Robert Steiner's essay on e-tailing, an aai column in FTC:Watch

Apr 24 2000



By Robert. L. Steiner

Two sessions at the 2,000 ABA, Section of Antitrust Law, Spring Meeting dealt with commerce on the Internet. In both sessions a presenter noted that historically whenever a new retailing format with lower prices to consumers entered the fray, the incumbent retailers of the day pressured manufacturers to adopt vertical restrains to retard the growth of the challengers. Both presenters reported that this is happening again in the opposition of certain bricks and mortar dealers to low-price competition from internet goods vendors, so-called e-tailers.

These events evoked a familiar refrain. Over the past 20 years I have contended that the major welfare-reducing use of vertical restraints has been its adoption by high-cost, high-market share incumbents to slow the entry of new retailing formats whose lower costs enabled them profitably to undersell existing retailers while offering a service package that was usually somewhat different, but not on balance inferior, to that of the incumbent dealers of the day. (Robert L. Steiner, How Manufacturers Deal with the Price-Cutting Retailer: When are Vertical Restraints Efficient?"65 Antitrust Law Journal,407, No. 2 Winter 1997).

Yet something quite different appears to be happening with this latest challenge faced by incumbent retailers. For the first time, on anything like the present scale, the new- breed retailers' lower prices may not in many instances reflect greater efficiency in the distribution of consumer goods. Some part of their lower prices may be due to their exemption from sales taxes, an advantage shared by conventional mail order houses. Even so, few e-tailers are earning a healthy profit and most have been operating at a loss since their inception. For example, Amazon. Com. was the pioneering innovator and probably remains the preeminent firm. Over the 3 years from 1997 to 1999 Amazon increased its revenues eleven fold, while its operating losses increased 18 fold and constituted 36.9% of net sales in 1999. The firm appears to be operating with strong diseconomies of scale. In 1999 Its gross margin declined to 17.72% - much lower than that of most other retailers of books, CDs, toys, drugs and other products that Amazon sells.(Data from Yahoo Finance web site and Amazon's financial statements).

How can this firm, and the myriad other e-tailers who undersell traditional dealers and are constantly in the red, keep it up? The answer is they have been able to raise so much money in the capital market and sometimes, like Amazon, to incur so much long term debt that they aren't forced to show a profit for years. In fact it has been fashionable in internet circles to disdain the objective of becoming profitable within the short and even the medium term. And despite Amazon's past performance, Yahoo Finance reported that as of April 6, 2000 of the 30 brokers who follow the stock 12 give it their top rating (strong buy), 10 rated it a moderate buy, 8 a hold and none rated it a moderate or a strong sell. The consensus estimate is for continuing, though somewhat lower, losses for 2000 and 2001. Perhaps brokers and investment houses have a pipeline to the financial deity denied to ordinary mortals. For it seems to me that in evaluating the stocks of most e-tailers there has been a grade inflation comparable to that which commenced in college classrooms at the time of the Vietnamese war.

Whatever the cause, we are seeing investors and long-term creditors massively subsidizing consumers to a heretofore unmatched extent. Reading about the accomplishments of such retailing innovators as Richard Sears, Frank Woolworth, James Cash Penney, Huntington Hartford, Charles Walgreen, John Wanamaker, and others, one finds that despite their low prices they earned a reasonable return almost from the beginning. They would have had to show a profit or a strong prospect of becoming profitable shortly to get a seasonal bank loan or to attract a private investor. To obtain longer term loans, bankers typically have imposed much stricter performance requirements. Likewise, to sell a large initial or secondary stock offering to the public has normally required a good earnings history and excellent prospects for future earnings growth. More recently, Kmart, the first successful national player in the discount store revolution of the 1960s, Home Depot a pioneer in the home center revolution of the 1990s, and most of the first movers in other contemporary mass retailing formats - like earlier pioneer retailing innovators - were able profitably to undersell incumbent types of retailers because they had a more efficient modus operandi.

This history is relevant because we seem to be experiencing an important new phenomenon without having recognized it. What are the implications?. One school of thought might hold that investors have bought on to a dream, acted irrationally, and are currently experiencing a day of reckoning. Indeed, the recent crash of the Nasdaq market may already have drastically changed the capital and debt markets for internet retailers. Investment bankers and the investing public may be returning to more traditional and more rational criteria in which profit is not a dirty word but a necessity. The market may now punish e-tailers who have no near-term prospect of decent earnings by barring their heretofore easy access to capital and long term debt. If so, we will discover what kinds of e-tailers can prosper when forced to provide a package of services and prices that simply reflects their underlying operating efficiency.

In some instances e-tailers have been able to survive their below-cost prices and drive out competing terrestrial retailers of perhaps equal efficiency because of their deeper pockets -pockets whose bulge is due to the generosity of investors and investment bankers rather than to any retained earnings. With the leading firm, Amazon, some analysts advise that its long range business plan is to do whatever it takes to build "a brand" so strong that someday it will be able to charge a premium price for goods of all kinds - like a dominant, prestigious department store.

But the market could also punish this strategy. Those who have written business plans in their own companies or reviewed them as directors of public companies are often embarrassed to reread last year's plan and discover how far off the mark it proved to be. And in this writer's experience, 3-5 year planning is a far greater crap-shoot, even in a relatively stable industry. In the new economy no one knows what things will look like in 5 months, much less in 5 years. As Yogi Berra is said to have observed, "Prediction is hazardous, especially about the future".

Finally, this new phenomenon forces us to think about market power and to modify some accepted definitions, for example the one provided in the DOJ/FTC, Horizontal Merger Guidelines, (Revised, April 8,1997) at page 2. "Market power to a seller is the ability profitably to maintain prices above competitive levels for a significant period of time." In the present context it has sometimes been the power to exploit the capital and long-term debt markets so as to enable firms to hold prices well below the competitive level while arguably not being more efficient than incumbent firms who are operating at the competitive level. Being a first or early mover in a euphoric capital market, rather than a more efficient operator than its terrestrial competitors, may prove to have been the secret behind the rapid growth of many internet vendors of consumer goods. In the interim consumers benefit by lower prices but some efficient but capital-short ompetitors may not survive.

Doubtless this latest innovative retailing format will prove to be a better way to sell consumer goods in some circumstances. But the jury is still out and may not return for several years. When it does we will learn in what categories of merchandise and in what combinations with a company's own bricks-and-mortar outlets does e-tailing represent an advance in the state of the art.