(Part II of the Hammer and the Dance Series)
I started writing this post as a sequel to the “Hammer and the Dance” post about health care. This one is focused on retail. As soon as I started writing it, the scope expanded significantly. I’ve been doing a lot of work on retail strategy for the past couple of years, and it quickly became clear that the pandemic is acting much more like a catalyst for changes already afoot in brick-and-mortar retail than as a prime mover event.
In this post I attempt to (1) outline the structural headwinds that brick-and-mortar retail faced before the pandemic; (2) discuss how the pandemic has accelerated these trends, and, (3) discuss a likely near-term future for brick-and-mortar retail. In a nutshell, the pandemic has fast-forwarded retail’s creative destruction by several years.
Brick-and-Mortar Retail Before COVID-19
COVID-19 has obviously been terrible for retail, but the struggles faced by “brick-and-mortar distributors” predated the novel coronavirus. The structural headwinds faced by the retail industry are rooted in changing human behavior, values, and demographics, and have been building for at least 20 years.
Retail represents, at its most fundamental level, a deal between consumers and manufacturers. From a consumer perspective, the ideal scenario for acquiring a functional physical item is for that item to instantly appear, fully assembled, in the home. From the manufacturer’s perspective, the ideal scenario is for the consumer to pick the item up, at the factory, with no packaging or marketing material surrounding it. In both cases, utility is maximized. When retail shifted from local to mass in the post-war period, a stable equilibrium was reached. Large stores would accept packaged items from manufacturers, and house and market these items. Consumers would drive to these stores and bring the items home. This equilibrium lasted until roughly 2000. Five decades isn’t bad
In the interim, retail kept innovating. It added experience to the utility-driven bargain, making shopping more interesting and compelling as an activity in itself. Stores like Nordstrom added live pianists; luxury brands made the store itself a badge; indoor malls attracted portfolios of stores around a common area to make shopping an all-day social experience. In all cases, expense was added to the equation by the retailers in an effort to create an emotional bond with shoppers. This reached its apogee in the last few decades, as experience-based retailers dominated with wealthy shoppers.
However, several concurrent megatrends were slowly eating away at this distribution structure.
1. Income Inequality
Income inequality, which began rising in the 1970s, continued to narrow the audience for which experience-based retail was profitable. Luxury brands like Neiman Marcus were insulated from this trend by an increasingly wealthy top 1-2% of the population, but mass affluent-targeted stores slowly saw shoppers purchase less and move away from their stores. Affluent brands retreated to the same ZIP codes across the United States that could support their prices, sort of like ants retreating to higher ground in a flood. Big box retailers moved in, stripping out experience for lower prices. They made minimizing price the explicit offer, vs. compromises between some service and reasonable prices. Retail bifurcated just like the lower middle class and upper class.
2. Logistics Improvement
Logistics—that boring management science that seeks to get things places faster and cheaper—has been undergoing a slow-motion renaissance for decades. When the retail compromise between manufacturers and consumers was first forged, it was exceedingly difficult to get small numbers of things to a large number of locations. Instead, large numbers of things were sent to a small number of locations. As that equation flipped, retailers’ cost advantage evaporated. Think of it this way—to go to the store, a typical consumer might drive 15 miles round trip and take two hours out of their day. Using IRS mileage rules and minimum wage as an opportunity cost, that trip—if the consumer views it as a chore, not a treat—this trip costs the consumer about $23. It’s logical to assume that when the cost to ship these items falls significantly below this threshold, a shopper will choose to stay home.
Technology has obviously changed everything when it comes to shopping, but too often this is left as a facile statement and not explored. Only two things really matter: search and platforms.
The achilles’ heel of functional in-store shopping is finding things. This problem can be broken down into two sub-problems: (1) finding a specific item in a vast store, and, (2) whether an item is in-stock at all. The first problem reduces the efficiency of the shopping visit itself, whereas the second prevents the shopper from acquiring the item at all. In the past, if an item wasn’t available locally, in most cases shoppers just didn’t go to the trouble of finding it elsewhere.
Search removes the “hard to find” use case, obviously. The concept of brick-and-mortar retail relies on shoppers knowing where things are generally. While this seems like a small thing to people who grew up before Google, today, it’s increasingly a lot to ask. The fact that “that one shop” has something cool is becoming less and less of a factor.
Platforms remove the “is it even in stock” use case by networking together thousands of providers to dramatically improve selection. Amazon continually repeats that it isn’t a retailer—it’s a platform. This is partially true; Amazon has giant warehouses and owns plenty of inventory. But the true part is that it is incredibly easy for Amazon to expand its selection through its affiliate program. By providing the “pipes” for marketing, product configuration, and fulfillment, sellers naturally flow to demand, creating a basically unlimited supply. The long tail of the supply—the part that very few people need—might be sketchy and take a long time to ship, but it will likely be available.
Combining search with platforms creates an almost unstoppable headwind for brick-and-mortar retail. I often tell the story of my basement refrigerator. It is an old piece of junk primarily used for storing beer. I do not want to replace it. It konked out a few years ago. I deduced that the fan had stopped running, and took out the fan motor, which had a code on it. I typed the code into my phone; an Amazon or eBay page popped up with the motor for something like $25; and I hit “buy now”. Two days later, a small box arrived. I replaced the motor and fixed the refrigerator. Keep in mind, I know nothing about refrigerators. Five years ago, this would have been unlikely; ten years ago, impossible. You can now find literally anything in a second.
The Pandemic Catalyst
The COVID-19 pandemic has taken these three megatrends—income inequality, logistics improvement, and technology—and accelerated them dramatically. At the same time, the physical problem of actually entering a store, either due to fear of contracting the virus or government restrictions—hammered retailers’ cash flows. And, further complicating the picture, consumers’ needs for products shifted overnight, adding a sector-by-sector plus or minus to the whole equation. The result, obviously, has been the single largest disruption to brick-and-mortar retail ever.
Income inequality has only gotten worse through the pandemic. Knowledge workers have largely held into their jobs. They began hoarding cash as their expenses shrank, and banks have reporting swelling balance sheets due to money sitting around at 0% interest rates in checking and savings accounts. Lower-middle class workers, on the other hand, have lost their jobs in droves in a vicious cycle. All those knowledge workers not eating out directly transferred cash from the poor to the well off. There is no reason to believe that this trend will reverse absent massive government action. The result will be a further acceleration of the demise of retail positioned to the ever more fleeting middle class.
Similarly, logistics providers have upped their games out of sheer necessity. W.B. Mason, who traditionally used its fleet of trucks to deliver office supplies, started delivering to homes. Amazon briefly lost ground to competitors as demand outstripped supply—which led Amazon to hire thousands more drivers and packers, add even more AI and machine learning, and move even more items physically closer to shoppers. The pandemic, in other words, has accelerated the ability of e-tailers to get more items to more shoppers even faster. The brick-and-mortar logistics compromise will be less relevant than ever.
Finally, technology has marched on even faster, as evidenced by the meteoric rises in the share prices of Google, Apple, Microsoft, and Amazon through the pandemic. After a slight hiccup in March, the tech giants are flying higher than ever, as people use technology to cope with being locked inside. Any barriers remaining for e-commerce are finally totally gone, as it has become essential for everyone to exist primarily online if they want to survive during a period of enforced physical distance.
Insulated Sectors and Brick-and-Mortar Adaptation
However, this acceleration is forcing retailers to adapt faster than ever, which might be a good thing for the long-term health of brick-and-mortar stores. At the outset of the pandemic, only a few people predicted that home improvement would get a giant boost as people staying at home all had the same idea at the same time—if I’m stuck here, I might as well fix it up. Hardware stores generally are seeing massive increases in sales, driven by people spending more time in their homes—and thus wanting to improve their nest. But home improvement stores have another critical advantage over online providers: timely need. Home projects happen on weekends, and DIYers typically need more supplies multiple times even during one day. Their supplies are also bulky and poorly packages (think, drywall.)
Still, home improvement retailers have adapted even with their sector advantage. Within two months of the first case, Home Depot had put in place a slick web-based curbside pickup engine for those who didn’t feel comfortable coming into their stores. And, this curbside pickup improved almost weekly. First, an associate came out and asked you for your ticket. This was inefficient, so Home Depot (and Domino’s Pizza) implemented a text-when-you’re here function.
Apparel, on the other hand, has been hammered, as people have few reasons to dress up. Department stores in particular, who order massive shipments of inventory before the season, have been crushed as stores were closed and demand evaporated. The list of bankruptcies reads like a who’s who of 1990s mall stores: J. Crew (May 4th), Neiman Marcus (May 7th), J.C. Penny (May 15th), Lucky Brand (July 3rd), Brooks Brothers (July 8th) and Lord & Taylor (August 2nd). It’s hard to see what adaptations, if any, apparel companies can make until COVID-19 is “over.” And unfortunately for them, as consumers get more used to ordering and returning clothes online, it’ll be harder and harder for them to come back. The pandemic is literally training a generation that they don’t need to go to a store to buy clothes or shoes.
One sector that also seems insulated is the “niche emotional boutique” store. These are the stores that exist on love, not need. After Marvel, D.C., Image, and Dark Horse all stopped printing new comics in mid-March, many wondered if local comic book shops would survive. But readers were patient, and when localities started reopening in mid-May, shops instituted their own curbside ordering and delivery, leveraging email marketing, podcasts to drive engagement, and a renewed focus on their websites. Generally, shoppers have rewarded those businesses that have made an effort to meet them safely with innovative shopping experiences and intimate marketing. And, because there is a high involvement relationship between the thing being sold and the store / proprietor itself, it’s quite possible that these types of brick-and-mortar storefronts will survive.
Conclusion: Creative Destruction at Light Speed
There will always be stores. People do enjoy going out and buying things, and certain sectors will never be replaced by a webpage and a brown cardboard box. However, the places people didn’t enjoy—or tolerated only out of necessity—are dying a quick and probably well-deserved death. The pandemic will accelerate the integration of online with brick-and-mortar, as supply chains are shortened in space, and more importantly, time. Expect to see long-awaited trends, like predictive inventory, mini-stores with quick-availability items, and walk-out checkout move much faster during and after COVID. In the long run, I have a feeling that this pandemic will be good for retail, as weaker sectors are cleaned out aggressively, and remaining entrants survive on relevance, irreplaceability, innovation, and love.