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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.

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.