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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.

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!