"Category killers," those highly focused retailers that specialize in a category of goods including Barnes & Noble, Best Buy, and Staples, were once the bane of mass-market retailers' existence. Their wide assortment, aggressive pricing, large stores, extensive store network, and deep expertise in the categories they served proved a massive competitive advantage.
“For mass-market retailers that can react quickly enough, this upheaval is survivable”
Today, however, these same distinguishing characteristics may prove to be the undoing of the big-box stores. We believe that retailing generally is at a tipping point, with category killers being the first significant casualties of the (r)evolution that is occurring. Retail store asset productivity has been in decline since the start of the recession in 2007, and we believe this trend will accelerate over the coming years.
For mass-market retailers that can see this trend coming and react quickly enough, this upheaval is survivable. But those slow to register the tsunami wave on the horizon stand to be swept away.
As retailing entered the new century, this slowing was hard to predict. Indeed, retail store asset productivity increased at an impressive pace in the early 2000s even though Internet sales in the United States grew dramatically. Retail sales advanced from $2.87 trillion to almost $4 trillion between 1999 and 2007. However, the current recession created many challenges for retailers: overall consumer spending has declined or held flat, and return on invested capital (ROIC) has suffered dramatically.
This decline in ROIC has been exacerbated by the significant growth in store square footage before the recession. Retail store count exploded through the mid-2000s, and the size of the prototypical store increased dramatically as well—retail square footage in the United States grew from 18.45 square feet per capita in 1999 to 23.06 square feet per capita in 2009. The hope among retailers (and commercial real-estate developers) was that as the recession faded and the economy began to grow again, retail productivity would improve—especially as the bricks-and-clicks retail model worked in an increasingly coordinated manner to offer the consumer a seamless shopping experience.
The Internet Threat
While recent retail sales figures seem to be comforting, this hope misses a very important trend. We believe retail asset productivity will not recover anytime soon.
The Internet has created a daunting situation for category killers, one that will eventually impact almost all of retail. The focus that made category killers so powerful in the 1980s and '90s is creating the conditions for their struggles in 2011.
In the early 2000s, e-commerce was seen as a threat to entire store formats such as grocery, music, and toy stores. But as consumer behavior evolved over the last decade and as supply chains improved, it became apparent that the danger to retail stores from online shopping was also at the item and category levels, which over time would destroy the economics of the entire store. Amazon.com and other e-commerce players did a tremendous job focusing on goods and categories that shoppers were now willing to buy via the Internet, such as books and consumer electronics.
This has left big-box stores in a very precarious situation. Because of their intense focus, these retailing giants have many fewer degrees of freedom to respond to the threat of e-commerce. For many, the economics of a store can suddenly become negative when 5 to 10 percent of their total floor space (in high-margin categories) becomes unproductive due to customers migrating to e-tailers. As entire sections of these stores die from online competition, category killers are being pressed to come up with solutions to keep their overall model afloat. The solutions so far haven't worked: over the last four years sales per square foot have not improved significantly since the depths of the recession—and the decline in ROIC is even more stunning for category killers.
“Best Buy and many similar businesses didn't see the bullet coming”
The inexorable adoption of technology by consumers has proven that e-commerce pioneers were ahead of their time. While sales in stores declined dramatically during the economic downturn, sales on the Internet continued upward, totaling $165 billion by the end of 2010. While still only 5 percent of the overall retail market, online sales have grown from a base of just $28 billion in 2000. At current growth rates, 2015 purchases via the Internet will likely exceed $250 billion.
Online sales tend to be highly concentrated in several categories, and are so significant that it is increasingly difficult for physical stores to justify allocating space for these products. As a result, retailers will need to reconfigure as vast spaces become unproductive.
The most obvious victims so far of this shift are music, video, and book retailers—these categories are virtually nonexistent outside the Internet channel. Barnes & Noble is continuously trying to find alternative uses for its retail space, as many areas of its stores fall below critical levels of retail productivity. But these are not the only categories that suffer from the consumer' embrace of e-commerce.
Best Buy, arguably a bricks-and-clicks monopolist in the electronics segment, is a prime example of this impact. With the demise of Circuit City in 2009 one would have reckoned that Best Buy's best days were ahead. Instead, Best Buy is working fiercely to reinvent itself: its comparable store sales have barely kept up with inflation since 2008, and space devoted to its vast collection of music, computers, and televisions is becoming increasingly unproductive. Return on invested capital at Best Buy has declined from 23.68 percent to 15.01 percent since 2007, and domestic sales per square foot (including online sales) have also declined in the same period, from $909 to $853.
Threats Not Detected
Best Buy and many similar businesses didn't see the bullet coming. Initially their sales lost to Internet competitors were quite small in relation to overall business, and confined to a small number of items. And as these retailers introduced their own shopping sites, they became complacent about the impact of the Internet to their overall store model. Much like the story of the frog in the slowly boiling water, they are finding out late in the game that their physical store businesses are fundamentally unsustainable. Given the item assortments they carry, these stores are just too large. Even a robust economic recovery is unlikely to do more than delay the inevitable restructuring.
As consumers become more comfortable with Internet shopping, the number of categories with significant e-commerce penetration increases. The electronics, toys, and baby products categories, for example, already have near 20 percent online market share. Apparel, greeting cards, party supplies, and office products have reached double-digit penetration as well while sporting goods and cosmetics will likely reach double-digit share in 2011. Pet products and health and beauty products are also increasingly moving to the web. Given that the forecast for total retail sales over the next several years is flat to minimal growth after inflation, any sales that occur online will be at the expense of in-store sales.
Clearly, bricks-and-mortar store productivity declines will likely accelerate over the coming decade; just this week, Gap Inc. announced it will shut a fifth of its stores in North America over the next two years. Even in categories where only one retailer now exists—Best Buy in electronics and Barnes & Noble in books—the category killer retail model is extremely stressed. To add insult to injury the existence of bricks-and-mortar stores actually help Amazon and other e-commerce players: they are the perfect place for online shoppers to touch and feel products they are considering purchasing.
Store retailers must also compete against the compelling economics of the web-only retail business model. Amazon leverages its higher inventory turns, lower investments in physical assets, and faster cash conversion cycle to deliver up to 20 percent cost savings to the consumer. At a 5 percent price advantage, consumers might not see much advantage in shifting their purchases online, but at a 20 percent discount, it is not a matter of if but when the category economics will shift.
“Can you be an office supply store if you do not sell paper?”
With technology making both pricing and assortment choices transparent for the consumer, there is little need to buy from a physical store, especially when a better price can be found online. The change in shopping habits will only speed up as the younger generation becomes a dominant force in retail shopping.
These consumers are increasingly comfortable buying online in categories that older shoppers believe still require a trip to the store. For example, the success of Gilt Groupe and other high-fashion flash sale sites has proven that younger shoppers are willing to buy these categories online. They are also comfortable purchasing high-fashion designer shoes on the web, given the liberal return policies of many sites. Expect these intragenerational differences in shopping behavior to accelerate the decline of store asset productivity even more.
Although these trends are felt hardest by category killers, they are by no means the only retailers feeling the pain. The impact of emerging technologies, expanding price and assortment transparency, and the increasing amount of excess retail space has created similar challenges for all mass-market retailers. Even Walmart is not impervious to these trends; many sections in its vast supercenters have become unprofitable.
While retailers may think the solution lies simply in forecasting accurately when certain product categories will shift to the web, we believe this is the wrong question to pose. Retailers need to ask the more strategic question of how to best deploy the assets of a store to generate a compelling return on capital. The situation with category killers is a preview of coming attractions in the retail industry.
In summary, just as category killers led to the demise of mom-and-pop shops, e-tailers are leading to the death of the big-box category killer. The economics of the Internet and its attractiveness to shoppers (a large and deep selection, one-stop shopping, low prices, and the ultimate in convenience) is giving online retailers the upper hand.
Thinking About The Future
We believe that category killers specifically and retailers in general need to think urgently about two key strategic questions in order to effectively navigate the currents of the industry:
- What consumer needs cannot be satisfied by e-commerce?
- What is the most effective use of store-level assets to offer a unique shopping experience?
In the current environment, online shopping cannot satisfy the desire for instant consumption or gratification. Although innovations like free two-day shipping for Prime members help Amazon to shrink the immediacy gap, there are still many items or occasions when a customer feels the need to have a product instantly. Convenience will thus become a key defense against e-commerce in many categories.
Sensory experience is another area that online retailers fail to satisfy. If a consumer needs to touch a fabric, smell a cologne, or sample food, bricks and mortar have an advantage (but only if it can solve the free rider problem created by the Internet).
Finally, if a category is complex and the consumer needs to be educated or requires personalized selling (cosmetics, for example), online shops have a hard time creating a satisfying experience. Hence stores have much to offer in these product categories.
What strategies can retailers implement given the increasing lack of productivity of their retail space?
There are several options to consider but the appropriateness of each again depends on the type of product category, the technological savvy of the clientele, and the nature of the customer experience currently offered in the store. In some cases, a retailer may need to concurrently adopt more than one of the following options to respond to these challenges:
Do Nothing. One strategic option is to maintain the status quo with the assumption that the customer base will not move online. This strategy is based on the belief that price and convenience are the only things that matter to your customers and that they will not migrate to the web for your category of goods (for example ALDI and Dollar General). There is an argument to be made that, for certain combinations of demographic groups and categories, Internet penetration will remain low, and therefore this strategy can be attractive. However, this strategy is not viable for the vast majority of mass retailers or for category killers in particular.
Unique Assortments. An alternative is for retailers to create unique item assortments that cannot be found elsewhere. This presents an opportunity to forge a bond and loyalty with consumers while eliminating direct price comparison. TJX has created enormous expertise in this area and has fostered a differentiated treasure hunt that is highly productive. Macy's is moving to strengthen its already wide-ranging assortment of unique items. Nordstrom's private label has always been a respected part of its offer. The unique assortment at Victoria's Secret clearly leverages its web presence. And Toys "R" Us recently announced that it will add significant amounts of unique merchandise to its assortment for this holiday shopping season. The marriage of bricks and clicks when employing this strategy can be very powerful.
Showroom Experience. Creating a showroom environment will likely have a significant role in the strategy of mass retailers and will be critical to the survival of category killers. The success of Apple's high-design, high-touch emporiums is causing retailers to examine how a showroom concept could work in their own categories. Both service and convenience will be key elements of this strategy. In most cases, these stores will also need to be equipped with people and technology that can help shoppers with the difficult shopping decisions that they face (for instance, technology compatibility issues or nutrition questions). But here is the problem retailers face with this strategy: the opportunity for free riding is enormous. Customers can easily use the showroom as a place to receive expert advice, then turn around and buy what they need from another, less costly source. Potential solutions to this issue include membership-only stores or allowing for price matching so that the consumer is unlikely to leave the showroom without making a purchase. Retailers must find ways to get consumers or manufacturers to pay for the value of the service they receive in these new retail environments.
Space Rentals. Retailers can also decide to become quasi real-estate companies that manage the overall merchandising look and feel of the spaces they rent. The UK chain Selfridges and department stores in Japan have employed this strategy for a number of years. Supermarkets rent space to banks and to fast-food establishments such as Starbucks. Some outlet mall operators, like Value Retail, do a tremendous job in this area as well. In a development to take note of, both Best Buy and Sears have recently announced that they will lease out space in existing big-box stores. As space productivity fades for category killers, this option will become appealing.
Service Alternatives. Category killers can develop expertise in services that could be deployed from their retail locations. PetSmart has used this strategy with excellent results, as has Best Buy with its Geek Squad. Interestingly, these services subsidize the declining productivity of key item and category sales in the store. This idea of subsidizing competitively challenged parts of the offer is a common occurrence in retail. For example, the grocery channel has long subsidized the diaper business even after Walmart and others made diapers a highly competitive, money-losing proposition. Why underwrite the loss? Eliminating diapers from a grocery's offerings would make their baby sections unappealing to parents with young children—an attractive clientele. This is the same problem that category killers face but with much less ability to subsidize money-losing items. If televisions became unprofitable, could Best Buy stop selling them and still be an electronics store? If it continued to sell them unprofitably, how would it make the math work? Where could it find the items or services to subsidize this important part of its offer? Single-category megastores have less room to maneuver than competitors with a broader assortment of categories. Therefore, service offerings will play an important role in the future of many category killers.
Go Nimble. Category killers can deploy smaller, more conveniently located stores that are paragons of flexibility: Best Buy Mobile outlets, which focus on selling mobile phones, are a good example of this phenomenon. Consumer behavior is changing faster than ever, and stores will need to evolve to remain competitive. As distribution technology develops, it is likely that no category will be spared from the pressures of transacting on the Internet, including groceries. However, as new products and technologies come to market, there will always be categories that will need inventory, real estate, and people/expertise to help consumers shop the category. Mobile phones, computers/tablets, and investment advice are three such categories today.
The Future Of Retail
Clearly, this is a new world for store retailers. To compete with online competitors, retailers will need to be agile both in eliminating or downsizing categories that do not benefit from their stores' assets, and in introducing new categories that cannot be bought without the help of the core assets of their stores. With this constant evolution of product categories, retailers will also need to be much more cognizant of how they develop and interpret their brands as they become more flexible in their offerings. Can you be an office supply store if you do not sell paper? What does it mean to be an electronics shop if the focus is on mobile devices and you don't sell televisions? Store productivity will come only if a store becomes known for offering a shopping experience that is consistent with the needs of the category. An ever-evolving retailer that understands how key store-level assets can be deployed in a category to create a compelling shopping experience will separate the winners from the bankrupt over the next decade.
The final question that all retailers must contend with is whether these trends are material to their business. One answer could lie in forecasting the impact of the Internet on sales in various categories in their stores. A more practical solution might lie in determining the trend in gross margin return on investment (GMROI) by category. Understanding the trend in productivity of the space, inventory, and labor in a category will determine the future viability of the economics of the store.
We believe that if retailers observe a serious negative trend in GMROI over time in a category, they are obliged to correlate it with category sales on the Internet. A strong positive correlation should set off the alarm bells, and the quest for finding a solution should be urgent. A lack of correlation is still indicative of a problem but not one that we have focused on above.