DECEMBER 1998 TOTAL WAR
TOTAL WAR
II. The Underlying Forces Driving Online Buying.
III. The Store in a Wired World.
IV. Sales Channel Reformation in a Wired World.
V. Winners in a Wired World.
VI. Summary. Speaker’s Biography Additional Articles
TOTAL WAR
An unseen foe is about to assault store based retailing by shifting sales from the store to cyberspace. The emergence of online buying represents total war against location based retailing by promoting non-geocentric shopping habits. Traditional merchants must prepare to do battle in a radically altered retailing environment. This will be true whether the cybersale goes to the mass merchandiser or jumps to the competitor. Doing business in a wired world requires mass merchandisers to think in a new way. They must consider how online buying can negatively impact store economics. This will require a change in long-term leasing practices and the development of single purpose buildings for stores. Mass merchandisers need to radically shorten lease commitments and store ownership growth or risk having them characterized as stranded assets on the balance sheet.
Sun-tsu, the legendary Chinese military strategist, wrote "shout in the east, attack in the west." 1; The ancient sage urged the use of diversionary tactics to gain strategic advantage in war. Today, mass merchandisers must recognize online buying will fundamentally alter the value of the store. Continuing to rely exclusively on the store based sales channel diverts their attention away from leveraging the value of cyberspace. Those mass merchandisers who grasp the new sales channel’s worth can achieve victory.
Examining the history of war helps to comprehend the profound impact online buying will have on location based retailing. Analyzing battles at the outbreak of the Second World War are instructive. See Table below. The French believed their massive defense perimeter along the Germany border would prevent attack. The highly mobile German army went around the Maginot Line neutralizing its value. In the Pacific, the Japanese attacked the island of Singapore, not from the sea but overland through Malaya. The British fortifications only faced the sea. The isolated location of Pearl Harbor on the island of Oahu was safe from attack. Few believed the Japanese could devastate American naval forces by projecting themselves across several thousand miles of ocean. Japan’s stealth blow negated American strategic advantage in the Pacific. At Dawn We Slept
Today, the underlying assumptions concerning store based retailing are not seriously challenged. Many continue to chant the manta "location, location, location" since they believe geocentric shopping habits are immutable. This is true in a location based world. In established markets mass merchandisers fight to improve visibility or move to better locations. Entering new markets they seize the high ground to achieve strategic advantage. The online sales channel creates a new strategic dimension and negates geocentric primacy. Mass merchandisers with superior locations will shortly find them less profitable.
Online shopping has a second order impact on retailing. It requires store leasing strategy to change to accommodate greater sales channel flexibility by reducing long-term space commitments. The customer’s changing expectations about how when, and where to shop are driving sale channel reformation. From the real estate perspective there are three interrelated facets to consider.
Deng Xiao Ping, the late party boss of China, said "…it doesn’t matter if a cat is black or white, so long as it catches mice."2 In the context of retailing, his aphorism points to the primacy of merchandising over location. Few well located stores can succeed without first class merchandising.
Internet time is running on what seems to be a ninety-day year due to the constant stream of innovations and willing adopters. Short time frames permit continual market corrections and strategy adjustments. If one form of online shopping does not appeal to buyers, another kind will quickly appear to get it right. Real estate time is just the opposite. It is glacial, measured in years or even decades. The lease commitment makes it difficult, time consuming, and expensive to modify sales channel strategy.
Customers are gravitating online for convenience, choice, and control. Many shoppers find it convenient to shop after stores close. Online sites can offer customers a wider selection of goods with their virtual shelf-space. They may also offer comparison shopping opportunities and useful third party reviews. Well done Web sites put the customer in control of the shopping process and do not depend on uninformed or non-existent staff. Online buying takes the shop out of shopping. The rapid diffusion of information technology, customer expectations about using the technology, and the inherent advantages of online buying are coalescing to force a sales channel transformation. The sine qua non for the sales channel transformation is flexible leasing strategy.
The technology creating online buying had a long gestation. In 1967 the Harvard Business Review carried an article by Davidson and Doody predicting the advent of computer-based home shopping. The piece discussed the likely changes in distribution, marketing and space demand.3 While conceptually sound the breakthroughs in hardware, software, networks and the telecommunications infrastructure had yet to occur. Today, high-tech’s promise of home shopping is a reality. "Everyday tech"4 is a convenient way to refer to the integration of computer hardware, software, networks, and telecommunications into daily life.5 Everyday tech takes the shopper out of the shop and ends the dominance of geocentric shopping patterns. While many bemoan the lack of bandwidth and other improvements still months or years away, today’s average hardware, software and Internet connection are sufficient for shopping online. Current limitations will not significantly retard online buying’s impact on space demand. Future improvements will only accelerate the trend. Everyday tech threatens mass merchandisers by fundamentally altering their location based advantages. Everyday tech creates discontinuity within the sales channel and among traditional and new competitors. The playing field is no longer secure, established relationship are at risk and new financial metrics are necessary.
Online buying creating a sales channel challenging the primacy of the store. It represents discontinuous innovation. Cyberspace gives mass retailers a new way of merchandising and interacting with their customers. Formerly, continuous innovation was characteristic of retailing. Continuous innovation reflects a competitive environment whereby technological change, competitors and market share are relatively stable. Process and product improvements are measured, incremental and gradual. Conversely, discontinuous innovation is a dramatic break with the past whereby business practices, product creation, competitors, and market share change rapidly. Moving shopping from physical space to cyberspace is the essence of discontinuous innovation. See Table below. Continuous & Discontinuous Innovation
Online buying immediately gives the advantage to stealth competitors
like the bookseller Amazon In addition to a new competitive hierarchy, the ability to buy online fundamentally changes how customers think about shopping, their buying expectations and the way they interact with mass retailers. In summary, online buying creates new risks for store based mass merchandisers as their sales migrate to cyberspace.
Is it possible everyday tech could reduce demand for physical space? Yes, movie theaters are a case in point. They went into rapid decline from 1948 to 1963. The Chart below depicts a 50 percent drop in theaters over fifteen years while the number of TV households rocketed from less than 1 percent to 90 percent. The tremendous popularity of TV, an example of information technology, had a devastating impact on movie theaters.
Source: US Census of Business, US Census of Service Industry. SIC Code 7832. Data for movie theaters with payroll excluding drive-ins. Christopher H. Sterling, The Mass Media, Praeger Publishers, 1978. While everyday tech partially explains the rapid decline in theaters, the population was also shifting to the suburbs. This was an important factor. However, everyday tech has the analogous affect on shopping as did the earlier suburban migration. Everyday tech deracinates place from activity by removing the shopper from the shop, another form of migration.
Egghead’s move to pure online retailing offers a view of future shock for mass merchandisers. In a sense, its abandonment of stores represents the post-WWII history of retailing. First, there was the need to secure convenient locations. Then size mattered, creating demand for Superstores, Big Boxes and Mega-malls. Now, everyday tech brings shopping home by offering ultra-convenience, virtual shelf-space and quick comparable pricing. While Egghead may not do any better online than in-line, it is an ongoing experiment on the evolving online sales channel.8 If Egghead continues to succeed, then mass merchants will find many attributes of their prosperity compromised. They will no longer find convenient location, competitive pricing, and vast inventory reliable predictors of store success.
The rise of the online sales channel requires a reformation of the sales channel matrix. In addition to the store and paper catalog, mass merchandisers will add cyberspace. However, recognizing there is change does not assure seizing the opportunity without a change in the location mindset. One way to change this kind of thinking is to use new metaphors. Metaphors allow one to understand and experience one kind of thing in terms of the visual image of another. Mass merchandisers need to understand cyberspace is the antithesis of real space: it is an abstraction where no there exists. Using a real estate metaphor like electronic storefront creates confusion. The image of the store bears no relationship to the void of cyberspace. Rather, it limits one’s ability to see the expanded possibilities of online buying from the customer’s perspective. Thus, place metaphors imprison thinking by conjuring real estate images to analyze an incorporeal phenomenon. The Table below suggests some metaphors helpful in explaining retailing in a wired world.
Making the strategic decision to change leasing practices requires senior management to understand everyday tech’s implications throughout society and the pace of online diffusion. Grasping the trend offers a framework for strategically altering the sales channel matrix. Profitably merchandising in cyberspace will give them the necessary insights to analyzing how migrating sales impact store location decisions and store economics. II. The Underlying Forces Driving Online Buying.
The Internet’s rapid diffusion is startling. Total users continue to grow quickly. Besides a rapid overall growth, women are reaching gender parity, older American are flocking online, credit card security concerns are fading, and online buying is becoming commonplace.
The June ’98 Nielsen Media Research/CommerceNet survey found there were 79 million Internet users sixteen and over in the US and Canada. The user base grew by 36 percent from the September 1997 survey. In 1995, the first survey found 18 million people online. This represents a 339 percent increase in four years. Among age groups, 50 percent of 16-34 olds are online!9 Surprisingly 48 million had gone online to browse or gather product information. This represented a 37 percent increase over September ‘97. Finally, actual buyers doubled to 20 million from the earlier period. The survey noted from September 1997 through June 1998, the growth of online buyers accelerated to 8 percent a month.10 In comparison to 1996 online buyers, those who actually purchased, increased twenty fold.11 The US data is equal to about 90 percent of each category. See Table below. Online US Demographic (June 1998)
Source: Nielsen/CommerceNet The Internet’s takeoff parallels the continuing albeit slower diffusion of PCs into US households. In January approximately 45 percent of US households owned a PC. Those with annual incomes above $75,000 had a 70% diffusion rate while households with incomes below $30,000 had only a 25 percent diffusion rate. 12 However, the ongoing fall in prices is bringing PCs to the lower income households. Those households earning less than $35,000 annually are expected to be the leading source of first time buyers in 1999.13 Furthermore, the lack of familiarity with computers at work is no longer a barrier to purchase. Fully 70 percent of these first time buyers do not use a computer at work. In addition, many of the new users are expected to get online. One overlooked trend boding well for mass merchandisers is the increase in moderately educated households coming online. The expanding PC user base spurred by falling prices, concern over educational opportunities for children and fear of being left behind are motivating them to get wired. Approximately 50 percent of the heads of AOL user households have a high school education or less.14 This is a tremendous pool of potential online buyers and appealing to them online will become a priority for many mass retailers.
The continuing rise of Internet households impacts work routines, learning and shopping habits. Everyday tech expands the home’s role as an activity center.15 Studying, shopping and working in the home took place before everyday tech. But, everyday tech introduces a quantitative and qualitative difference.16 First, the Internet promotes a broader range of activities from home. Second, the quality of what can be accomplished continues to increase. Finally, wired families can buy back time, a precious commodity, by spending less time coming and going. In the case of education, the home can take on the role of public library and a skill building center for improving math, reading and writing. All on-demand and self-paced. In the case of shopping, the home becomes a show room for many items, a comparison shopping center and convenience store. In the case of work, the home becomes a venue for undertaking complex tasks in an island of tranquillity but still affords the opportunity to maintain contact with colleagues. The side benefits to home owners are fewer trips and less time spent driving. In short, the home’s role is undergoing a basic shift in lock-step with society’s changing expectations about using information technology. The prime beneficiaries are women.
The question no longer is whether women will achieve gender parity online but when they will become the majority of shoppers. The Nielsen Media Research/CommerceNet Study found women represented 43 percent (30 million) of online users17 and AOL reports women represent 52 percent of subscribers.18 In early 1995 they had only accounted for 10 percent of the online population.19 For the Internet to become a robust shopping medium, women must be able to fulfill most of their regular needs online. In response shopping sites are refocusing to cater to women. In addition, there are a galaxy of sites for little girls,20 teenagers,21 working women,22 pregnant women,23 parents, 24 and everything in between to inform, entertain and offer advice. Women now equal men buying online. 25 In other cases they are the majority of shoppers. See Table below. For example, women buy 75 percent of Peapod’s groceries, they buy 69 percent of the Internet Florist’s flowers, 50 percent of travel services from Preview Travel, and 43 percent of Amazon.com’s books. 26 The growing importance of the home as activity center reinforces the trend of women getting online and using the medium to their advantage, including shopping. Who Says Women Don’t Shop Online?
Source: Business 2.0 Premiere Issue 1998, p. 29
The Internet is an integral part of college life. An April survey of 100 campuses nationwide found 95 percent of undergraduates used the Internet. It is becoming part of their daily life. 27 Younger students are also heavily into the WEB. Simmons TeenAge Research believes two-thirds of 12-19 year olds have gone online. 28 This strongly suggest students are acquiring new habits about communicating and studying online. Once started online it becomes very easy to move your work and shopping there.
Those 55 and older represent about 4.3 million online users. 29 While numerically small they represent the fastest growing group of PC buyers, and WEB TV notes 30 percent of its users are over 60. 30 In addition, older Americans are online longer than any other age group. 31 Finally, seniors are online buyers. They have a higher propensity than other age groups to purchase books and business equipment and to invest.32
There is no longer significant press concern over credit card security. Last year’s Christmas online buying hoopla was more interested in selection and where to find items than credit card fraud. While consumer concerns over security persist in buyers minds, 33 in reality they are using credit cards in record numbers. One study claims 43 million online shoppers are using plastic.34 The SET (Secure Electronic Transaction) initiative continues parallel with the use of SSL encryption found on the Microsoft and Netscape browsers.35
The degree online buying cannibalizes in-store sales partially reflects the number of customers going online, the degree the online channel meets the needs of shoppers, and whether the subtle preference shift for online purchasing continues to develop. Despite the rapidly accumulating evidence, many mass merchandisers and property owners still believe online shopping is nothing more than another catalog scare. Catalogs have had no negative impact on store based retailing. However, there is a fundamental difference between online shopping and catalogs. Buyers receive greater value from shopping online than by flipping through a catalog. Although retail property owners mostly ignore the prospect of online buying, there is a noticeable shift in retailer attitudes. On October 28 a poll of the 400 attendees at the National Retail Federation’s Financial Executive conference revealed over 90 percent believed online shopping would have an impact within five years. Online shopping is another example of Metcalfe’s Law of networks. 36 It states the value of a network increases exponentially as the size of the network grows arithmetically. For example, when the Fax was gaining popularity only a small annual increase in units was necessary to double the value to users. Amazon.com offers an example of Metcalfe’s law. The bookseller provides customers with the opportunity to author their own book reviews and alerts readers to books of interest by email. In contrast, the catalog is static and can not provide enhanced value to customers. This is the critical element distinguishing catalog shopping from online buying. 1. Market Size. The Nielsen/CommerceNet study shows about a third (79m / 230m) of the North American population sixteen and over online. The user base should grow to 50 percent over the next several years. The study also disclosed online buyers, those who actually purchase, are about a quarter (20m / 79m) of the Internet population.37 If the online population reaches 50 percent, then there will be 115 million people online. Assuming the same 25 percent ratio, then there would be almost thirty million online buyers (50% X 230m X 25% = 28.75m). As noted, women are expected to become the majority of shoppers over the next several years. The prospect of fifteen million women online should compel mass merchandisers to offer ever more appealing and user-friendly shopping sites for females. 2. Parallel Developments Accelerate Online Buying. a. Greeting Cards are Emblematic. The impact of the online channel on in-store sales may be glimpsed in the greeting card business.38 Those familiar with Blue Mountain Arts [www.bluemountainarts.com] know how easy it is to send a customized birthday, holiday or friendship card electronically. Even better, many cards are free. Customizing paper cards in the store can be done but it is much easier to create and send them online. This is the dilemma for the card companies. Do they try to capture the online market by offering a better mix of free and pay-for-view cards while seeking to retain their shrinking store based clientele or do they concede cyberspace to the upstarts like Blue Mountain Arts and protect their base? Paradoxically, the demand for e-cards is likely to explode as the number of email users hits 135 million in 2001.39 It also may weaken the habit of going to the card store to make the selection and reduce overall foot traffic in malls and centers. While the greeting card scenario is a distinct possibility, the paper based encyclopedia is a victim of everyday tech. The Encyclopaedia Britannica has gone from being sold door-to-door to a CD or online subscription service. Even the value of this proprietary information will decline as ever more powerful search engines evolve and library archives come online. b. Bill Presentment is the Killer App. Another example is bill presentment. Bill presentment offers people the ability to electronically pay their bills. For almost everyone this is the "killer application" 40; no more paper or searching for stamps. Bill presentment is a god send for procrastinators. It could spread quickly once bank-biller interoperability standards coalesce. By one estimate only 200 billers account for 70 percent of all US bills. 41 The current estimate for bill presentment is 12 percent of all bills paid in the year 2000.42 Bill presentment, like the implementation of the SET security protocol, increases the usefulness of doing routine tasks online. On the other hand, online stock trading has already proven its usefulness to investors. During the January-June period 22 percent of retail trades were conducted online and they may reach 30 percent by December. 43 c. Shopping Bots Make Life Easier. Comparison shopping software robots ("Bots") are the next big thing for online buyers. These software agents visit retailer sites looking for a specific item and then report back on the basis of price or other search criteria. Some retailers block them hoping to avoid pure price competition, while other merchants try using them creatively. In the case of books, doing a search in Acses [ www.acses.com] provides a ranking of online sellers by price along with shipping cost information. 44 Bots benefit customers tremendously and add pricing pressure on mass retailers. Conversely, Books.com [www.books.com], one of Cendant Corporation’s online stores, allow customers to comparison shop while at the site. If the Books.com price is higher, then the in-house Bot can adjust to the competitor’s price.45 This acts to retain the sale but at a lower profit. Using Bots offensively makes sense for mass merchandisers with high brand equity. Bots are in their formative stages. They are controversial since they reduce almost all consumer decisions to one based on pure price. 46 In addition, searches are still too much of a "hit & miss" proposition, many only scan a predetermined subset of sellers or are blocked by uncooperative merchants. 47 Nevertheless, Bots are seen by the search engines as offering a major competitive advantage for driving customer traffic 48 and for taking the bookseller Amazon.com to the next level of online retailing. 49 Bots are of interest for two other reasons. First, branded goods and services are priced nationally and constantly compared. This eliminates regional pricing discrepancies and makes the Bots a new form of price competition. Second, to the extent the mass retailers seek to match the lowest price online, they may create a discrepancy between in-store and online pricing. This gives an incentive for in-store customers to arbitrage thereby reducing their in-store purchases in favor of shopping online. In addition, some may mistake the Bot induced pricing battle as a form of price discrimination against off-line customers. 50 Future legislation could mandate an online price check at the time of sale to maintain consistency between the online and physical worlds. The cumulative impact of Grandma receiving her birthday card via WEBTV, Mom paying her bills online, and Sis comparison shopping for a stereo on the Internet all reinforce the coming life-style change. One major beneficiary is online buying. 3. Embracing a New Shopping Habit. American consumers are starting to develop a new shopping habit. While still in the early stages of growth, the trend favors cyberspace for displacing or downsizing stores for a number of retailers, i.e., software [www.egghead.com]. This year 30 percent of online users are purchasing online and it will increase to almost 40 percent in 2000.51 The present generation of shoppers is learning to avoid the store in favor of online buying. This is similar to their parents and grandparents adjusting to self-service shopping. Many people intuitively agree with the nascent research showing a change in attitude. There is nothing novel anymore with buying books, casual clothes, groceries, toys, office supplies, CDs, and cars online. The lack of merchandise and other barriers to full scale merchandising are quickly falling away. Davidson and Doody’s 1967 prediction is coming to fruition. 4. Watch the Supermarkets. For those mass merchandisers continuing to wait for the online market
to mature before establishing a presence, they should follow events in the grocery
business. An industry consortium, Consumer Direct Cooperative (CDC), led by Andersen
Consulting estimates that over the next ten years 15 percent of US households will
purchase groceries online and the biggest share of sales migrating online will be for the
weekly stock-up trip.52 Oddly, the one area where
online grocery shopping would seem to be at a disadvantage, picking fresh produce, is a Peapod [www.peapod.com] and Streamline [www.streamline.com] are pioneering the consumer-direct revolution. If they succeed, it negates the value of a convenient location. 54 This has ominous implications for non-food mass retailers and real estate. If customers are gravitating online to buy their groceries including produce along with most of their other daily needs and paying their bills, then their geocentric shopping attitude significantly changes about where to shop. There will be a strong incentive to go online to comparison shop, obtain advice and purchase. This invisible paradigm shift will affect mass merchandisers. III. The Store in a Wired World. A. Where are Stores Going? The role of the store is about to undergo a profound change. Many off-line mass merchandisers will experience intense price and market share competition from traditional competitors who offer the third sales channel, stealth competitors who only exist online, trusted intermediaries providing bundle buying services and manufacturers seeking to exploit channel conflict. Some fortunate mass retailers will have either goods or customers unlikely to migrate online. However, if off-line mass merchandisers fail to incorporate the online sales channel they may very well find themselves in a competitive free fire zone unable to protect their in-stores sales. B. A Future History of Online Buying. Underlying trends should galvanize mass merchandisers into incorporating cyberspace’s impact on their business and customers into their strategic thinking. The Table below suggests the kind of trigger events likely over the next three years. This is the short-term in real estate time. If these events materialize, it will confirm the pace and strength of online buying. The key events to monitor are the inexorable increase in wired households and customer expectations about shopping online. If this possible future happens, then existing store leasing strategies are clearly out of sync with retailing in a wired world. A Future History of Online Buying
C. How Will Migrating Sales Impact Store Location Decisions? There is a strong parallel between banks and mass merchandisers in leveraging the value of the online channel. In the past they have sought to grow assets and sales by opening more branches and stores. Cyberspace allows them to reach customers with less physical infrastructure. See Table below. Parallel Futures
1. The Bankers’ Response. The threat to banks from not getting online is to lose many of their most profitable customers while continuing to maintain an expensive branch network. An estimated 22 percent of households are expected to be banking online by the end of 2001. 55 In response banks are taking the offensive by going online to retain and nurture these customers.56 They are also seeking to entice customers online by offering bill presentment.57 In some cases branches are moving into supermarkets to better serve their customers. They must also eliminate costly branches and personnel.58 2. The Mass Merchandisers’ Response. Many of the same dilemmas face mass merchandisers when much of their goods and customers can easily move to cyberspace. Off-line mass retailers now have to confront existing and unknown competitors while maintaining stores, a high cost sales channel, and even when they go online be pressured by autonomous Bots constantly reporting on their prices. In order to develop a survival strategy, mass merchandisers need to perform an INFOTECH SCANsm. An INFOTECH SCANsm asks three interrelated questions. First, what portion of the merchandise can migrate online? Second, what portion of the mass retailer’s customers are likely to buy online? Third, how profitable is the customer segment going online? See Diagram below. INFOTECH SCANsm
a. Examine the Merchandise Mix. Today, what goods and services can be sold online? See Table below. If the merchandise mix consists of name brands like Kleenex, Heinz ketchup, Pilot pens, and HP laser printers or trusted retailer brands, then customers can easily buy or comparison shop online. A subsidiary question asks how much extra value does the mass merchandisers add to the transaction from the customer’s perspective? What Works Online
The more the transaction resembles a "park, pick and purchase" exercise with little human involvement, then the more incentive to buy online. This level of commodity shopping negates the value of location. b. Examine the Customer’s Technographics. How willing is the customer to migrate online? How many customers are already wired? What percentage of the local customer base is likely to become wired over the next several years? Should the mass merchandisers offer incentives to customers for going online? Today, 27 percent of US households are online. 59 By the year 2000, more than 35 percent are likely to be online.60 As previously noted, wired consumers increasingly expect to shop online. Technographic Profile
c. Does Pareto’s Rule Apply? Who are the most profitable group of customers for the mass retailer? What if that group migrates online? Will the online customers confirm Pareto’s 80/20 rule?61 One example from the online world illustrates the point. Virtual Vineyards [www.virtualvineyard.com] found 10 percent of their "core visitor" customers purchased 80 percent of their wine. 62 The best situation for an off-line retailer is to know most of their profitable customers will not migrate to cyberspace. Conversely, the greater the correlation between the most profitable customers and to the pertinent demographics, psychographics and technographics, the greater the risk sales will migrate online. 3. Location Analysis in a Wired World. How can mass merchandisers make location decisions about new stores, adding stores in existing markets, and increasing store size without considering the prevalence of wired customers and online buying? Whether using the gravity model for convenience stores or the analog model for specialty stores, all site selection methodologies rely in some manner on a rear view mirror analysis, i.e., the correlation between distance and the propensity to patronize a particular location. This is a two dimensional spatial model. Cyberspace adds a third dimension to the customer’s decision calculation. The third dimension fundamentally alters the predictive value of existing location decision algorithms. Mass merchandisers face the distinct possibility of falling into a site selection sinkhole by employing analysis not incorporating the likelihood of online buying. They must ask their site selection staff and location software vendors to explain how migrating sales will impact location decisions. Presently, the state of the art is behind the times.63 4. Buying Activity in Cyberspace. Once a determination is made of how much merchandise can readily be sold online, mass merchandisers need to analyze the customers having the greatest propensity to buy online. Surveying store customers is one method. Another is matching the target customer profile with the online population in the store’s trade area. This information is just starting to appear among demographic data providers. One firm, Scarborough Research [www.scarborough.com], conducts semi-annual consumer surveys in over sixty DMAs (Designated Market Area) representing 75 percent of the continental US population eighteen years and older. In 1996, Scarborough began tracking online use and shopping as an adjunct to PC ownership. Shopping encompasses browsing, gathering information and online purchasing. The Charts below contain survey data for the New Orleans, Orlando and San Francisco DMAs.
The second Chart focuses on shoppers. Again San Francisco clearly leads the way with 12 percent shopping online. This represents a tripling since 1996. Orlando’s increase is also impressive. It quadrupled to 8 percent of online users. New Orleans’ growth was rapid but leveled off during the first survey period in 1998.
The online shopping data available from providers like Scarborough is a necessary factor in future location decisions. While shoppers may be in physical proximity to stores, mass merchandisers can no longer assume they will go there when the online channel is available in the home or office. Whether they continue to patronize the same mass retailer online is another question. 5. The Marginal Sales Analysis. The third sales channel would have very little impact on leasing strategy, if there were no effect on store economics. However, this is not the case. Online buying will have a profound impact on individual store financial performance by cannibalizing sales. a. Online Buying Cannibalizes Sales. Retail analysts know it only takes a small change in store sales to have a dramatic impact on individual store profitability. 64 In 1997 at the ICSC Research Conference a presentation entitled Are New Store Sales New?: How The Department Stores Assess Sales Transfer And Incremental Sales Gains discussed the loss of sales either from new competition (sales diversion) or by adding another store in the trade area (sales transfer). Sales transfer is the polite term for cannibalization. One analysis of cannibalization suggested that a mere seven percent shift in store sales could drive down profitability by almost fifty percent. A sluggish decline in variable costs in the face of falling sales is one explanation for the dramatic change in profitability. Unlike catalog shopping that did not impact stores, online shopping is analogous to building a sister store nearby. It transfers a portion of in-store sales from the old store to cyberspace as if it were new store. 65 Already, this is the subject of academic inquiry. 66 Estimating the potential impact on store performance from migrating sales will require knowing the customer’s propensity to shop online, the relative profitability of the customer segment, and the degree store sales could increase from other sources. b. An Expanding Pie? Many believe on-line buying will have a limited impact on store profitability so long as store sales expand. This is known as the expanding pie argument, the assumption being that the ratio between online sales and in-store sales remains constant for each new sales dollar. If the ratio were to remain constant, then the presumed negative impact of migrating sales would be held in check. However, the argument implicitly assumes new sales will come from consumers shopping in the same old way. That is incremental sales are asymptotic in nature, continuing to flow in the same proportion. See Chart below. Such an assumption is very dangerous to make in the face of a rapidly expanding wired population. One need only recall the rise of self-service shopping to realize how quickly habits change. Thus, whether online sales directly cannibalize in-store sales or store sales grow at a slower rate than expected, the new sales channel can dramatically impact store performance.
c. EC MentorTM Shows the Way. The credit card companies and the banks recognize the potential benefits of online shopping. They are encouraging greater online transactions by lowering fees to members, promoting SET and making the benefits of the online channel known to merchants. MasterCard’s EC MentorTM is an example of promoting electronic commerce’s benefits. 67 EC MentorTM is an Excel spreadsheet template developed by Easton Consulting of Stamford, Connecticut,68 for merchants to use in evaluating the net benefit of online sales. It measures the cost to establish the new sales channel versus the added revenue and cost savings associated with online sales. The financial model also seeks to quantify the second order impacts of customer buying habits changing as a result of migrating their purchases online. The implicit message of EC Mentor TM is fixed expenses like rent will decline after the introduction of an online sales channel. Mass merchandisers are facing the prospect of having their in-store sales stagnate, their best customers migrate online and their stores’ financial performance suffer. It will be true whether they capture the migrating purchase in cyberspace or not. The inherent benefits of online buying coupled with the credit card institutions’ incentives to move business online are going to exert a negative force on the store. How should mass retailers bring their store leasing strategy into sync with a wired world? D. Bundle Buying. The stealth competitor Amazon.com demonstrated how quickly an online specialty retailer could develop a large customer base, threaten off-line competitors and achieve market recognition. This is the initial shock online buying brings to mass merchandisers. A second shock awaits them with the advent of bundle buying. Bundle buying is the "next big thing" 69 and should appear within two years. Bundle buying describes a trusted party’s online offering of a wide variety of goods and services in an intuitive and easily shopped format. See Table below. The trusted party goods and services would reflect those from the best supermarket, super drug store and warehouse club. The item offered being the most popular at the lowest price including delivery. The trusted party or intermediary could be a known mass merchandiser, a joint venture under the banner of a nationally know firm, a well know financial institution partnering with recognized category leaders, or perhaps Microsoft. Cendant Corporation’s NetMarket [www.netmarket.com] is the archetype. Customers can purchase groceries, health and beauty items, pet supplies and consumer electronics.
Achieving a critical mass of customers likely requires making the order size small enough for restocking of everyday items while encouraging customers to expand their purchases. Taking orders as low as at fifteen dollars would be a great convenience for singles and the elderly. Bundle buying could devastate community shopping centers anchored by supermarkets and drugstores as sales migrated online. The potential combination of lower prices, wide selection, convenient delivery, minimum order size and ancillary services should give off-line mass retailers pause in continuing to pursue present leasing and construction plans. IV. Sales Channel Reformation in a Wired World. A. Charting a Strategic Course. Aligning real estate practices with the mass merchandiser’s strategic goals is not possible without a clear mandate from senior management and its active involvement. Unless the mass merchandiser believes the online channel will lead to increased profits and cost savings there is little incentive to change leasing and store acquisition strategy. However, changing strategy requires the enthusiastic embrace of the new medium by the merchandising team. Only a mediocre Web presence is possible without savvy merchandisers to know what works and is useful online. In additional, there continues to be a mismatch between space use and space commitments. 1. Ernst &Young Retail Real Estate Survey. The results of the 1998 Ernst & Young survey of retail real estate substantiate the findings of the 1997 survey: planning cycles are considerably shorter than lease terms. 70 See Table below. Planning cycles averaged four years versus a thirteen year average lease commitment. Although, the authors noted smaller retailers were moving towards planning in harmony with shorter lease terms, no trend was yet evident. The second annual survey again highlights the fact real estate leasing is not a fundamental concern of strategic planning. Online shopping, while acknowledged, was not considered a substantial threat to store operations, with income, population and age being the most important site selection criteria. Ernst & Young 1998 Retail Real Estate Survey
B. Strategic Planning Imperative. Many mass retailers can successfully leverage their name recognition into cyberspace. The window of opportunity remains wide open, but failure to implement a strategy within the next eighteen months will most likely cede first mover or second entry advantage to existing or stealth rivals. Traditional mass retailers need to develop new competencies or partner with those providing database management, online merchandising design, and order fulfillment skills. The techniques for developing a successful Web site are more art than science. It gives latecomers a little bit more time. It is reminiscent of 1950s TV programming. The rapid redesign of Web pages makes concern over trying to build the perfect site a fruitless endeavor. Rather, the effort should be seen as a work-in-progress, constantly evolving. New feedback mechanisms are necessary to guide the process and gage customer satisfaction. In addition, what are the metrics for measuring the channel’s return on investment? A common standard must exist to allow comparison with store and catalog operations. Initially, the FUD factor (fear, uncertainty, and doubt) will permeate the group charged with building the new sales channel. However, FUD must not hinder the decision to develop an integrated channel strategy. C. Financial Planning in a Wired World. The opportunities of the third sales channel require mass retailers to evaluate their cost and benefits against the return from stores and paper catalogs. Hybrid metrics are likely necessary to capture performance for the new retail business model. The use of battle management software is one method. 1. Battle Management Software. The introduction of the cyberchannel as a competitor to the store suggests tracking sales and costs in a way to quickly adjust sales channel performance. Instead of waiting years to get out of a lease or remodel a store, performance measurements should signal when to emphasis one channel over another. This requires greater leasehold flexibility. See Diagram below.
Battle management software would provide the continuous feedback and analysis necessary to leverage channel value and allocate resources to maximize return. One important indicator would be to track the location of online shoppers and compare their delivery zip code with the closest store to determine the extent of sales migration. The program should seek to discover opportunities from merchandising in each channel or combination of channels by use of financial metrics to uncover what works online versus what works in the store and/or the catalog. Another feature should be to aid leasing strategy based on sales migration patterns. D. Creating a Wired Leasesm. The goal of a Wired Leasesm is to provide the mass retailer with sufficient flexibility at an affordable cost to reconfigure the sales channel matrix as the online channel grows. Failure to obtain shorter lease terms and early termination rights over the next two to four years carries the risk of having greater difficulty in modifying or terminating store leases as investment opportunities expand online. Already, there are hints in the trade press of online shopping causing retailers to put surplus space on the market. 71 In addition, questions about online sales are beginning to enter some of the sessions at the annual ICSC Law Conference. The Wired Leasesm is a retail lease but with a very different purpose. The primacy of the location is no longer assumed The online channel adds a new dimension to the mass merchandiser’s calculation by fundamentally altering the value of the store. Therefore, space leases must incorporate the concept of migrating sales and lesser demand for space. Many provisions of the traditional retail lease take on new strategic meaning. Early termination rights, the length of the initial term and option periods, and percentage rent rise to a higher level of importance in a wired world. E. Wired Leasesm Objectives. Conceptually there are three interrelated sections in a Wired Leasesm . The first concerns entry strategy. The second section deals with operating strategy. The third part relates to exit strategy. The Diagram below illustrates the interrelated provisions.
1. Entry Strategy. The major issue for entry strategy is to minimize the initial term. The strategic decision to open the online sales channel explicitly requires determining what portion of sales will come from cyberspace, the store and catalog. This guides the initial term decision. If customers are likely to remain geocentric, then the initial term may be lengthened. Conversely, if a rapid migration is envisioned, then a shorter initial term is necessary. If options are sought, then determining the length of each option period and number of options becomes a function of estimating the portion of the customer base likely to remain store shoppers. Seeking a short-term lease impacts build-out expenses and fixture costs. Who absorbs them and over what time period? Perhaps the real question to ask is "How does online shopping change the store’s format, build-out requirements, and fixture needs?" 2. Operating Strategy. The major issues in operating strategy analysis are use, percentage rent, co-tenancy, and contraction/expansion/relocation rights. a. Use. Merchandising philosophy is at the heart of the use clause. In a wired world an attempt to limit merchandise mix is counter productive. The mass merchandiser should be expecting to reinvent itself because of online shopping and competitive challenges. It is very disadvantageous to commit to a merchandise mix via the use clause. The Wired Leasesm requires a very expansive use clause. b. Percentage Rent. The tenant’s obligation to pay percent rent takes on several new facets for mass retailers going online. The issues are the cybercafe "gotcha", what percent to apply if the tenant’s primary merchandise mix changes, and the associated issues of exclusive use and radius clauses. Cybercafes are becoming popular in malls. 72 Patrons can go online while having a snack. But what happens if the patron makes a purchase online in the Cybercafe from a mall tenant’s Web site? Is the retailer obligated to pay percentage rent? Will landlords begin including a cyber-radius clause for recouping off-site sales back into the mass merchandiser’s percentage rent obligations? An expansive use clause undermines the value to a mass retailer of the exclusive right to sell specific merchandise in a center. A mass merchandiser’s overall strategic goal will balance these inconsistent positions. If there is a flexible use provision, will changes in merchandise mix over a certain threshold trigger a new percentage rate to apply? Will it apply across the board or along categories? How will the rate be set? c. Co-tenancy. Cyberspace may significantly diminish the value of co-tenancy. What happens when the co-tenant in the mall significantly reduces store size, changes use or alters merchandise mix? d. Expansion/Contraction/Relocation Rights. The Wired Leasesm requires mass retailers to be able to contract, expand, and relocate a store within the project. The lack of flexibility in the face of changing customer buying habits hinders the goal of aligning store size with shopping patterns in a wired world. The mass merchandiser needs to view this provision as a cost item and expect landlords to bargain aggressively. 3. Exit Strategy. The essence of a Wired Leasesm is to shorten the lease commitment. This can be done in a number of ways by use of a kick-out right, right to go dark, a Put and a flexible assignment/sublet provision. Each tactic carries a cost to compensate the landlord for the increased risk of uncertain cash flow. It is likely all of these provisions require modification and need to be used in conjunction with other lease clauses to achieve the mass merchandiser’s goal. a. Kick-Out/Early Termination. Generally, a kick-out provision terminates the lease early based on under performing sales. If sales fall below a predetermined level within a specific period, then one party may terminate the lease. It can be a unilateral or mutual right. The Ernst & Young survey noted retailers consider this a key provision. 73 The ongoing impact of online shopping on in-store sales requires the provision to continue through the original term and option periods. Also, should the sales target change over time due to the retailer’s shifting space needs? A proxy of sales per square foot could be used to established the level. If the property owner contributes to space improvements or fixture costs, how will a portion of the cost be recaptured? Will leasing commissions be paid in arrears? What other actual and opportunity costs will the landlord seek to claim? 1. Synthetic Lease. If use of a synthetic lease structure is under consideration, the concern should be with early termination rights. 74 Under what circumstances, if any, can the tenant obtain the synthetic lease’s financial benefits and still terminate early? What are the costs and risks? b. Go Dark. A variation on the "Kick Out" is the "Go Dark" provision allowing the retailer to discontinue operations although still requiring the tenant to pay rent and perform other lease obligations. If the tenant is obligated to pay percentage rent, then the continuous operations clause may frustrate the ability to terminate operations.75 c. Put. Alternatively, the retailer could obtain the right to "Put" the space back to the landlord. Could the tenant give a portion back? Pricing this right, over what time period, and having it apply to options will be the subject of hard bargaining. d. Assignment/Sublet. The Wired Leasesm requires a flexible assignment or sublet right. Will the retailer have the right to assign the lease? Will the tenant receive a novation from the landlord? Can the space be partially sublet? Can the tenant have concessionaires? If the tenant has concessionaires, is there a maximum amount of space they may occupy? Does the use provision significantly restrict a potential assignee or subtenant? Finally, how will mass retailers deal with a potential subtenant seeking to negotiate a Wired Leasesm? 4. Rent’s Role. It is counter-intuitive for most real estate practitioners to consider rent as a residual issue since almost all discussions about space start with asking "How much?" However, the question assumes there is no direct competitor to location. This is no longer the case for many mass merchandisers. Instead, location is becoming more commodity like and will have to start competing with cyberspace for the channel investment. The question to ask in the context of a Wired Leasesm analysis is "What is the cost of buying flexibility for changing the sales channel matrix?" Will the cost be expressed in terms of fixed rent with periodic increases and decreases? Will rent be a percentage of the tenant’s gross store sales and adjusted periodically? Or will the rent be a lower fixed amount traded for a higher percentage rent?76 It will be a challenge to quantifying the cost for lease flexibility. Further, those who seek to create the Wired Leasesm will have to devote considerable time in educating property owners and lenders. However, the failure to pursue greater flexibility in lease termination rights will narrow the mass retailer’s flexibility during a period of great upheaval. F. Adaptive Reuse of Stores Many mass retailers own stores. This moves them over the landlord/property owner side of the relationship. If owning the property is an attractive investment option, mass retailers need to consider the adaptive reuse potential of the property. Online buying’s growth will cause some locations to close within a trade area, others will require downsizing into showrooms along with abandoning locations. Will these properties be attractive to other retailers or can they serve another purpose? In the case of existing stores, what tax incentives are available for conversion? 77 Are there zoning, use and community opposition hurdles? Will lenders come forward? Will the new use generate a sufficient return? New construction offers the opportunity to design-in multiple use possibilities, seek flexible use and zoning restrictions, explore different kinds of government and tax incentives and improve on the return. Consider the case of a 100,000 square foot Big Box going on the block. Possible new uses include a pet hospital and vertical cemetery (the Necropolis), a wellness and convalescent center (Health World), a continuing education and training facility (Learning Land), and a theme residential development (Paris in the 1920s). Part of the parking lot could also be made into a park. Adaptive Reuse Big Box Example
When the mass merchandiser seeks to sell the property with a Wired Leasesm, prospective buyers may balk at taking on the perceived uncertainties inherent in a Wired Leasesm or the buyer’s lender may find the lease terms a little too novel. This is a foretaste of the conflicts ahead but owners, buyers and lenders will discover pragmatic solutions for laying-off risk. G. A trading market for retail space. Everyday tech’s disintermediative influence on retail space could also become a reintermediative one. Everyday tech allows the networking of mass merchandisers and Wall Street. This would lead to a national online market for trading leased and owned retail space. The commodity and options markets offer an analog. Although daunting in complexity, market makers would develop standardized lease clauses assuring delivery and accepted option pricing formulas. 78 Mass retailers could then hedge their space needs and adjust the sales channel mix by increasing and decreasing physical space. Mass merchandisers, developers, REITs and other owners could enter the market to hedge their investments thereby adding liquidity. The powerful networking capability of everyday tech stands to fundamentally change the attendant risks of owning and leasing retail space. H. Reward Past Success. The strategic decision to develop the online sales channel and to change the role of stores will send shock waves throughout the retailer’s organization and demoralize the real estate staff. Site selectors, deal negotiators, construction people and property managers will all suffer a loss of self-esteem. Part of the strategic decision must recognize the continued value of the real estate team. A "thank you" bonus or immediate staff salary increase would help to stem defections and offer reassurance of their continuing value. Their success in finding, developing and maintaining profitable sites has to be acknowledged and cultivated. They are the ones who can take the new goals and mold them into workable strategy. The real estate team has the experience and personal contacts with the developers, property owners and lenders to take what seem "far out" ideas and bring them to fruition. They are best suited to renegotiate existing agreements or push for a Wired Leasesm . V. Winners in a Wired World. Utilizing a Wired Leasesm is part of the strategic shift necessary for mass retailers to leverage and enhance their merchandising skills in a wired world. However, to be successful they will need to exceed the expectations of their customers and Wall Street. A. Customer Expectations. Traditional mass merchandisers online will encounter a very different type of customer. These customers are not reticent about criticizing bad service, lack of inventory, missed deliveries, high prices and a host of other complaints that most off-line customers would never express. Mass retailers should plan for parody sites mocking the company, email barrages or worse. On the other hand, mass merchandisers will find online customers very complimentary when they receive better service, selection, price and value. Customers will praise the site, make valuable suggestions, seek to add features and in many ways begin community building around the site.79 B. Don’t Disappoint Wall Street. TIME magazine’s July 20 cover screaming "KISS YOUR MALL GOODBYE Online shopping is faster, cheaper and better" captured the public’s excitement over online shopping. It culminates Wall Street’s two year love affair with Internet firms and shopping stocks in particular. Witness Amazon.com’s value. On October 5 the stock was worth $5.3 bn as compared to Barnes & Noble and Border’s combined value of $3.4 bn. Although, some analysts challenge the Amazon.com model,80 the stock market’s extraordinary valuation of this storeless bookstore relates to the market’s perception of a fundamental change in retailing ahead. 81 Publicly traded mass retailers slow to embrace the new sales channel risk incurring the ire of stock analysts and market commentators.82 Those particularly susceptible to the growing online competition may find their stores derisively referred to as a "stranded asset"83 and the stock price punished. Others outside the equity market may begin expressing concern when a mass merchandiser fails to understand the online channel’s long-term consequences. Lenders are one such group. Another group is credit rating agencies. Recently, Fitch IBCA expressed concern over the credit quality implications for traditional mass retailers of online buying and the failure to adapt. 84 Mass merchandisers providing employees with stock options also need to be concerned with negative market sentiment. This will add subtle pressure on management to implement the new sales channel. VI. Summary. A ferocious battle is about to erupt over the primacy of the store for mass retailers. Online buying is quickly seizing sales from traditional land based merchants. Over the next several years many mass merchandisers will provide their customers with fully transactional sites. In doing so they will initiate a cycle of sales migration to cyberspace and declining store performance. This is the benign sales cannibalization scenario. Some mass merchandisers will not be so lucky. Stealth competitors will accelerate the migration and pirate greater online sales. This is the search and destroy sales cannibalization scenario. In either case, the economics of the store are coming under attack. Defending their business requires mass retailers to reform the sales channel. Space flexibly is one means. This requires the use of a Wired Leasesm. It gives the mass merchandiser the ability to shift among the store, cyberspace and the catalog to achieve maximum sales channel profitability. Continuing to pursue an exclusively store based strategy will result in collateral damage. Security analysts, bankers and investors will downgrade the stock and creditworthiness for the lack of foresight. In the transition to a wired world mass merchandisers have the opportunity to develop a sales strategy aligned with everyday tech. The strategy will rely less on physical space and more on cyberspace. Future space leases will be of substantially shorter duration and store design will incorporate many multipurpose features for later adaptive reuse. Victory will follow from this battle plan. (10/7/98)
Copyright © 1998. Mark Borsuk. All Rights Reserved, except the reader may copy this article into electronic form or print for personal use only, provided that: 1) the article is not modified; and 2) all such copies include this copyright notice. *Mark Borsuk is Managing Director of The Real Estate Transformation Group, a firm analyzing information technology’s impact on space demand and providing strategies for property owners, developers, retailers and lenders. In addition to consulting, Mark is a retail leasing broker and real property attorney practicing in San Francisco. Mark’s focus is on store leasing strategy in a wired world. Some have called him a "fringe visionary" for pointing out this embryonic issue. In his view, high tech is becoming everyday tech for many families. Everyday tech will shift a portion of their buying online thereby changing fundamental geocentric shopping patterns. In other words, online buying will take the shop out of shopping. Mark has written extensively on how the daily use of computer hardware, software, networks and telecommunications transforms attitudes about work, learning and shopping. His articles appear in Discount Store News, Pensions & Investments, The Journal of Applied Real Estate Analysis, Real Estate Review, and Urban Land. Much of his analysis is on the Internet. Mark has addressed this topic before the Stanford Real Estate Round Table, the ICSC, the Urban Land Institute, the NRF, and institutional investors. Prior to entering real estate, Mark was a foreign exchange trader and currency advisor in New York and Tokyo. Speaking and reading Japanese, he pioneered in the analysis of the Yen and the Japanese money markets. His articles appeared in many financial publications including Euromoney and the Asian Wall Street Journal. Mark holds an MBA from Sophia University (Tokyo), a Japanese language certificate from Nichibei Kaiwa Gakuin (Tokyo), and a JD from Loyola University (Los Angles) where he was a member of the Law Review.
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