How Ants Kill Elephants – The Amazon.com, Sears & Walmart Story

How Ants Kill Elephants – The Amazon.com, Sears & Walmart Story

The US e-commerce market is just under 10% the size of entire retail market. On the face of it this would indicate that the game is far from over for big traditional retail. After all, how could such a small segment kill profits for such a huge industry based on enormous traditional players?

US ecommerce Statista

Yet, Sears – once a Dow Jones component and the world’s most powerful retailer – has announced it will close 100 more stores. The Kmart/Sears chain is now only 894 stores – down from thousands at its peak and 1,275 just last year. Revenue dropped 30% versus a year ago, and quarterly losses of $424M were almost 15% of revenues.

But, that ignores marginal economics. It often doesn’t take a monster change in one factor to have a huge impact on the business model. Let’s say Sales are $100. Less Cost of Goods sold of $75. That leaves a Gross Margin of $25. Selling, General and Administrative costs are 20%, so Operating Income is only $5. The Net Margin before Interest and Taxes is 5%. (BTW, these are the actual percentages of Walmart from 1/31/18.)

Now, in comes a new competitor – like Amazon.com. They have no stores, no store clerks, and minimal inventory due to “e-storefront” selling. So, they are able to lower prices by 5%. That seems pretty small – just a 5% discount compared to typical sales of 20%, 30% even 50% (BOGO) in retail stores. Amazon’s 5% price reduction seems like no big deal to established firms.

But, Walmart has to lower prices by 5% in response, which lowers revenues to $95. But the stores, clerks, inventory, distribution centers and trucks all largely remain. With Cost of Goods Sold still $75, Gross Margin falls to $20. Fixed headquarters costs, general and administrative costs don’t change, so they remain at $20. This leaves Operating Income of …$0.

(For more detailed analysis see “Bigger is Not Always Better – Why Amazon is Worth More than Walmart” from July, 2015.)

How can Walmart survive with no profits? It can’t. To get some margin back, Walmart has to start shutting stores, selling assets, cutting pay, using automation to cut headcount, beating on vendors to offer them better prices. This earns praise as “a low cost operation.” When in fact, this makes Walmart a less competitive company, because it’s footprint and service levels decline, which encourages people to do more shopping on-line. A vicious circle begins of trying to recapture lost profitability, while sales are declining rather than growing.

Walmart was (and is) huge. Even Sears was much bigger than Amazon.com at the beginning. But to compete with Amazon.com both had to lower prices on ALL of their products in ALL of their stores. So the hit to Walmart’s, and Sears’, revenue is a huge number. Though Amazon.com was a much, much smaller company, its impact explodes on the larger competitor P&L’s.

This disruption is felt across the entire industry: ALL traditional retailers are forced to match Amazon and other e-commerce companies, even though there is no way they can cut costs enough to compete. Thus, Toys-R-Us, Radio Shack, Claire’s and Bon-Ton have declared bankruptcy in 2018, and the once great, dominant Sears is on the precipice of extinction.

All of which is good news for Amazon.com investors. Amazon.com has 40% market share of the entire e-commerce business. The fact that e-commerce is only 10% of all retail is great news for Amazon investors. That means there is still an enormously large market of traditional retail available to convert to on-line sales.

The shift to e-commerce will not be stopping, or even slowing. Since January, 2010 the future has been easily predictable for traditional retail’s decline. The next few years will see a transition of an additional $2.5 trillion on-line, which is 5X the size of the existing e-commerce market!

As stores close new competitors will emerge in the e-commerce market. But undoubtedly the big winner will be the company with 40% market share today – Amazon.com. So what will Amazon’s stock be worth when sales are 5x larger (or more) and Amazon can increase profits by making leveraging its infrastructure and slow future investments?

Twenty years ago, Amazon was a retail ant. And retail elephants ignored it. But that was foolish, because Amazon had a different business model with an entirely different cost of operations. And now the elephants are falling fast, due to their inability to adapt to new market conditions and maintain their growth.
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Author’s Note: In June, 2007 I was asked to predict WalMart’s future. Here are the predictions I made 11 years ago:

  • “In 5 years (2012) Walmart would not have succeeded internationally” [True: Mexico, China, Germany all failed]
  • “In 5 years (2012) Walmart would no new businesses, and its revenue will be stalled” [True]
  • In 5 years (2012) Walmart would be spending more on stock repurchases then investing in its own stores or distribution” [True – and the Walton’s were moving money out of Walmart to other investments]
  • “In 10 years (2017) Walmart would take a dramatic act, and make an acquisition” [True: Jet.com]
  • “In 10 years (2017 Walmart’s value would not keep up with the stock market” [from 6/2007 to 6/2017 WMT went from $48 to $75 up 56.25%, DIA went from $134 to $180 up 34.3%, AMZN went from $70 to $1,000 up 1,330% or 13.3x]
  • “In 30 years (2037) Walmart will only be known as “a once great company, like General Motors”
Why McDonald’s and Apple Investors Should Be Very Wary

Why McDonald’s and Apple Investors Should Be Very Wary

Growth Stalls are deadly for valuation, and both Mcdonald’s and Apple are in one.

August, 2014 I wrote about McDonald’s Growth Stall.  The company had 7 straight months of revenue declines, and leadership was predicting the trend would continue.  Using data from several thousand companies across more than 3 decades, companies in a Growth Stall are unable to maintain a mere 2% growth rate 93% of the time. 55% fall into a consistent revenue decline of more than 2%. 20% drop into a negative 6%/year revenue slide. 69% of Growth Stalled companies will lose at least half their market capitalization in just a few years. 95% will lose more than 25% of their market value.  So it is a long-term concern when any company hits a Growth Stall.

Growth StallA new CEO was hired, and he implemented several changes.  He implemented all-day breakfast, and multiple new promotions.  He also closed 700 stores in 2015, and 500 in 2016.  And he announced the company would move its headquarters from suburban Oakbrook to downtown Chicago, IL. While doing something, none of these actions addressed the fundamental problem of customers switching to competitive options that meet modern consumer food trends far better than McDonald’s.

McDonald’s stock languished around $94/share from 8/2014 through 8/2015 – but then broke out to $112 in 2 months on investor hopes for a turnaround.  At the time I warned investors not to follow the herd, because there was nothing to indicate that trends had changed – and McDonald’s still had not altered its business in any meaningful way to address the new market realities.

Yet, hopes remained high and the stock peaked at $130 in May, 2016.  But since then, the lack of incremental revenue growth has become obvious again. Customers are switching from lunch food to breakfast food, and often switching to lower priced items – but these are almost wholly existing customers.  Not new, incremental customers.  Thus, the company trumpets small gains in revenue per store (recall, the number of stores were cut) but the growth is less than the predicted 2%.  The only incremental growth is in China and Russia, 2 markets known for unpredictable leadership.  The stock has now fallen back to $120.

Given that the realization is growing as to the McDonald’s inability to fundamentally change its business competitively, the prognosis is not good that a turnaround will really happen.  Instead, the common pattern emerges of investors hoping that the Growth Stall was a “blip,” and will be easily reversed.  They think the business is fundamentally sound, and a little management “tweaking” will fix everything.  Small changes will lead to the  classic hockey-stick forecast of higher future growth.  So the stock pops up on short-term news, only to fall back when reality sets in that the long-term doesn’t look so good.

Unfortunately, Apple’s Q3 2016 results (reported yesterday) clearly show the company is now in its own Growth Stall.  Revenues were down 11% vs. last year (YOY or year-over-year,) and EPS (earnings per share) were down 23% YOY.  2 consecutive quarters of either defines a Growth Stall, and Apple hit both.  Further evidence of a Growth Stall exists in iPhone unit sales declining 15% YOY, iPad unit sales off 9% YOY, Mac unit sales down 11% YOY and “other products” revenue down 16% YOY.

This was not unanticipated.  Apple started communicating growth concerns in January, causing its stock to tank. And in April, revealing Q2 results, the company not only verified its first down quarter, but predicted Q3 would be soft.  From its peak in May, 2015 of $132 to its low in May, 2016 of $90, Apple’s valuation fell a whopping 32%!  One could say it met the valuation prediction of a Growth Stall already – and incredibly quickly!

But now analysts are ready to say “the worst is behind it” for Apple investors.  They are cheering results that beat expectations, even though they are clearly very poor compared to last year.  Analysts are hoping that a new, lower baseline is being set for investors that only look backward 52 weeks, and the stock price will move up on additional company share repurchases, a successful iPhone 7 launch, higher sales in emerging countries like India, and more app revenue as the installed base grows – all leading to a higher P/E (price/earnings) multiple. The stock improved 7% on the latest news.

So far, Apple still has not addressed its big problem.  What will be the next product or solution that will replace “core” iPhone and iPad revenues?  Increasingly competitors are making smartphones far cheaper that are “good enough,” especially in markets like China.  And iPhone/iPad product improvements are no longer as powerful as before, causing new product releases to be less exciting.  And products like Apple Watch, Apple Pay, Apple TV and IBeacon are not “moving the needle” on revenues nearly enough.  And while experienced companies like HBO, Netflix and Amazon grow their expanding content creation, Apple has said it is growing its original content offerings by buying the exclusive rights to “Carpool Karaoke – yet this is very small compared to the revenue growth needs created by slowing “core” products.

Like McDonald’s stock, Apple’s stock is likely to move upward short-term.  Investor hopes are hard to kill.  Long-term investors will hold their stock, waiting to see if something good emerges.  Traders will buy, based upon beating analyst expectations or technical analysis of price movements. Or just belief that the P/E will expand closer to tech industry norms. But long-term, unless the fundamental need for new products that fulfill customer trends – as the iPad, iPhone and iPod did for mobile – it is unclear how Apple’s valuation grows.

Investors May Regret Target’s CEO Ouster – Look at Sears, JCP

Investors May Regret Target’s CEO Ouster – Look at Sears, JCP

Lots of press this week about Target’s CEO and Chairman, Gregg Steinhafel, apparently being forced outBlame reached the top job after the successful cyber attack on the company last year.  But investors, and customers, may regret this somewhat Board level over-reaction to a mounting global problem.

Richard Clark is probably America’s foremost authority on cyber attacks.  He was on America’s National Security Council, and headed the counter-terrorism section.  Since leaving government he has increasingly focused on cyber attacks, and advised corporations.

In early 2013 I met Mr. Clark after hearing him speak at a National Association of Corporate Directors meeting.  He was surprisingly candid in his comments at the meeting, and after.  He pointed out that EVERY company in America was being randomly targeted by cyber criminals, and that EVERY company would have an intrusion.  He said it was impossible to do business without working on-line, and simultaneously it was impossible to think any company – of any size – could stop an attack from successfully getting into the company.  The only questions one should focus on answering were “How fast can you discover the attack?  How well can you contain it? What can you learn to at least stop that from happening again?”

So, while the Target attack was large, and not discovered as early as anyone would like, to think that Target is in some way wildly poor at security or protecting its customers is simply naive.  Several other large retailers have also had attacks, include Nieman Marcus and Michael’s, and it was probably bad luck that Target was the first to have such a big problem happen, and at such a bad time, than anything particularly weak about Target.

We now know that all retailers are trying to learn from this, and every corporation is raising its awareness and actions to improve cyber security.  But someone will be next.  Target wasn’t the first, and won’t be the last.  Companies everywhere, working with law enforcement, are all reacting to this new form of crime.  So firing the CEO, 2 months after firing the CIO (Chief Information Officer), makes for good press, but it is more symbolic than meaningful.  It won’t stop the hackers.

Where this decision does have great importance is to shareholders and customers.  Target has been a decent company for its constituents under this CEO, and done far better than some of its competitors.  The share price has doubled in the last 5 years, and Target has proven a capable competitor to Wal-Mart while other retailers have been going out of business (Filene’s Basement, Circuit City, Linens & Things, Dots, etc.) or losing all relevancy (like Abercrombie and Fitch and Best Buy.)  And Target has been at least holding its own while some chains have been closing stores like crazy (Radio Shack 1,100 stores, Family Dollar 370 stores, Office Depot 400 stores, etc.)

Just compare Target’s performance to JCPenney, who’s CEO was fired after screwing up the business far worse than the cyber attack hurt Target.  Or, look at Sears Holdings.  CEO Ed Lampert was heralded as a hero 6 years ago, but since then the company he leads has had 28 straight quarters of declining sales, and closed 305 stores since 2010.  Kmart has become a complete non-competitor in discounting, and Sears has lost all relevancy as a chain as it has been outflanked on all sides.  CEO Lampert has constantly whittled away at the company’s value, and just this week told shareholders that they can simply plan on more store closings in the future.

And vaunted Wal-Mart is undergoing a federal investigation for bribing government officials in Mexico to prop up its business. Wal-Mart is constantly under attack by its employees for shady business practices, and even lost a National Labor Relations Board case regarding its hours and pay practices. And Wal-Mart remains a lightning rod for controversy as it fights with big cities like Chicago and Washington, DC about its ability to open stores, while Target has flourished in communities large and small with work practices considered acceptable.  And Target has avoided these sort of internally generated management scandals.

CEOs, and Boards of Directors, across the nation have been seriously addressing cyber security for the last couple of years.  Awareness, and protective measures, are up considerably.  But there will be future attacks, and some will succeed.  It is unclear blaming the CEO for these problems makes any sense – unless there is egregious incompetence.

On the other hand, finding a CEO that can grow a business like Target, in a tough retail market, is not easy.  Destroying KMart, while battling Wal-Mart, and still trying to figure out how to compete with Amazon.com is a remarkably difficult job.  Perhaps the toughest CEO job in the country.  Steinhafel had performed better than most.  Investors, and customers, may soon regret that he’s not still leading Target.

2 Wrongs Don’t Fix JC Penney

JCPenney's board fired the company CEO 18 months ago.  Frustrated with weak performance, they replaced him with the most famous person in retail at the time. Ron Johnson was running Apple's stores, which had the highest profit per square foot of any retail chain in America.  Sure he would bring the Midas touch to JC Penney they gave him a $50M sign-on bonus and complete latitude to do as he wished.

Things didn't work out so well.  Sales fell some 25%.  The stock dropped 50%.  So about 2 weeks ago the Board fired Ron Johnson.

The first mistake:  Ron Johnson didn't try solving the real problem at JC Penney.  He spent lavishly trying to remake the brand.  He modernized the logo, upped the TV ad spend, spruced up stores and implemented a more consistent pricing strategy.  But that all was designed to help JC Penney compete in traditional brick-and-mortar retail. Against traditional companies like Wal-Mart, Kohl's, Sears, etc.  But that wasn't (and isn't) JC Penney's problem.

The problem in all of traditional retail is the growth of on-line.  In a small margin business with high fixed costs, like traditional retail, even a small revenue loss has a big impact on net profit.  For every 5% revenue decline 50-90% of that lost cash comes directly off the bottom line – because costs don't fall with revenues.  And these days every quarter – every month – more and more customers are buying more and more stuff from Amazon.com and its on-line brethren rather than brick and mortar stores.  It is these lost revenues that are destroying revenues and profits at Sears and JC Penney, and stagnating nearly everyone else including Wal-Mart. 

Coming from the tech world, you would have expected CEO Johnson to recognize this problem and radically change the strategy, rather than messing with tactics.  He should have looked to close stores to lower fixed costs, developed a powerful on-line presence and marketed hard to grab more customers showrooming or shopping from home.  He should have targeted to grow JCP on-line, stealing revenues from other traditional retailers, while making the company more of a hybrid retailer that profitably met customer needs in stores, or on-line, as suits them.  He should have used on-line retail to take customers from locked-in competitors unable to deal with "cannibalization."

No wonder the results tanked, and CEO Johnson was fired.  Doing more of the tired, old strategies in a shifting market never works.  In Apple parlance, he needed to be focused on an iPad strategy, when instead he kept trying to sell more Macs.

But now the Board has made its second mistake.  Bringing back the old CEO, Myron Ullman, has deepened JP Penney's lock-in to that old, traditional and uncompetitve brick-and-mortar strategy. He intends to return to JCP's legacy, buy more newspaper coupons, and keep doing more of the same.  While hoping for a better outcome.

What was that old description of insanity?  Something about repeating yourself…..

Expectedly, Penney's stock dropped another 10% after announcing the old CEO would return.  Investors are smart enough to recognize the retail market has shifted.  That newsapaper coupons, circulars and traditional advertising is not enough to compete with on-line merchants which have lower fixed costs, faster inventory turns and wider product selection. 

It certainly appears Mr. Johnson was not the right person to grow JC Penney.  All the more reason JCP needs to accelerate its strategy toward the on-line retail trend.  Going backward will only worsen an already terrible situation.

You have to change to grow – including Starbucks

Today the U.S. Federal Reserve indicated that the worst of America's economic downturn may be over, according to "Fed stands pat, and says worst may be over" at Marketwatch.com.  Fed officials seem to think that the rate of decline has slowed.  Note, they didn't say the economy is growing.  The rate of decline is slowing.  They hope this points to a bottoming, and eventually a return to growth.

With interest rates between banks at 0%, and short-term rates for strong companies near that level, there really isn't much more the Fed can do to create growth.  It will keep buying Treasury securities and keep pushing banks to loan.  But growth requires the private sector.  That means businesses – or what reporters call "Main Street."

The government doesn't create growthIt can stimulate growth with low interest rates and money that will stimulate business investment.  Growth requires people make products or services, and sell them.  Those who are waiting on the government to create a growing economy will never gain anything from their wait, because it's up to them.  Only by making and selling things do you get economic growth.

Recent events, closing banks and massive write-offs, are a big Challenge to old ways of doing business.  Those who keep applying old practices are struggling to generate profits.  The tried-and-true practices of American industrialism just aren't turning out gains like the once did.  And they won't.  The world has shifted.  Entrepreneurs in India, Malaysia and China – places we like to think of as poor and "third world" – are building fortunes in the information economy.  American businesses have to shift.  If you make posts to install on highway sides, well lots of people can do that and competition is intense.  To make money you need to make products that help move more people on the highway faster and safer – some kind of post that perhaps can provide traffic information to web sites and aid people to look for alternate routes.  Posts aren't what people want, they want better traffic flow and today that ties to more information about the highway, who's using it, and what's happening on it. 

Growth will return when businesspeople move toward supplying the shifted market with what it wants.  Like Apple with a solution for digital music that involved players and distribution.  Or Amazon with a solution for digitally obtaining books, magazines and newspapers, storing them, presenting them and even reading them to you.  These companies, and products, appeal to the changed market – the market that values the music or the words and not the vinyl/tape/CD or the ink-on-paper.  The customers that want the information, not necessarily the tangible item we used to use to get the information.

For the economy to grow requires a lot more businesses realize this market shift is permanent, and adjust.  During the Great Depression those who refused to shift from agriculture to industrial production found the next 40 years pretty miserable – as rural land prices dropped, commodity prices dropped and the number of people working in agriculture dropped.  Agrarianism wasn't bad, it just wasn't profitable.  And going forward, industrialism isn't bad – but to grow revenues and profits we have to start thinking about how to deliver what people want – not what we know how to make.  You have to deliver what the market wants to grow sales – even if it's different from what you used to make.

Starbucks offered people a lot of different things.  And the old CEO tried to capitalize upon that by expanding his brand into liquor, music recording, agency for entertainers, movie production, and a widespread set of products in his stores – including food.  But then an even older CEO returned, and he said Starbucks was all about coffee.  He launched some new flavors, and he pushed out an instant coffee product.  But a year later "Starbucks profit falls 77% on store closure charges" reports Marketwatch.com.  His "focus" efforts have cut revenues, and cut profits enormously.  He's cut out growth in his effort to "save" the company.

By trying to go backward, Chairman Schultz has seriously damaged the brand and the company.  He has closed 570 stores – which were a big part of the brand and perhaps the thing of greatest value.  Stores attracted people for a lot more than just coffee.  People met at the stores, and buying coffee was just one activity they undertook.  So as the stores were shuttered, the brand began to look in serious trouble and people started staying away.  The vicious cycle fed on itself, and same store sales are down 8%.  No new flavor or packaged frozen coffee bits for take home use is going to turn around this troubled business.  It will take a change to giving people what they need – not what Mr. Schultz wants to sell.

With more and more people working from home the "virtual office" for many small businesspeople can still be a local Starbucks.  When you can't afford take a client out for a snazzy lunch you can afford to take them for a coffee.  When your wasteline can't take ice cream, you can afford a no-cal hot coffee in a great environment.  Starbucks never was about the coffee, it was about meeting customer needs in a shifted market.  And when the CEO realizes this he has the chance to save the company by taking into the new markets where customers want to go.  Not by bringing out new instant coffee granules.

Starbucks is sort of a model of the recession.  When you try to do what you always did, and you blame the lousy economy for your troubles, you'll see results worsen.  As businesspeople we must realize that the recession was due to a market shift.  We went off the proverbial cliff trying to extend the old business – just like Apple almost did by trying to be the Mac and only the Mac.  To get the economy growing we have to look to see what people really want, and supply that.  And what they want may be somewhat, or a whole lot, different from what we used to give them.  But when we start supplying this changed market what it wants then the economy will quit contracting and start growing.

So be more like Steve Jobs, and less like Charles SchultzQuit trying to go backward and regain some past glory.  Instead, look into the future to figure out what people want and that competitiors aren't giving them.  Be willing to Disrupt your business in order to take Disruptive solutons to the market.  And get your ideas into White Space where you can develop them into profitable businesses.  Don't wait for someone else to turn the economy around – just to find out then it's too late for you to compete.