experience, trying to bridge their rapidly growing gaps with the hyper-aggressive Amazon and protect their multi-billion dollar advertising business with retailers.

Interestingly, this competition could be used to help explain one of what I initially considered to be Amazon’s more unusual efforts, A9.  According to their website, A9 “manage(s) critical capabilities – high availability, cross-platform, scalable products search and an advertising platform that serves advertisers and publishers alike – for our parent company Amazon and other clients.”  If I’d read this statement without the company being identified, then I’d have assumed they were describing Google.

E-commerce is clearly the future of retail and there is a growing battle brewing for dominance in this new world.  Amazon is bringing a vibrant alternative to product search and they’re threatening one of Google’s core businesses.  Google’s market cap as of this writing is $272 billion, while Amazon’s is $113 billion.  Godzilla is going to war with Mothra and it promises to be very interesting to watch!

We at a16z believe we are seeing the “creative destruction” of traditional physical retailers by their online competitors.  At a high level, this is happening for two reasons.  First, e-commerce companies are substantially advantaged in terms of cost structures, particularly in areas like real estate, labor and inventory.  Second, we believe that we’re seeing an explosion in innovation among online retailers that we refer to as “e-commerce 2.0“—where companies are innovating across numerous dimensions including sourcing, curation, distribution models and social marketing.

On Thursday, Julep, a fast growing online beauty brand out of Seattle, announced that Andreessen Horowitz led their $10.3 million Series B round (here).  There’s a whole lot we like about Julep:

  • They are participating in a very attractive market: the beauty category.  The market is huge, with global sales estimated at $160 billion, and we believe it’s ripe for disruption by online competition.  Offline beauty moves slowly and is expensive.  Brands are distributed largely through department stores, where the brands must rent real estate, hire staff and fill the space with inventory.  Product refreshes typically happen twice a year, and retailers demand the brands support their products with large marketing campaigns.  Online beauty competitors are freed from these costs and constraints of their offline rivals.  Julep sources their own products and their ability to deliver new product constantly help them stay current with fashion trends.  And their direct-to-consumer relationships help them largely avoid the very expensive offline channel costs.
  • Julep is run by a very determined team.  Founder and CEO Jane Park and Chief Experience Officer and COO Kate MacDonald started the business by operating four nail polish parlors in the Seattle area to get hands-on customer knowledge and feedback.  They managed to secure physical distribution through Sephora and QVC for their early stage company to help establish their brand.  They are well along the way in building out a vibrant Web presence.  Jane and Kate are completely driven to develop a world-class beauty brand.
  • They have developed a very innovative business model, selling both subscriptions and a la carte product side-by-side.  This is hard to do.  Typically, many people won’t sign up for the commitment of a subscription if the same product is available without that commitment.  But Julep provides meaningful discounts on their products through the subscription channel relative to a la carte pricing, providing an incentive for women to delight themselves with their monthly Julep care package.

The company is off to a very strong start.  The products are great—as my 18-year-old daughter Ali tells me constantly.  Part of my diligence was bringing her home a care package of Julep products—I was a very popular father that evening!  Their brand is out-sized to the stage of the business.  For example, they were selected as one of Oprah’s “Favorite Things” of 2012, a highly coveted endorsement for any brand.  As a result, their growth trajectory has been extremely impressive.

Julep is a perfect example of an e-commerce 2.0 retailer:

  • They source their own product, which allows them to offer consumers strong value while retaining attractive margins.
  • They carefully curate the product assortment in their monthly subscriptions, tailoring them to the different style preferences of their customers.
  • They adroitly leverage the subscription business model.
  • They empower their passionate community of users to spread their enthusiasm through social channels, helping to build their brand and customer base.

We believe the next generation of great retail brands will be built online, and we believe Julep is well on their way to becoming one of these brands.

I’m also delighted to announce that Spencer Rascoff will join the Julep board.  Spencer is CEO of Seattle-based Zillow, one of the largest Internet real estate businesses.  I first met him when I served on the board of Hotwire, an Internet travel business that Spencer co-founded. He is an experienced, extremely talented Internet executive and a very good guy.  We’re delighted to have the benefit of his talents at Julep.

Online is clearly taking share from brick and mortar…this is likely to continue
—International Council of Shopping Centers, last week

America has too many malls.

I’ve recently blogged that many traditional brick-and-mortar retailers are being threatened with “economic destruction” by their advantaged online competition.  In an interview with Bloomberg TV, anchorwoman Nicole Lapin asked about the implications of this dynamic on retail real estate.  I said I hadn’t studied it, but I thought the ramifications would be very big and very negative (I believe the phrase “apocalyptic” was used).

I’ve since had the opportunity to spend some time looking at this issue, and I believe we’re seeing clear signs that the e-commerce revolution is seriously impacting commercial real estate.  Online retailers are relentlessly gaining share in many retail categories, and offline players are fighting for progressively smaller pieces of the retail pie.  A number of physical retailers have already succumbed to online competition including Circuit City, Borders, CompUSA, Tower Records and Blockbuster, and many others are showing signs of serious economic distress.  These mall and shopping center stalwarts are closing stores by the thousands, and there are few large physical chains opening stores to take their place.  Yet the quantity of commercial real estate targeting retail continues to grow, albeit slowly.  Rapidly declining demand for real estate amid growing supply is a recipe for financial disaster.

There are very few thriving physical retailers these days outside of the daily consumables markets.  I did a quick analysis on the high-level health of the National Retail Federation’s list of the Top 100 retailers in 2012, focusing on merchandise retailers that would likely be located in malls (removing grocery, drug, restaurant and online retailers).  I looked at three measures of retailer health: total sales growth, comp store sales growth and number of stores.

Stores.org Top 100 Retailers

The analysis doesn’t paint a very pretty picture regarding the health of the leading physical retailers in the United States.  Total sales growth is mixed and is negative for 20% of the sample.  Comp store sales growth—arguably the key measure of retailer health—is also mixed and a quarter of the sample is negative.  And note that many of these sales results include the retailers’ online segments, so the picture for their physical stores is even worse.  Lastly, store counts are simply stagnant—about as many top retailers shrank their store count as expanded it, and precious few are expanding aggressively.  The largest retailers in the U.S. do not look very healthy.  And if they’re struggling, it’s likely that their more marginal physical competitors are struggling even more.

I went back to the Top 100 retailers in 2007 to see how that crop had fared five years later and found that four of these top retailers had already gone away through Chapter 11.  Interestingly, the picture of these four doesn’t look that different than the 2012 list.

2007 chart

Source: Stores.org Top 100 Retailers

This declining retailer health is directly impacting malls and shopping centers in the form of very high vacancy rates and sluggish rents—exactly what you’d expect to see where supply exceeds demand.  Both factors deteriorated quickly during the economic crisis of 2008-09, but they’ve shown virtually no improvement since in spite of improved economic conditions.  The recession was the catalyst, but competition from online retailers can only be the continued driver.  The mall business isn’t very healthy either.

Regional Mall Trends

Neighborhood and Community Center Trends

These trends are hitting the market capitalizations of most of the largest owners of retail real estate.  Simon, General Growth, DDR and Kimco between them own over 600 MILLION square feet of U.S. retail real estate, according to nreionline.  Simon’s stock has performed strongly, but the other three stocks have created virtually no value over the past decade.

Stock Performance

Source: Yahoo! Finance

Most real estate professionals understand that profound changes are afoot.  Don Wood, CEO of Federal Realty Investment Trust, says  “there is too much retail supply in this country.”  The Wall Street Journal reports “Green Street Advisor, an analysis firm that tracks REITs, has forecast that 10% of the roughly 1,000 large malls in the U.S. will fail within the next 10 years and be converted into something with far less retail.  That’s a conservative estimate; many mall CEOs predict the attrition rate will be higher”.  And Daniel Hurwitz, president and CEO of DDR, observes, “I don’t think we’re overbuilt, I think we’re under-demolished.”

I agree with the above perspectives, although I believe they likely understate the eventual impact on malls.  A report from Co-Star observes that there are more than 200 malls with over 250,000 square feet that have vacancy rates of 35% or higher, a “clear marker for shopping center distress.”  These malls are becoming ghost towns.  They are not viable now and will only get less so as online continues to steal retail sales from brick-and-mortar stores.  Continued bankruptcies among historic mall anchors will increase the pressure on these marginal malls, as will store closures from retailers working to optimize their business.  Hundreds of malls will soon need to be repurposed or demolished.  Strong malls will stay strong for a while, as retailers are willing to pay for traffic and customers from failed malls seek offline alternatives, but even they stand in the path of the shift of retail spending from offline to online.

This in turn creates further opportunity for online commerce.  If I were thinking of starting a new retail brand right now, I would unquestionably start it online.  And many very talented entrepreneurs are doing just this! I personally shop at Bonobos for pants, J.Hilburn for sweaters, Ledbury for shirts and Warby Parker for eyeglasses.  All of these brands design and source their own goods.  They historically would have started in the mall but they now are starting online, a trend that will undoubtedly continue.  There clearly will be fewer new offline retailers to take the space vacated by the disappearing brick-and-mortar chains, further pressuring malls.

And in an ironic turn, many of these online brands are experimenting with offline stores—but typically with some important twists.  Bonobos and Warby Parker have built showrooms in their New York offices where consumers can come in and try on samples.  But if the consumer wants to purchase items, then the companies fulfill the product from their warehouses—they don’t stock inventory in their “stores”.  Bonobos has expanded this concept into a few additional locations, but not mall locations.  Instead, they are selecting lower cost, non-mall locations and using emails to their online customers to drive folks to these locations.  They do this because a consumer’s purchasing typically expands after a visit to their physical store, and the costs are not high given the lack of inventory and lower rents and staffing costs.  If this trend expands, it will provide further challenges to malls.

In researching this post, I came across a fascinating (and slightly morbid) website called deadmalls.com, a site that chronicles the tales of hundreds of already or soon-to-be dead malls.  Co-founder Brian Florence writes, “I started deadmalls.com with my friend Peter Blackbird in 2000 when we both realized that Pete had mountains of data about dead and dying malls stuck up in his head.  Why keep this information to yourself?  And, realizing the burgeoning power of the Internet and its ability to draw in more information, the site was created to harness stories of woe and merriment from others.  It’s been a great success.”

Unfortunately for mall owners, the content on deadmalls.com is about to expand substantially.  There just are too many malls in America, and this will only get worse.

Competition, send ‘em south.
If they’re gonna drown put a hose in their mouth
Mark Knopfler, Boom Like That

If you’re a physical retailer and you sell the same SKU’s as Amazon, you will not have a Happy Holiday this season.

Starting with the hoopla around Black Friday and Cyber Monday, the media has been full of stories on how physical retailers plan to beat back the competitive pressure from online retailers (for example, Wall Street Journal and CBS News).  They detail a number of strategies, such as expanding their hours, guaranteeing to match lower online prices, offering customized shopping apps and trying to build up their own online businesses.  Unfortunately, these strategies are destined to fail for many of these physical retailers.

The reason?  They are burdened with an inferior business model.  I’ve described in a previous blog post how creative destruction has happened in retail in recent decades, with independent retailers giving way to chain store retailers, who in turn gave way to big box retailers, who in turn are in the process of giving way to online retailers.  Physical retailers are not inept; they’re cemented to a business model that is uncompetitive.

It’s long been conventional wisdom in retail that the keys to a retailer’s value proposition are how they deliver on three core tenets: price, selection and convenience.  Let’s compare physical retailers to their online counterparts on each metric.

Price

Selling through brick-and-mortar stores is substantially more expensive than selling through online channels due to multiple factors.  Let’s compare one of the most economically efficient physical retailers, Best Buy, with its most significant online competitor, Amazon.

  • Real estate expense: Best Buy sells primarily through over 4,000 brick-and-mortar stores (as of the end of their 2012 fiscal year) that cost them billions in capital costs and over a billion a year in rent.  Amazon avoids store investment entirely.  Cost advantage: Amazon.
  • People expense: Best Buy needs to staff all of these stores with employees; their total headcount as of year-end FY2012 was 167,000.  Amazon doesn’t.  Best Buy’s revenue per employee in 2012 was $0.3 mil, whereas Amazon’s was $0.9 mil.  Cost advantage: Amazon.
  • Inventory: Best Buy needs to fill each of these 4,000+ stores with inventory, whereas Amazon keeps their inventory concentrated in a network of 70-80 fulfillment centers.  Best Buy turns their almost $6 billion of inventory an impressive 8.7x per year, but Amazon’s centralization enables them to do it at an even more impressive 10.3x.  Cost advantage: Amazon.

Each of these is a multi-billion dollar item, and Best Buy is disadvantaged on every one.  There’s no way they can compete with Amazon on price if Amazon is motivated to have the lowest price.  And Amazon is maniacally committed to having the lowest prices.  They scour their online competitors constantly throughout the day, dynamically adjusting their prices in response to competitors’ changes to make sure they are the lowest (see: New York Times).

Amazon participates in a number of business segments.  They sell physical products and digital downloads themselves, get commissions/fees on the sale of physical product by third parties, sell advertising and promotions on their site, offer Amazon Web Services, manufacture hardware like Kindles, etc.  They report a consolidated gross margin of 22%, but provide scant financial detail beyond this.  A few different equity analysts have made noble attempts to disaggregate Amazon’s reporting into its component parts.  They’ve observed that many of their ancillary businesses are quite high margin, which Amazon in turn uses to aggressively subsidize their core business.  These analysts estimate Amazon’s gross margin on physical products to be between 12-16%, an astonishingly low number.  As a point of comparison, Best Buy’s gross margins last year were about 25%, as were Wal-Mart’s.  The net result: Amazon’s gross margins on apples-to-apples products are about half of the gross margins of two of the most price competitive physical retailers.  Amazon is a brutal competitor—and I mean that as a compliment!

The strategy of physical retailers trying to price-match Amazon is absolutely doomed to fail.  A physical retailer loses lots of money charging the same price as a substantially cost-advantaged, ultra-price-competitive Amazon.  Any incremental sales will likely be offset by cannibalizing the prices paid by their “loyal” customers.  Pricing is a battle that physical retailers cannot win.

And what’s more, their higher physical cost structure completely hamstrings their efforts to compete online.  I haven’t yet met a physical retailer that is comfortable offering products at lower costs through their online channel than through their physical channel.  They are doomed before they even start.  It shouldn’t be surprising then that Best Buy’s online business in the U.S. accounts for only 5% of their total, nor that it’s 1/18th the size of Amazon’s.

Selection

A physical store is constrained in the breadth of inventory they can carry by the size of their store.  An online retailer is constrained on breadth by the size of their warehouses.  Amazon can keep a staggeringly large breadth of inventory in their 44 million square feet of fulfillment space, and they even supplement that through a network ofthird party merchants that list their inventory for sale on Amazon.  Selection advantage: Amazon.  They truly offer the “Earth’s Biggest Selection”.

The strength of the selection advantage of online retailers really hit home when we were doing diligence on our investment in Fanatics.com, a large online business that sells licensed sports apparel and merchandise.  If you search online for licensed sports stuff, you’ll likely encounter a Fanatics-owned website.  Fanatics.com has the ability to stock a vastly broader range of sports apparel and merchandise than virtually any physical retailer possibly could.  Take the example of my hometown San Francisco 49ers.  One can often buy the player jersey of a few of the 49ers stars at the local mall.  But on the Fanatics-run NFL Shop, you can buy the uniform of every player on the team—in multiple colors and most every size (see: 49er Uniforms).  They have 11 different jersey styles for star running back Frank Gore— including men’s, women’s, youth and even newborn styles!  There’s no physical store in the Bay Area that can hope to match this selection.  And if you cheer for a team from another city, you haven’t got a prayer of finding your favorite player’s jersey at physical retail.

Convenience

The one area that physical retailers have historically had an advantage over their online rivals is in convenience.  If you want or need something today, your only option has been to drive to your local store.  Physical retailers typically open multiple brick-and-mortar stores to make that drive as short as possible.  Convenience advantage: Best Buy.

But this advantage is eroding, again driven by Amazon.  With their Prime service, you get free two-day shipping and discounted one-day shipping for a flat annual fee.  Prime helps to close the convenience gap, and its share of Amazon’s sales is growing rapidly.  Other e-commerce companies are following suit, many aided by Shoprunner.com.

And online companies aren’t stopping there—they’re shooting for convenience parity.  A number of very large companies are trialing same-day delivery of online orders.  Amazon (again) is being very aggressive here, building out a distributed network of fulfillment centers near major population hubs from which they’re starting to test same-day deliveryUSPS has announced a test in San Francisco.  Other companies are trying to leverage the locally-held inventory at physical stores to also offer same day delivery.  eBay has debuted an application called eBay Now, and Wal-Mart is testing same-day delivery from their stores in a number of citiesConvenience advantage: Best Buy… for now.

Online retailers have a greatly advantaged business model, and it’s little wonder they are rapidly gaining share of the retail pie.  Early holiday sales forecasts for online retailers seem to imply year-over-year growth rates in the mid-teens.  But the overall retail pie is not growing very fast of late; most holiday sales forecasts for this year are in the low single digits.  The piece of the pie left over for physical retailers is rapidly shrinking.  And what’s worse for them, competition from their online counterparts is starting to push them towards suicidal tactics like matching the prices of competitors that have much lower costs.  For many, this might be their last holiday season.

We at a16z could not possibly be more bullish on the prospects for e-commerce, and we believe growth is poised to accelerate.

Part of the reason for this is due to competitive market dynamics.  As I’ve blogged before, e-commerce players have substantial cost advantages over their physical competitors.  They are massively more efficient in terms of real estate and labor costs in particular, and as a result hold a significant pricing advantage over physical retailers.  Online is rapidly gaining share of retail spend across the majority of specialty retailing categories, shrinking the portion of the marketplace available to physical retailers.  These physical retailers have very high operating leverage and their P&L’s cannot withstand shrinking revenue.  The result has been physical stores dramatically downsizing or going bankrupt, which we believe will only increase going forward, clearing the playing field for their online rivals.

But another part of the reason is a renaissance in innovation among e-commerce players.  At a16z, we often refer to the early development of e-commerce as either “e-commerce 1.0” or “e-commerce for nerds”.  The typical shopping experience at both is that the user enters a keyword phrase into the search box, and the company tells you what they have that matches your query.  This era ended up being dominated by two on-line behemoths, Amazon and eBay.

At a16z, we’ve been delighted of late to see a surge in e-commerce innovation that we refer to alternatively as “e-commerce 2.0” or “e-commerce for everyone else”.  Talented entrepreneurs are trailblazing entirely new approaches to e-commerce, and many of these companies are being rewarded with explosive growth.  Some examples:

Direct Sourcing

E-commerce 1.0 consisted almost exclusively of retailers that distributed other companies’ goods.  These days, more and more e-commerce companies are designing and sourcing their own goods.  Often they are collapsing inefficient legacy supply chains by cutting out multiple intermediate layers.  One of my favorite examples of this is prescription eyeglass retailer Warby Parker.  They are bypassing a bloated, antiquated industry supply chain to offer high quality, high fashion eyeglasses that they design and source themselves at a fraction of the typical market cost (the mark-up on glasses sold at physical retailer in the U.S. can be 10-20x the cost of manufacturing).  Other examples are Bonobos in men’s pants, Bauble Bar and Chloe & Isabel in women’s jewelry, and Ledbury in men’s shirts.  We believe that new retail brands going forward will increasingly be built online, not in your local mall.  It’s just so much more efficient financially.

Curation

E-commerce 1.0 players typically display their available product as a search result, typically depicted as page after page of small product snapshots.  But many of their 2.0 counter-parts are re-inventing classic physical retail merchandising into the online space.  One of the leaders in this is Fab.com, one of our portfolio companies.  They do a phenomenal job of picking beautifully designed product and presenting it in a highly compelling way and in a consistent voice.  I’m not a big shopper but I love receiving my daily Fab email, and the steady flow of boxes from them delivered to my home is a running joke among my family.  Others who do a great job on this include NastyGal for young women’s apparel and AHALife for luxury lifestyle products.

Alternative Distribution

Innovative companies are developing alternative ways of distributing their products.  Selling physical product through subscriptions is becoming increasingly common and provides retailers with a fantastic way to keep consumer mindshare each month.  Companies like Dollar Shave Club typically send you a monthly shipment of product that they design and manufacture.  Others like Birchbox or Citrus Lane include products in their monthly shipments from companies that are interested in having you sample their wares.  Alternatively, companies like Stella & Dot and J. Hilburn are distributing their product through a network of representatives, who they support with technology.

Engagement

Many e-commerce 2.0 players strive to build very strong consumer loyalty and engagement, going above and beyond the specific commerce transaction.  They seek to delight their best customers by offering free shipping and returns and doing things like providing unexpected gifts in shipments.  Many consider their consumers as a “community”, and engage with them well beyond their orders, hosting meet-ups, providing supporting content, and doing real-world promotions and events.  One of my favorite community executions is RentTheRunway’s new “Our Runway” feature.  It allows their users to upload pictures of themselves wearing the dresses they rented onto the website, where they can be browsed by new users as part of the dress rental process.  Their community members have become their models!  And lastly, all of the 2.0 players seek to have contextually relevant integrations with today’s leading social platforms—Facebook, Pinterest and increasingly Instagram—taking their content into the daily lives of their users.

Event Sales

There’s been a proliferation of companies that offer online “flash sales” events, often offering significant savings on designer brands that have surplus inventory.  French Retailer Vente-Privee is usually credited with pioneering the category about a decade ago, and aggressive retailers like Gilt Group and Rue La La quickly followed.  A number of entrepreneurs took this concept and applied it to specific target markets, like One King’s Lane in home furnishings.

We believe that all of this innovation will only improve the competitive position of online players relative to their offline counterparts, contributing to accelerating e-commerce growth.  Consistent with this belief, a16z has made a number of investments in these e-commerce 2.0 retailers, including Fab and ShoeDazzle.  And today we’re proud to announce that we’re leading an $85 million round in zulily, an event sales site that offers daily deals for moms, babies and kids.

There are a number of things that attracted us to zulily:

  • The very talented founding team of Mark Vadon and Darrell Cavens have pulled off a singular feat: They are in the process of building their second, large, highly successful e-commerce franchise.  Mark was the founder and former CEO of Blue Nile, the largest online retailer of certified diamonds, engagement rings and fine jewelry, and Darrell was his head of technology and marketing (an intriguing combination of functions that I had never before encountered as an Internet executive).  At their encore zulily, Mark is chairman and Darrell is the CEO.
  • zulily is one of the fastest growing businesses we have ever encountered.  What is even more impressive is how they have done this: The company spent minimal capital to achieve this result.  But maybe that shouldn’t surprise us—they achieved similar results at Blue Nile.
  • zulily participates in enormous markets.  They started out offering kid’s apparel that moms bought.  But as they grew, they also realized that moms were interested in women’s apparel and hardline goods (e.g. housewares), and they now sell large quantities within these categories as well.
  • We are impressed with zulily’s strategic positioning.  One reality in e-commerce today is that you want to avoid trying to compete directly with Amazon, who is hyper-aggressive in leveraging their enormous scale and cost advantage to offer the largest selection and lowest prices on the Internet.  Like Fab, zulily does this by aggregating a long tail of talented designers who typically lack extensive national distribution.  These designers offer consumers strong value, but almost always make money on their zulily sales and highly value the channel.
  • We are also impressed with zulily’s execution.  They are as data-driven as any company we’ve encountered, and use it to great advantage in both marketing and merchandising.  They leverage technology adroitly to optimize the business.  And they’ve rapidly developed operational capabilities that have enabled their hyper-growth.

We believe we’re in the early stages of a revolution in retail, where inefficient physical businesses are giving way to highly efficient, innovate online ones.  We’re delighted to have the privilege of supporting the zulily team’s efforts to build (yet another!) iconic e-commerce franchise!

Joseph Schumpeter said in his theory of “creative destruction” that the “process of industrial mutation…incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.”

I believe we’re approaching a sea change in retail where physical retail is displaced by e-commerce in a multitude of categories.  The argument at a high level:

  • Online retail is relentlessly taking share in many specialty retail categories, resulting in total dollars available to physical retailers stagnating or even declining.  This is starting to put intense pressure on their top lines.
  • Physical retailers are very highly leveraged and often have narrow profit margins.  Material declines in their top lines make them unprofitable and quickly bankrupt.
  • Online retail will benefit greatly from the elimination of their physical competition and their growth should accelerate.

Let’s start with the historical context.  What’s been happening in retail in recent decades is a perfect example of creative destruction in action.  In a little over a half century, multiple generations of specialty retailing concepts have been created and subsequently destroyed.  The widespread building of large suburban shopping malls after World War II led to the development of the specialty retail chain store, at the expense of independent, sub-scale “Main Street” retailers.  A few decades later, many of these mall-based specialty retail chains were in turn crushed by the development of “big box” retailers, who had had substantial cost, pricing and selection advantages.  And currently, many of these big box retailers have been in turn devastated by the rise of e-commerce and its substantial capital and cost advantages.  E-tailers don’t need to build, rent, stock and staff a large chain of individual stores; instead, they enjoy significant efficiencies from centralization.  An example of their relative efficiency can be seen in labor: Revenue per employee for Amazon is $0.9 million per year vs. $0.2 million at Wal-Mart.

Book retail provides a good example of this evolution.  Independent bookstores gave way to mall-based chains like B. Dalton and Waldenbooks in the 1960-70’s, who in turn gave way to big box chains like Barnes & Noble and Borders in the 1980’s, who in turn are giving way to e-commerce players (particularly Amazon).  B. Dalton, Waldenbooks and Borders are now out of business, and Barnes & Noble is struggling to morph itself into an e-commerce and e-book company before its physical bookstore business evaporates.

I believe that the demise of physical bookstores is just the canary in the coalmine for all of the big box players, and that the same creative destruction will play out across specialty retail.  It’s already happened in music and video retail: Tower Records, Virgin Music and Blockbuster Video are all history.  And it’s starting to happen in other categories.

The steady, relentless share gains of e-commerce have been widely documented.  According to the U.S. Census Bureau, e-commerce had grown to 7% of total retail by 2010.  But there is wide variation in online share by category:

Source: U.S. Census Bureau, Annual Retail Trade Survey

The large “supermarket” categories of Food & Beverage and Health & Personal Care have tiny online participation, but the specialty retail categories have large and rapidly growing online shares.  And the huge category buckets reported by the U.S. Census probably obscure the magnitude of some of the share impacts.  For example, the bulky, heavy appliances in the “Electronics and Appliance” bucket probably haven’t gone online as fast as electronics, suggesting that online share in electronics is probably much higher.

And things get even more interesting when you look at this in terms of dollars, such as in the Electronics and Appliance bucket:

Source: U.S. Census Bureau, Annual Retail Trade Survey

Total category sales have stalled over the past half decade, likely impacted by the housing bust.  But the steady growth of online is causing the portion of the market available to offline retailers to be substantially pressured.  Total offline sales among all Electronics and Appliance retailers were lower in 2010 than they were in 2004!

So, imagine you are Best Buy.  They are the leading electronics retailer in the U.S., and they also sell computers, media and appliances.  They historically have been among the most innovative and successful of the big box retailers, and were named “specialty retailer of the decade” in 2001 by Discount Store News. Between 1998 and 2008, they ripped off 10 straight years of positive comp store sales growth; compounded, their comp store sales were up a staggering 75% over this period.

But as we see above, the portion of the market available to offline retailers in Best Buy’s verticals is shrinking due to withering competition from online players with substantial price and selection advantages, exacerbated by “show-rooming” enabled by mobile devices (see my previous post about Belly).  Best Buy’s amazing 10-year run in comp store sales growth screeched to a halt in 2009, and they’ve had negative results three of the past four years. Many of their offline competitors have already gone out of business, as No. 2 player Circuit City did in 2009.

You get a sense for the hurricane that Best Buy is trying to navigate when you look at their performance by category:

Two-year
Compounded
Comp Store

Ending
Revenue

Category

Change

Mix

Consumer Electronics

(11%)

34%

Computing and Mobile Phones

2%

43%

Entertainment

(37%)

9%

Appliances

13%

6%

Services

2%

7%

Other

1%

Total

(7%)

100%

Source: Best Buy

It’s flat out brutal when your #1 and #3 categories have dropped 11% and 37% respectively in just two years.

Once upon a time, I was CFO of The Disney Stores Worldwide.  One thing I learned there is that physical retail is very highly leveraged as a massive chunk of the expense structure is fixed.  Each store typically has a long-term lease with fixed rent payments and requires minimum staffing and inventory to operate.  And stores require warehouses and trucking fleets to house and transport inventory, and central staffs to manage it all.  Due to these high fixed costs, even small changes in comp store sales can enormously impact profitability.  I experienced this in vivid detail at The Disney Store.  We enjoyed record profits behind surging merchandise sales for the run-away hit “The Lion King” in 1994, but the following year’s results were hammered by anemic product sales for the much-less-successful “Pocahontas”.

Relatively small declines in comp store sales, if sustained, can quickly prove fatal to physical retailers due to this leverage.  The Circuit City example is instructive here. Their bankruptcy was preceded by just six quarters of declining comp store sales.  They essentially broke even in their fiscal year ending in February 2007; they declared bankruptcy in November 2008 and started liquidating in January 2009.  It is also notable that Circuit City’s bankruptcy has had only modest benefit to Best Buy, as did Borders’ bankruptcy for Barnes & Noble.  Not even the elimination of the largest competitor provides material reprieve from brutal market headwinds.

Here is the case for e-commerce acceleration.  Continued share gains by e-commerce players shrink the pie available to physical retailers.  Marginal physical players go bust, providing only a temporary boost to the remaining offline players and a sustaining boost to online players.  But the underlying market dynamics stay the same, and pressure again builds on the remaining physical players.  When their top-lines drift below their highly leveraged water lines, they too drown and liquidate.  At that point, e-commerce becomes about the only place where consumers seeking a broad selection of merchandise can go.  They essentially run unopposed.

This Darwinian struggle for survival has already played out in music and is in the last act in books and movies.  In electronics, Best Buy is the last man standing and the pressure is building.  They have virtually no margin for error as their operating margin is down to 2%.  When they succumb (and unfortunately for them, I believe this is a “when” and not an “if” unless they are able to pull off a radical transformation of their model), e-commerce will become the only place to find a comprehensive selection of electronic products.  And other specialty retail categories like apparel and home are not that far behind their media and electronics colleagues.

We’re extremely bullish on the prospects for e-commerce, and we’re very bearish on the prospects for offline retailers who compete head-to-head with them.  The implications are broad.  To paraphrase Schumpeter: We believe that offline retailers that cannot deliver a differentiated value proposition to consumers will be destroyed by a new generation of online retailers that is being created before our eyes.

On a final note… I’d like to thank my colleague Wei Lien Dang, who provided strong analytic support for this post.

Marc and Ben founded Andreessen Horowitz with some very explicit beliefs.  We would invest in Information Technology companies, and not in things medical, green or clean.  We would have a preference for companies with deep technical roots and innovations.  We would have one office, in Silicon Valley, and would not seek to invest in companies being incubated in places like China or India where we lacked expertise.  We would be stage-agnostic, seeking to invest in the best companies regardless of what round they were seeking.  And we would have a preference, all else equal, for companies being built in Silicon Valley.

The Silicon Valley focus is due to a couple of factors.  First, we are all believers in the power of the Silicon Valley ecosystem to incubate and grow new technology companies.  Just this week, the New York Times referred to it as “the world’s epicenter of innovation”.  We know of few places in the world that sport Silicon Valley’s combination of financial capital, intellectual capital, entrepreneurial and engineering talent and experience, and support infrastructure.  Many of the Internet’s most highly valued companies are from the Valley—Google, eBay, Yahoo, LinkedIn, Facebook and Zynga.  And the second factor is that local companies best leverage our most precious asset as investors, which is time.

Indeed, the majority of our investments have been based in Silicon Valley.  There have been exceptions—we are or have been involved in a handful of non-Valley companies such as Skype (Luxembourg), foursquare (New York) and Groupon (Chicago)—but the majority of our investments are in the Valley and all four of my Andreessen Horowitz investments (LikeALittle, Airbnb, Lookout and Pinterest) are within a 45-minute drive of each other.

With this as background, I’ve been encountering an unexpected finding as I’ve been looking at potential e-commerce investments in the U.S. (and note that I’m considering “marketplace” businesses like eBay and Airbnb as separate from e-commerce).  It strikes me that the majority of innovative new e-commerce businesses are being started outside of Silicon Valley.  There are some innovative local ones like One Kings Lane, Tiny Prints and Plum District, but the list outside of the Valley dwarfs the local list: Groupon and Trunk Club are in Chicago, ShoeDazzle and HauteLook in L.A., LivingSocial in Washington D.C., zulily in Seattle, J. Hilburn in Dallas and Hayneedle in Omaha.  And the epicenter for e-commerce innovation right now has to be New York City with companies like Birchbox, Bonobos, Diapers.com (in nearby New Jersey), Gilt Groupe, H.BLOOM, ideeli, Lot18, OpenSky, Rent the Runway and Warby Parker.  Just five months on the job and I’m already on a first-name basis with United Airlines and Virgin America crews on the SFO-JFK route.

What has driven this blizzard in e-commerce innovation in the Big Apple?  I must admit I’m not sure.  It could be because much of the nation’s fashion business is centered there, or because of Manhattan’s world-class retail infrastructure.  But it’s extremely impressive.

Given this preamble, it’s probably not a big surprise that we’re investing in an e-commerce company in New York and that company is Fab.com, a site that features daily design inspirations and sales at up to 70% off retail.  The Fab.com site was launched in June of this year and has taken off like a rocket.

We were attracted to Fab for a number of reasons:

  • The team is great.  The founder and CEO of Fab is Jason Goldberg, a talented serial entrepreneur who also founded socialmedian and Jobster.  His co-founder is Bradford Shellhammer, a fantastic merchant with a fabulous eye for design.  Their engineering function is led by Nishith and Deepa Shah, both talented technologists.
  • Their execution has been extremely impressive.  They’ve nailed the product: both the website itself and the merchandise assortment.  The site and mobile apps are beautiful and very easy to use, and Bradford’s merchandise team constantly finds beautiful, inspiring goods to offer to consumers, typically at attractive values.  They’ve leveraged social extremely effectively, sourcing over half of their users, and they leverage data as effectively as any company I’ve ever worked with—startup or not.
  • They are playing in a big market.  The umbrella of “design” allows them to offer merchandise across a wide variety of categories (such as home products, jewelry, artwork, apparel, workplace items, toys and outdoor products) and price points.  The Fab merchants scour the world to source product from a long tail of great designers who often struggle to gain national distribution, and designers love that Fab.com sales are profitable for them.
  • Their early traction is simply phenomenal.  Jason is extremely transparent with Fab.com’s business metrics and recently revealed that the company is averaging $200,000 in sales a day.  Not bad for a company that made their first sale in June.
  • They have a very big vision for where they want to take the business.

I’ve rapidly become a big Fab.com consumer, as the UPS man and my spouse can attest.  It’s as close to addicting as anything I’ve ever experienced in e-commerce.

Fab.com is an example of a new wave of highly innovative e-commerce companies; indeed, I believe there has been more e-commerce innovation in the past few years than at any time since the beginning of the Internet, and at Andreessen Horowitz, we need to update our assumption of Valley centricity, at least when it comes to e-commerce.  Fab.com joins my partner John O’Farrell’s investment in L.A.-based ShoeDazzle as examples in our portfolio of this trend.

Jason signs off on much of his correspondence with the phrase “smile, you’re designed to”.  We’re smiling from ear-to-ear at the prospect of partnering with Jason, Bradford and the Fab team to build a big, important e-commerce company.