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. 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 about 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 noncompetitive.
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.
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 (BBY), with its most significant online competitor, Amazon (AMZN).
- 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 every time. 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 (WMT). 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.
Moreover, 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 one-eighteenth the size of Amazon’s.
A physical store is constrained in the breadth of inventory it can carry by virtue of size. An online retailer is constrained on breadth by the size of its 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. 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.
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.
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 delivery. USPS 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 cities. Convenience 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.
Jeff Jordan (@jeff_jordan) is a partner with venture capital firm Andreessen Horowitz. Previously he served as CEO of OpenTable (OPEN) and, before that, ran PayPal for eBay (EBAY). This post originally appeared on his blog.