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Internet Retailing Vs. Traditional Retailers' Equity Values

This is an article I wrote in April 2009 and it holds true now as it ever has.

Over the past few years I have had countless numbers of thoughts regarding the overall impact the internet has had on society. There are so many potential debates on whether the benefits to society outweigh the problems created for society. If you spend two minutes thinking about the pros and cons I bet you could jot down several of each. My focus today is on the benefits to the consumer and the problems posed to traditional retailers by the internet and how they impact share price.

There is no doubt that the creation of the internet has given the world many benefits, especially when it comes to saving time. The speed at which information can be obtained would have been unimaginable a few decades ago. Shopping could not be better for the consumer. A consumer can buy online from countless numbers of businesses and individuals, or at least find where the best bargains are located. As beneficial as these avenues appear, there are significant problems facing the equity values of numerous retailers.

Just a few years ago when consumers wanted to purchase discretionary items ranging from small electronics to apparel they would simply go to a local store and purchase that product. Sometimes, if that product was not needed immediately, consumers would order products over the phone using a catalogue. I can still remember circling Christmas gifts that I wanted from the Sears catalogue.

That was then, this is now. The consumer has numerous sellers both large and small eager to provide that same type of product. But instead of visiting the local retailer, the consumer can shop possibly hundreds of online retailers selling similar products anytime day or night. Mr. Love Goel, Chairman and CEO of Growth Ventures Group, stated on CNBC's "Closing Bell" December 29, 2008 that "Over 60% of customers actually research products, prices, and promotions online before they ever walk into a store". Increased product information and suppliers force the retailers to cut prices. Prices may continue to fall as online vendors, with lower overhead, can slash prices even further and offer free shipping to increase the attractiveness of their product.

There are other forces at work causing pain for retailers besides an increase in competition. Add to this supply side pressure the introduction of substitute goods. These goods may not be name brand, but work just as well as the original and again add supply & choice to the market. High quality counterfeits are another area of concern that can decrease demand for a retailer's product. Many counterfeit goods are produced with such similarity to the original that many consumers do not know the difference, or simply don't mind claiming its authenticity to maintain social status. The introduction of these quality counterfeit items not only act as a small increase in supply, but viewing these items online at discounted prices, conditions the consumer to become more price conscious. These global competitive forces have altered the consumer to be patient and wait for a sale or shop around. If a consumer is willing to delay their purchase they will most likely be able to find the desired product for a price much lower than the price they first encountered.

We have witnessed an explosion of regional competition throughout the world due to the internet. Once rural retailers isolated by geographic location now feel the pricing pressure due to growth in online merchants able to deliver anywhere. This exponential growth in competition along with increased product supply and product substitution has a problematic effect on profit margins. Once a product has lost its luster as the "newest" and "hottest" product on the market, competitive forces slash a retailer's profit margins. For the publicly traded "Traditional" retailer, this squeeze on margins will result in reduced equity values. The value of a firm's common stock declines as some investors fear a continued squeeze on profit margins. Other investors sell shares being displeased with earnings, and short sellers take increased notice at the first sign of concerning news.

Certain areas of the retail industry are facing a convergence to Pure Competition. Pure Competition, defined from Investorwords.com, is "A market characterized by a large number of independent sellers of standardized products, free flow of information, and free entry and exit. Each seller is a "price taker" rather than a "price maker."

The problem in this situation comes when the cost-of-sales are so vastly different based upon the nature of the competitors. The "Brick and Mortar" or "Traditional" retailers with higher operating expenses compared to online merchants with expenses that could possibly be a fraction of the overhead of traditional retailers. Because of this lower cost-of-sales the online merchants are willing to provide the market additional supply having a larger profit margin than their "Traditional" counterparts. This increase in supply causes the market's equilibrium price to decline. This price decline squeezes the profit margins from a comparable yet diminished yield to one where many retailers in an effort to sell goods to cover fixed costs now operate at some levels in the "Red."

Going forward there are several changes that can affect the structure of the industry.

  1. The competitive forces which eliminated profit can cause many sellers to freely exit the market opening an opportunity for the reduced number of sellers to profit.
  2. An unknown dynamic change to the business models of certain retailers that afford them larger market share and profit, if only for a short period of time until that business model is replicated by the competition and erodes profit.
  3. As a larger portion of all products sold are via the internet, the government may impose sales tax on those products. This change may force many individual sellers and smaller online competitors to exit the marketplace due to an increase in labor, record keeping, and expense of operation.
  4. Current economic issues involving availability of credit force merchants out of business causing a drop in the number of competitors in the marketplace.
  5. Adverse economic conditions and possible overcapacity of goods being produced force manufacturers to abandon certain product lines. This fundamental change in the industry will diminish the availability of products to be sold causing a shift in the Supply curve.

Another conundrum created by the internet facing publicly traded companies is the speed at which information is delivered to market participants. In my opinion, there is a major, yet infrequent, problem created by fraudulent reports and rumors quickly being disseminated throughout the market. There are several instances where a false rumor was spread using the extreme speed at which information can be delivered via the internet. Even though the rumor was quickly dismissed by the firm the damage had already been done. Due to the speed at which the rumor hit the market that particular company's shares had traded in multiples of the average daily volume and had suffered severe share price declines.

These comments are just my observations and opinions. I by no way claim to be an expert in the retail industry. My opinion is that this new environment will need to be addressed for long run stability of retailer's share prices.