Discount retail profitability: a harbinger for e-commerce?

Abstract

Expansion of electronic commerce has the potential to increase retail productivity. However, these gains may not translate into enhanced retailer profitability. This study examines profitability of the discount retail industry from 1981-1998, a period during which the industry realized significant productivity gains. Although productivity measures like inventory turnover and sales per employee increased during this period, industry profitability did not increase. Instead, consumers benefited from the increased efficiency through paying lower markups. The experience of the discount retail industry may indicate that retailers face a product price treadmill: gains in efficiency result in lower prices rather than higher profits. The projected efficiencies of the Internet and the expansion of electronic commerce may portend lower retail profitability but greater savings for consumers.

Introduction

At the end of the twentieth century, the potential of electronic commerce fueled investor optimism and helped propel U.S. equity valuation to historic heights. Investors believed that productivity gains of network technology would generate increased corporate profitability for companies involved in electronic commerce. Although the bubble has burst on Internet valuations, the question remains about whether innovations that lower production costs will result in increased profitability. In a competitive market, lower costs produce lower prices. Innovative firms may be able to capture abnormal profits before other firms in the industry adopt the new technology or business mode but once the innovation is widely diffused, sustained profitability is possible only if significant barriers to entry exist. This paper examines discount retailers, a category that includes firms like Wal-Mart and Kmart, to determine whether increased efficiency attributable to improvements in distribution and inventory management have resulted in abnormal profits for retailers or lower prices for consumers. The fortunes of discount retailers during a period of technological innovation may be a harbinger of the financial impact that electronic commerce will have upon retailers.

The Internet, Retailers and the Treadmill

This work is motivated by the uncertainty regarding valuations of Internet-based retailers. In 1998 and 1999, financial analysts were discarding traditional price-earnings (P/E) valuation models for other methods in order to justify the high valuations of etailers (Laderman & Smith, 1998). Although many Internet companies lost the majority of their market valuation when the NASDAQ corrected sharply in 2000, analysts continue to disagree about the proper valuation of companies utilizing a new technology (Trueman, Wong & Zhang, 2000; Schwartz & Moon, 2000). One of the arguments advanced for high market valuations of Internet retailers is the increased efficiency and the reduced costs that the Internet brings to businesses (Johnson, 1999; Tully, 2000). However, the benefits of cost saving technology may not accrue to the firm. Instead, consumers may enjoy lower prices or a factor of production, like labor or landowners, may realize increased compensation.