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Much of what we do as investors involves studying businesses and critically evaluating the returns that are likely based on management’s competitive strategy. The elusive search for true “moats” is often frustrated by quick technological change which can make yesterday’s incumbent firm today’s dinosaur. Investors who pay a rich valuation for a business with a moat must be confident that the advantages leading to high returns today are not destroyed by new types of competition in the near term.

Competition has always been a threat to retailers and numerous strategies have been employed to achieve acceptable returns on investment. Most investors are familiar with Michael Porter’s work on competitive strategy and the three “generic strategies” firms can successfully employ. In his well known book, Competitive Strategy, Mr. Porter describes the three generic strategies: Overall Cost Leadership, Differentiation, and Focus. This can be translated into a retail context by observing the strategies used to appeal to mass markets, elite shoppers, and niche markets. A business that fails to develop competitive advantages supporting one of the generic strategies is said to be “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms. Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system. Competitive Strategy, p. 41-42

It is not particularly difficult to think of companies that are neither cost leaders nor differentiators. Usually such companies produce sub-par returns on invested capital but many have historically muddled along for years with incoherent strategies.

The days of muddling along without a clear strategy may be numbered for retailers in the age of the smart phone. As The Wall Street Journal observed today in a front page article, shoppers are increasingly equipped with mobile phones that not only provide internet access but also often allow instant price comparisons by scanning bar codes on merchandise. This is surely the nightmare of middling retailers that have long relied on confusion or ignorance to move uncompetitive merchandise.

Earlier this year, Nielsen projected that the smart phone market would exceed fifty percent of mobile phones in the United States by the end of 2011 as the chart below illustrates:

click to enlarge

If it is possible to browse through the selection at Best Buy (NYSE:BBY) and immediately check prices at Amazon.com (NASDAQ:AMZN) or Wal-Mart (NYSE:WMT), pricing pressure is eventually going to drive most business to the lowest cost provider. Even worse for “brick and mortar” retailers, most online retailers benefit from not being required to collect sales tax in jurisdictions where they lack a physical presence. Customers who are reluctant to buy products “sight unseen” can then use the infrastructure provided by physical retailers to get comfortable with their purchase and then immediately scan the product’s bar code and order from the lowest cost online provider.

Best Buy recently reported disappointing results and the CEO made comments during the conference call related to competitive pressures. Shares plummeted in the wake of the results as investors reconsidered the company’s strategic position and competitive strengths. Retailers such as Best Buy have long competed for business by keeping a wide variety of merchandise in stock and promoting select products in order to bring customers into the stores and allow for cross selling higher margin merchandise. This strategy may no longer be viable as smart phones begin to dominate consumer behavior in ways that would have been unthinkable just a few years ago.

Physical retailers will not become extinct, but they will increasingly be forced to choose a coherent strategy based on a broad offering of very low prices or true differentiation. While the threat of internet commerce has been a consideration for investors for much of the past fifteen years, the threat has become much larger with new smart phone technology.

Source: ‘Stuck in the Middle’ Retailers May Soon Face Extinction