The Big Squeeze, Part 1

Includes: BBY, RSH
by: Arne Alsin

Over the next several years, you're going to see lots of retailers get squeezed out of existence, the victims of a paradigm change that has rendered their business models functionally obsolete. The demise of Borders is just the tip of the iceberg. Best Buy (NYSE:BBY), RadioShack (NYSE:RSH), and Big 5 Sporting Goods (NASDAQ:BGFV) are soon to follow, with many more yet to come, as I explain below.

The problem for brick and mortar retailers, simply put, is that they are designed to compete in a different world, a world that no longer exists.

In the old days - before the Internet empowered consumers with information and choices - retailers could get away with big markups (given their bloated cost structures, big markups are necessary for survival). Check out how much retailers add to the wholesale cost, on average: Best Buy, 33%, Macy's, 82%, Dick's Sporting Goods, 54%, and JC Penney, 60%. Despite fat markups, however, traditional retailers have historically generated tiny profit margins (2 to 5%).

Investors, take note. This combination - big markups plus thin profit margins - is lethal when subjected to competitive pressure. Such a combo means that brick and mortar retailers have very little financial flexibility, very little room to maneuver. They can't lower markups when they make very little profit to begin with.

The takeaway: Retailers are caught in a trap, and there's no way out. If they reduce markups in order to compete online, they won't be able to cover their costs, and they'll go out of business quickly. If they don't reduce markups, sales will continue to migrate to low-overhead online retailers, with the same (though delayed) end result.

A New Reality

Ironically enough, it's not the fault of brick and mortar retailers that they are facing extinction. They were configured to succeed in a different world, a world without the Internet. brick and mortar retailing is an expensive way to distribute product, but when it's the only game in town, it works.

And then came the Internet. Now the consumer is armed with information and distribution choices. What should scare every brick and mortar retailer is this: The empowerment of the consumer is just getting started. Soon enough, no amount of coupon trickery will preclude the consumer from obtaining accurate information. It's only a matter of time before consumers have full knowledge of markups as well as a broad array of purchasing options.

The Big Squeeze

The troubles affecting retailers are part of a larger, much more profound dynamic that I call "The Big Squeeze." The Big Squeeze is an efficiency squeeze on middlemen. And while retailers are a woefully inefficient type of middleman, others are a risk as well. Here is a link to a video column in which I explain the concept.

By the way, just because many big-name retailers will eventually disappear, it doesn't mean that shoppers won't have a place to shop. As I'll explain in upcoming columns, inefficient retail models will be replaced by much more efficient models, such as the outlet model in which the creator/producer (brand) deals direct with the consumer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.