The Case for E-commerce Acceleration (aka, Bye Bye BBY?)

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:

1. 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.

2. Physical retailers are very highly leveraged and often have narrow profit margins.  Material declines in their top lines make them unprofitable and quickly bankrupt.

3. 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:

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.