The deflationary forces of online shopping

Today’s commentary

Today, I ran a story in the links on Best Buy which showed Best Buy’s share price getting savaged by poor earnings. I added the caveat that “This doesn’t mean that GDP growth was poor. It means that margins were bad in retail.” The interesting bit here is that the only other large national electronics retailer Circuit City went bankrupt and was liquidated in the last recession. So what we are seeing with Best Buy and the discounting is a relentless assault on margins in this space. The assault is not coming from other electronics retailers; they are too small or have been shuttered like CompUSA. What is happening to Best Buy is Amazon – and all the other online retailers like it.

Amazon doesn’t have to worry about expensive retail space. It just has to be an efficient warehouser and distributor because its business model piggybacks on the advanced delivery distribution systems of UPS and Fedex. Amazon is even branching out to US Postal Service weekend delivery and a fleet of other smaller private delivery companies. Their distribution network is awe-inspiring. This is one reason why the Vaporware Amazon CEO Jeff Bezos peddled on 60 Minutes about drone delivery caught everyone’s imagination. And in this past holiday shopping season, even Fedex and UPS had delivery snafus as the online shopping assault broke their delivery systems. That’s how much retail is being changed by the Internet.

Here’s the thing though. The Internet is about search, discovery, and specifically as it relates to retail price discovery. Nimble competitors win because they can respond to the relentless competition that instantaneous comparison shopping creates with business models geared to increasing margin despite the deflationary nature of Internet discovery on business. For example, Amazon is inventing an increasing number of customer lock-ins to ensure sales even when it doesn’t have the lowest price. Amazon’s free shipping program Amazon Prime is all about this lock-in. Amazon Subscribe and Save is also about locking customers in by getting them to switch to a repeat buy model for a perceived discount. Basic human psychology says that in both cases, customers will become less price sensitive allowing Amazon to benefit from margin increase in select product categories.

This is a crushing blow to the Best Buy’s of the world which heavily depend on physical retail locations. By comparison, hybrid companies like B&H Photo or J&R are interesting in terms of understanding Best Buy’s predicament. As a gadget guy, I have been using both J&R and B&H for at least 15 years. In the late 1980s, when telephone shopping and mail order were the equivalent of the Internet today, I started shopping at J&R Music World for stereo equipment, CDs and music accessories. They advertised their company in the back of stereo equipment magazines with other US electronics companies like Crutchfield. If you bought four or five of these magazines, you could get price comparisons from 20 or 30 companies for electronics. B&H always had good prices and exceptional reliability. So I often went with them. Having lived in New York City, I also went to J&R’s only retail store in Manhattan. It was a cramped, but bustling and high turnover place. But it was clear to me that mail order business was their bread and butter.

A few years later, I also started shopping at B&H photo via photography magazines. It was the same sort of thing with 20 or 30 companies hawking Nikons and Canon cameras and Tamron, Sigma and Tokina lenses. Names that stick out are Abe’s of Maine and B&H. Both were ubiquitious advertisers and both had excellent reliability. B&H has only one retail store on 34th Street and 10th Avenue. Like J&R, it is a small, factory like place that does seriously high turnover. But again, this is just one store. The heart of the organization was the mail order shop.

When the Internet came online, the likes of B&H and J&R went online. For UK readers, think Dabs Direct or Simply Computers or PC World. These companies were already virtual storefronts. All they needed to do was webify their presence. And that’s what they did. Best Buy, Circuit City, and CompUSA couldn’t compete against that because their retail stores meant that they had to sell at higher prices. What’s more is that it also forced these companies to sell at higher prices online as well in order to reduce channel conflict. Eventually, prices had to come down in retail stores to compete on the web – and this was fatal for Circuit City and CompUSA during the last recession. Best Buy is very vulnerable here in the next recession.

What are the key takeaways? For me, it is that recession weeds out retail stores. Big department stores and store chains succumb every recession. Next recession will be no different. That means the stocks of weaker players like JC Penney could go to zero. A second key takeaway here is that the assault on retail from the Internet began in easy to webify categories like electronics. But the assault will continue – and that makes retailers in other categories vulnerable. Monoline companies like Bed, Bath and Beyond can only survive by dominating their space in retail high streets and malls and online. What I anticipate will happen is that price discovery will continue to reduce margins in retail, leading to the heavy discounting we already saw this past holiday sales season. Retailers that cannot compete will see sales and earnings fall. When the next recession hits, some of these companies will fail. I expect a big shakeout in retail in the US in the next recession. Until then, it will be a big fight for share, with heavy discounts dominating the holiday season. Best Buy is a harbinger of what is to come elsewhere.