Online Vs. In-Store: Retail Cost Comparison

Feb. 20, 2020 9:04 AM ETM, MAC, SPG, TCO, TGT, WMT34 Comments19 Likes

Summary

  • Price of good is not a good measure of cost to supply that good.
  • Online appears cheaper because retailers are so far willing to sell at low or negative margin online.
  • From a supply side perspective, online is significantly more expensive than in store.
  • This idea was discussed in more depth with members of my private investing community, Retirement Income Solutions. Get started today »

Is it cheaper to buy online than in store?

The fate of brick and mortar rests on the answer to this question. In the long run, sales will gravitate toward the more cost effective channel. Presently, it seems that most people believe it is cheaper to buy online and the proof seems obvious – an equivalent of the $50 jeans at Urban Outfitters can be purchased online for $45.

Case closed right?

From a customer’s perspective that is about as complex as it needs to be. A simple comparison shop between online and brick and mortar will allow customers to get the better deal.

As analysts, however, we must examine the cost from the supply side, not the cost to the end customer. Just because an item sells at a lower price does not mean it is lower cost.

In fact, there is reason to believe that brick and mortar is a substantially lower cost means of getting a product to a consumer as we will demonstrate in this article. Let us begin with the theoretical basis for why brick and mortar is a cheaper cost structure, then we will get into the numbers.

Theory

Sales from both bricks and clicks begin with inventory in a regional warehouse, but the path from the warehouse to the consumer differs. In traditional retail, inventory is shipped in bulk from the warehouse to the store so as to replenish the store’s stocks. This means an entire truckload of items in one shipment. As it is only a single trip for a single truck, the regional warehouse doesn’t have to be that close to the stores. The radius of the hub and spoke logistics model can be up to a couple hours of driving time while still remaining reasonably efficient. Thus, a few regional warehouses can service an entire network of stores.

The efficiency of this model is that it is a large number of items going to a limited number of destinations. In contrast, online retail involves sending small numbers of items to a large number of recipients. This means more trucks, and more driving time per item. It is cost prohibitive to have regional warehouses service end users directly, so they must instead rely on satellite localized warehouses in submarkets where items are most frequently sold. For direct to consumer online sales, these satellite warehouses function similarly to stores in the logistics sense. The small local warehouses will get bulk shipments from regional warehouses to replenish supplies. However, unlike stores, there is an additional step. The seller must pick out the ordered items and ship it to each customer’s home. In brick and mortar retail, the customers fill this picking and delivery role themselves. The gasoline, trucks, drivers and pickers are all incremental expenses that online retail has to bear that brick and mortar retail does not.

Thus, for any given omnichannel retailer, the profit margin should be greater for brick and mortar sales than for online sales. The numbers seem to back this up.

Numbers

AlixPartners, in an interview with CNBC reported baseline profits were greatest for in-store sales which came in with a profit margin of 32%.

Source: CNBC

Online came in at 30% with BOPIS (buy online pick up in store) at 23% and online ship from store at 12%.

Omnichannel retailers themselves agree that in store has the highest profit margins, but they seem to think BOPIS comes in second above direct to consumer online. From the same CNBC article,

“J.C. Penney said its profitability order is a little different, with in-store being the most profitable. The order online, pick up in-store option is the second most profitable, followed by order online, ship from distribution center, and lastly order online, ship from store.”

Michael Kors seems to have a similar experience to J.C. Penney as detailed in Jeremy Bowman’s article;

“Apparel and accessories retailer Michael Kors (NYSE: KORS) CEO John Idol told analysts that the online channel currently delivers lower margins than brick-and-mortar sales due to investments in fulfillment centers, extra staff, free shipping, free returns, and appeasing an increasingly demanding customer that does things like buy multiple sizes of an item just to return all but one.”

The advantage of brick and mortar is actually larger than the 200 basis point gap shown here because of the things that happen during and after the point of sale.

When an item is shipped to a consumer’s house there is no opportunity to upsell, but when an item that was ordered online is picked up in store, the customer will often purchase additional items while in the store.

The AlixPartners margin numbers do not attempt to capture the missed sales of this nature that online retail suffers. Further, by AlixPartners’ own admission, the numbers do not reflect the returns problem.

According to AlixPartners,

“Clothing items bought online are returned three times more than items bought in-store on average. But processing those online returns can be six times more expensive compared to in-store.

Industry standard suggests 30 to 40 percent of all clothing bought online ultimately gets returned. This makes sense given it’s very hard to know how clothing will fit and feel without seeing it in person first. Plus, consider that many consumers may order the same clothing item in several sizes or colors online, only ever intending to keep one.”

Returns are very costly and with 30 to 40 percent of online sales being returned, profit margins are quite slim.

Given the logistical costs of online sales and the data, I think the answer to our original question is an emphatic no. It is not cheaper online.

So then why are online retailers willing to sometimes sell at prices below the price in stores?

There has been a broad willingness among retailers to operate their online sales division at a near zero or even negative margin. We believe this is because they get rewarded for doing so.

Retailers like Walmart (WMT) and Target (TGT) that have been successful in building their omnichannel platforms are rewarded with healthy trading multiples while those such as Macy’s (M) which have been less successful online get punished with a sub 6 PE multiple. Given the strong preference of investors, retailers are incented to increase their online sales as much as possible, even if it means sacrificing margins.

This preference toward online sales amplifies the appearance of market share shifting toward online. Many of the in-store sales are falsely being recorded as online sales. BOPIS is inextricably tied to brick and mortar, yet it is almost universally being recorded as an online sale. The physical real estate does all the heavy lifting, but online gets all the credit.

Matters are made worse by negative online sales being recorded as negative brick and mortar sales. Specifically, retailers are in some instances deducting the returns of online sales from their brick and mortar sales. This is done to juice the online sales number and comes at the expense of lowering the in-store sales figure. There are few who understand retail better than David Simon, CEO of Simon Property Group (SPG) and he discusses this practice in depth on conference calls and as reported by bloomberg.

Investment implications

Reported numbers show brick and mortar sales at an all time high. These recorded numbers are not including BOPIS and they are not adjusting for the misreported returns. Therefore, in actuality, brick and mortar sales are even higher.

Over the long run, retail will gravitate toward the most effective sales methods. Online has an edge in convenience while in-store is more cost effective. BOPIS is the best of both worlds and I believe the future of retail. BOPIS cannot exist without brick and mortar, so demand for physical real estate will persevere. Presently, the physical real estate is deeply undervalued, with many of the mall REITs trading at a fraction of NAV. Simon’s purchase of Taubman (TCO) woke the world to the idea that these assets still have value. The merger was done at a 6.2% cap rate which sets a baseline price for the rest. Macerich’s (MAC) sales per foot and property quality are nearly identical to Taubman’s. Thus, a 6.2% cap rate would be a reasonable baseline for MAC and this implies a price of $44 a share. It is a true bargain at under $25 a share.

BOPIS is the way of the future which means brick and mortar is the way of the future.

Full Disclosure: All content is published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The information offered is impersonal and not tailored to the investment needs of any specific person. Please see our SA Disclosure Statement for our Full Disclaimer

2nd Market Capital and its affiliated accounts are long MAC and SPG. I am personally long SPG and MAC.

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This article was written by

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Full Disclosure. All content is published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The information offered is impersonal and not tailored to the investment needs of the specific person. Please see our SA Disclosure Statement for our Full Disclaimer.

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Disclosure: I am/we are long SPG, MAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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