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For years we have all been told that online retailers, led by Amazon (AMZN), would be the death knell of physical retailers. We've been told that physical retailers simply cannot compete with the Internet.

The truth is that retail, no matter what medium it takes, is all about one thing: customer service. If you are selling the same product as someone else, you must compete either on price, service, or value. Retail concepts extend far beyond the traditional retail industry, spreading into other areas such as healthcare, food, and defense. We think that the discussion of the retail space has been dominated by a physical vs. Internet debate for far too long. Retailers, no matter how they operate, still live or die by customer service. And while it is true that some subsectors are simply better fits for e-commerce (books, movies, and music), most retail sectors are still dependent on customer service for differentiation between online and physical retailers. This article is intended to remind investors to be wary of pundits and retailers who blame e-commerce for a physical retailer's troubles. Often, that is a sign of a deeper underlying problem.

The past several years have seen e-commerce truly enter the mainstream. In December, traditional retail sales were flat, while e-commerce sales were up 13% from 2010. Amazon bulls, and by extension all e-commerce bulls, would like to believe that someday, there will be no physical stores, that everything will be bought online. While we think that down the line, e-commerce sales will be a far greater slice of the retail sales pie than it is now (5% of all sales are e-commerce), to assume that e-commerce will supplant all retailers is a bit farfetched. To illustrate our point, we would like to present several cases where e-commerce has succeeded, and where it has "failed"

Record stores and bookstores are perhaps the best example of what e-commerce can do to physical retailers, with Tower Records and Borders as the highest profile victims. Media retailers such as these suffered from a fatal flaw: a lack of differentiation. What is the point of buying the latest Stephen King book at Borders for $30 if the same book sells at Amazon for $15? Chains like Tower Records and Borders failed because they did not offer their customers a compelling reason to shop there. If you are asking customers to pay more for a product they can get cheaper elsewhere, then you must be prepared to make up the difference in other ways. It is why independent bookstores still stand while Borders is gone and Barnes & Noble (BKS) is going through a radical restructuring. Independent bookstores offer something that the chains, and even Amazon cannot. They offer a sense of community and culture for book lovers. That is something Amazon cannot replicate, no matter how low it prices its books. Below we offer several case studies to show that e-commerce retailers are no different in terms of physical retailers in what needs to be done to attract customers.

Tiffany & Blue Nile

This is a simple comparison, yet it yields a wealth of insight. Blue Nile (NILE) is the world's largest online diamond and jewelry store, with revenues of nearly $236 million in the first 3 quarters of 2011. The company is the leader in the online jewelry space, and it used the recession to expand and gain market share. Yet none of that has shown up in the results of Tiffany & Co. (TIF), the largest American jewelry company. Does Blue Nile have cheaper products than Tiffany? Certainly. But no matter how hard Blue Nile tries, it will never be as successful as Tiffany's, for Tiffany's offers something that Blue Nile cannot. Status. Saying you bought something at Blue Nile means little to the average person. But anyone will know what you mean when you tell them that you bought a piece of jewelry at Tiffany's. This is a good example of a market where e-commerce can be successful, but not at the expense of entrenched market leaders. There is no one at Blue Nile to help you select the piece you would like. At Tiffany's, you pay more for jewelry, but the extra price is more than offset by the value of shopping at Tiffany's. And these dynamics show up in the stock prices of the 2 companies. Since its IPO in March 2004, Blue Nile stock has appreciated almost 14%, a good showing. But that has underperformed the S&P 500. And when you compare it to the stock performance of Tiffany's, the spread widens dramatically.


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Tiffany's shares have returned over 80% since Blue Nile went public, a testament to the resilience of the Tiffany brand, as well as its value proposition to consumers. That is something that Blue Nile, no matter how low it prices its jewelry, cannot ever replicate. We think that Blue Nile will be successful, but not at the expense of the market leader.

Borders, Amazon, & Barnes & Noble

If there is one market that epitomizes the success of e-commerce, it is the book market. Amazon, as the Wal-Mart (WMT) of the Internet, is widely seen as the reason for Border's bankruptcy and liquidation, as well as Barnes & Noble's recent troubles. And to some extent that is true. The latest Stephen King book will be the same at all three retailers, therefore it is only natural that customers will gravitate to the one that offers it to the lowest price. Therefore, it is natural that Amazon will win, for it's overhead costs are far, far lower than at either of those two booksellers. This structural advantage could not be replicated by Borders, and unlike independent bookstores, Borders did not offer much in the way of differentiation. For the most part, people did not go to Borders to discover a new book. They went there with a specific book in mind, much as they do on Amazon. We think that the majority of people do not spend their time perusing the vast collection of books Amazon has looking for what to buy. They think of a book they want, and log on and buy it.

Barnes & Noble is going down the same path Borders did, but at least it is trying to be more proactive. Unlike Borders, which only started its own e-commerce business after it was too late to stop Amazon, Barnes & Noble is aggressively investing in its Nook business, which is showing signs of being able to compete with Amazon and the Kindle line. But like Borders, Barnes & Noble's physical stores suffer from the fatal flaw of no differentiation. Why buy a book in store for more when it can be ordered online for much less? That is the reason why Amazon is estimated to account for over 50% of book sales in the United States, despite having books represent a small fraction of its overall sales.

There will be people for whom books must be in paper form. But that is why independent bookstores exist. As the largest booksellers in the United States, Borders' and Barnes & Noble's size actually works (or worked in Borders' case) against them. People are angered when they feel Amazon is trampling on the corner bookstore. It is harder to feel sympathy for a bookstore when it is the size of a Wal-Mart. People, however, tend to extrapolate the success of e-commerce in this market to other markets, something we feel is an error. The media market (books, music, movies), is fundamentally different from other markets in that you know what you are getting. The CD from Tower Records has EXACTLY the same songs as the digital album on iTunes. The only difference is that the iTunes version is less. This is why the only real record stores left today are small, independent ones where people go to discover new music, something that is much harder on iTunes.

Amazon & Nordstrom

If any company is the definition of great customer service, then it is Nordstrom (JWN). Many stories of truly unique customer service exist, such as the tale of the man for whom Nordstrom altered an Armani tuxedo in just a day, for free, so that he could make it to his daughters wedding. On its own, that is a great tale. What makes it worthy of being a Nordstrom tale is that Nordstrom does not even sell Armani tuxedos.

It is service like that allows Nordstrom to thrive in a world increasingly dominated by e-commerce. We would like to use UGGS as a prime example of that. At Amazon, a grey pair of size 6 UGGS costs $149, with no sales tax or shipping charges. At Nordstrom, that same pair costs $179.95, without tax. It seems obvious that everyone should buy them at Amazon. Yet only Nordstrom can tell you which color of UGGS goes with your outfits, or which feel is the best for you. Nordstrom differentiates itself with unbelievable customer service, service that even Amazon cannot compete with. Nordstrom knows how to retain its customers, and convince them to pay top dollar for products found cheaper elsewhere. For many customers, the $30 difference in the cost of those UGGS is well worth the knowledge that their shopping needs are personally being attended to. That service has shown up in Nordstrom's stock price.


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While Amazon has trounced both Nordstrom and the S&P 500 since its IPO with a gain of almost 11,000%, we think that few Nordstrom investors are upset with its 325% rise in that time frame, which is over 5.6 times that of the S&P 500. Nordstrom is proof that what makes a retailer successful is the shopping experience, and not where a retailer is located.

Amazon & Best Buy

Currently, Best Buy (BBY) is seen as Amazon's next "victim," the next retailer to fall to the relentless march of e-commerce. Best Buy bears often cite Amazon as the reason it will eventually join Circuit City in bankruptcy. While we agree with the bearish case that Best Buy is slowly sliding into irrelevance, we disagree with the methodology used to arrive at that conclusion.

Best Buy's failing stems not from Amazon's rise, but from the fact that Best Buy has terrible customer service. Let us repeat that again. Terrible customer service. Best Buy's fatal flaw stems from one simple fact. It sees a customer with a product in their hands and tries to up-sell them other products they do not need, without regard as to whether or not that will drive them to avoid Best Buy in the future. Best Buy seems to care only about selling its customers more today. Amazon, on the other hand, bends over backwards to make sure that you will come back tomorrow to purchase from them. A few weeks ago, a great profile of Best Buy by Larry Downes in Forbes highlighted exactly this problem. Best Buy's troubles stem not from Amazon's competitive advantages as an online retailer. They stem from the fact that Best Buy does not treat its customers properly.

Best Buy's supporters (and by extension supporters of physical retailers in general), argue that Amazon is on an uneven playing field, due to the fact that it does not need to collect sales tax in the vast majority of states. The loudest arguments for this come from retail trade associations, which represent physical retailers. Politics of sales taxes aside, an analysis by William Blair found that in many instances, even if Amazon was forced to collect sales taxes, its products would be cheaper than at the average physical retailer, especially Best Buy.

As we have seen in the cases above, of Nordstrom, Tiffany's, and bookstores, retailers have to offer customers value in some other way if they cannot compete on price. Since Best Buy cannot compete with Amazon on price, due to its cost structure, it has to offer customers value elsewhere. And no one can say that Best Buy has done so successfully. Retailers win or die based on their treatment of customers. And Best Buy is losing because it does not know how to treat its customers. The irony is that since its IPO in 1985, Best Buy has delivered great returns to investors. The stock is up nearly 15,000%, besting even Amazon's 11,000% rise since its IPO. Yet over the last 5 years, Best Buy shares have steadily been falling, and no amount of buybacks or dividends has been able to prop it up. Best Buy's best days are behind it, and unless the company radically changes its retail strategy, its days will soon be numbered.


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Conclusions

Readers should not mistake this article as an attack on the investment appeal of e-commerce companies. We have been long Amazon, in one form or another for years, are currently long, and continue to believe that the stock's best days are ahead of it. That being said, we disagree with the notion that e-commerce can supplant all physical retail, and with the notion that e-commerce is what destroys physical retailers. Retailers are destroyed if they alienate their customers, and that is exactly what Best Buy is doing. That is why Best Buy is on the list of the top ten most hated companies in America. Amazon tops ForSee Research's 2011 Retail Satisfaction List. Best Buy is not even in the top 20. All retailers, no matter their operating model, have to please their customers, and offer them a value proposition that compels them to return, be it low prices or exceptional service. Best Buy is failing because it offers neither.

Tim Hulbert of Hulbert & Associates sums things up brilliantly, stating that, "The problem for many retailers, especially the larger national chains, is that by necessity (they're trading in commodities and near-commodities) they've had to emphasize the rational considerations of price and convenience. The challenge is to find ways to re-engage customers on more than just a rational level, to make shopping in their stores a more stimulating and satisfying experience, rather than just another trip to pick up whatever is on sale." The best retailers are the ones that makes shopping an adventure, such as Tiffany's, Nordstrom, and Apple (AAPL). Apple stores may be among the most expensive places to buy Apple products, but no one can deny that shopping there is a truly unique experience. It is why Apple sells more per square foot than any retailer in America. (Note: we did not include Apple as a case study because Apple retail stores are not retail stores in the traditional sense. They exist to sell Apple products, and to Apple, it is not that relevant where its products are sold.) The best retailers are not online retailers. The best retailers are those that offer customers the best value for their money. Amazon is not admired by so many because it is on the Internet. It is admired because of the way it treats its customers. No retailer, physical or Internet can escape the fact that they must not forget that the customer always comes first. Retailers who forget that do so at their own peril. And investors must not forget that when a company's supporters blame e-commerce for its troubles (Best Buy), it is often a sign of deeper, more fundamental problems.

Source: Do Not Blame E-Commerce For A Retailer's Troubles