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Monday, September 13, 1999

The following article originally ran as a Fool Portfolio (now Rule Breaker) article on August 19, 1998.

Off-line Commerce Emerges
...can it amount to anything?

By Jeff Fischer (TMF Jeff)


Today imagine that the order has been reversed: imagine that online commerce existed long before off-line commerce.

The year is the same, life is generally the same, but imagine that online commerce came first, and now, during the past four years, off-line commerce has finally emerged. This being the case, let's consider a timely news article.

Off-Line Commerce Emerges;
Analysts Doubt its Potential for Profit

Online commerce has been with us for centuries, but now entrepreneurs are attempting to build a new model for selling, and they call it "off-line" commerce. This novel idea is being met with skepticism, even as very young off-line companies come public and are treated to soaring stocks. New names like Wal-Mart and Home Depot -- despite the skepticism of analysts -- are trading at valuations never before seen for traditional retailers. Can off-line businesses compete and survive? Many people believe that the very notion of off-line commerce is fraught with danger, and that profits will be slim, if they ever arrive at all.

For insight on the issue, we interviewed Mr. Baron of the Wisonomic Journal. His criticism of the new selling model is poignant. Sitting at his Manhattan desk, Mr. Baron looked through his office window at the surrounding woods and said, "It's going to be extremely difficult to make money using this new off-line sales model, and the potential for failure is enormous."

"First, consider the costs. They're tremendous. These new companies are spending millions of dollars to build immense stores and then stock them with products, and they're doing so without any promise that they'll actually attract customers. Not only are real estate and inventory costs outrageously high compared to the online selling model, but companies attempting this new selling approach need to hire and train thousands of employees to run the stores." Mr. Baron smiled and shook his head.

"It's ludicrous, when you think about it," he snickered. "These entrepreneurs -- kids, really -- are planting giant stores in the middle of rural America and counting on people to drive out and buy things, when everyone can just as easily shop online from their living room. But that's just one immediate obstacle to off-line sales: point-of-presence. It's hard to compete with a sale that can be made in someone's living room rather than outside, twenty minutes down the road. And even if off-line retailers leap this hurdle, these new companies still face an enormous cost for informing people about what they actually sell in the first place. How do I know what a store sitting along the road sells? I can't click an 'information link' as I drive by a physical store. So how can an off-line company make me enter its place of business? They'll need to constantly advertise on the Web and television -- not only informing everyone of what they sell, but where the heck they're located!"

Mr. Baron smiled and continued, "Now, compare this to the Internet, where attracting customers usually means providing simple, logically placed links. One strategically placed link makes your product available to people anywhere in the world. True, the cost for an effective promotional link is substantial, but it easily beats the expense of opening stores across the planet, staffing them, and then promoting them locally. Adding the real estate, employee, and marketing costs to each off-line store will all but insure that these companies never make a profit. Not to mention competition. If you open an off-line bookstore -- and I have no idea why you'd want to -- how do you stop your neighbor from opening one across the street and undercutting you?"

Many Americans are as skeptical of the young off-line selling model as Mr. Baron. We interviewed thirty-seven-year-old Amy Fields, of Peoria, Illinois, and her first question was, "How do I know that off-line stores have what I need? In most cases, I can't know until I actually visit the store and search aisle after aisle of product. That seems illogical, as well as inefficient. Especially because I can type what I want into my computer and not only be told where to buy it, but compare prices, too, and then buy it from the least expensive vendor.

"So, imagine that I visit one of these new off-line places. Assuming that I even find what I need, how do I know that I'm getting the best price? I won't know. Also, once I make my purchase, do I need to haul it home myself, or will they deliver it to my front door like usual?"

Yet, the main concern that Ms. Fields raises is one shared by the entire nation, including Mr. Baron. It is the concern of security.

"I feel very uncomfortable," said Ms. Fields thoughtfully, "with the idea of handing my credit card to a total stranger at the cash register. They can see the number in plain view and they'll also print the number on the register receipt, as I understand it. That's unthinkable. Online, of course, credit card numbers are encrypted and secure. I simply can't see handing my credit card to a stranger, or having a printed copy of my number floating around on a receipt each time I buy something. That sounds incredibly dangerous."

Off-line company officials acknowledge that this is a common fear and it makes people leery of shopping their stores. But they assure the public that employees are honest and, said the Vice President of Wal-mart, "Even if an employee did misuse a customer's credit card number, they would be very easy to catch. They wouldn't get away with it for long."

Mr. Baron listed other reasons why he believes the new off-line commerce idea is doomed. Beyond the enormous cost of expanding physical stores over the world geographically, he mentions the inconvenience of the model.

"I've never known a new business model to work," he said, "when it's less convenient than the one that has worked all along before it. For example, the majority of these new off-line stores will have operating hours. You usually can't keep them staffed and open twenty-four hours a day, like an online store, because costs are too high. In fact, it's incredibly amusing to me that many of these stores actually close at around 9:00 p.m. each day. That is precisely when most people are finished with work and dinner and might go out to shop. Of course, instead they'll go online in the comfort of home and shop, especially since off-line stores will be closed. It's very amusing, this new model."

Mr. Baron doesn't hide his doubts surrounding this new retail model, but he particularly dislikes emerging off-line companies that are spending millions in an attempt to sell commodities, like books and music, on a local level. "It makes absolutely no sense," he laughed. "These are items that a vendor needs to stock in the thousands, if not millions, of titles. Why would anyone want to open thousands of stores and replicate incredibly high inventory costs across the country? Not only that, but they can't possibly offer a complete selection. If they did, their store would be so large that it would be daunting. As it is, real estate costs will be high and selection will be limited. It's a losing model all around."

He continued to grin and finally shook his head. "How can they compete with online sellers? Selling commodities such as books, music and videos is obviously an online business. Books don't need a fancy middleman. The off-line companies going into this business, which is low-margin even online, are ideal shorting candidates. They have no chance of achieving success."

Whatever these new companies are selling, off-line retailing is an incredibly risky proposition, even though stocks of new off-line companies continue to soar. Before investing a dime in these expense-heavy, brick and mortar operations, remember that most analysts doubt off-line companies have staying power for many reasons. To summarize why:

1) The lack of ease in shopping. It's hard to know that a store will have what you need on-hand, especially because off-line stores have limited selection compared to online stores.

2) The lack of pricing knowledge. You can't easily know which store has the best price on what you need, unless you take the time to visit or call each local store. Internet price comparisons are immediate.

3) The lack of security when you make your purchase. The idea of handing one's credit card to a stranger appalls most people, because everyone is used to the safety of computer encryption.

4) Then, of course, there is the enormous start-up and maintenance cost. Plus, one off-line retail location doesn't scale into more sales as can one retail site on the Web. Off-line, a company needs to continue building more locations, at great expense, in order to sell more.

5) And, in general, the poor use of time that off-line shopping represents. No one wants to waste their weekend in a crowded store looking for things that are easily found online at the best prices.

So, investors, beware of new off-line commerce companies, including high-flyers like Wal-Mart and Home Depot. Everything is stacked against them and it appears that profit will be virtually impossible to achieve. In fact, the only thing we know for certain is that many shareholders will end up holding worthless shares of these companies because most off-line businesses, for want of customers, will soon stand empty and boarded over.

-----------------------

This Fool column serves to remind us that it's usually a new method or approach to business that is criticized, no matter its merits, and that any new approach to business is open to criticism. In fact, there are arguably stronger negative arguments to make about off-line business then there are about online business, and yet we all know that off-line retailers have done incredibly well and many have made millionaires of patient investors despite the obstacles. Even leading off-line booksellers have been excellent investments.

Criticism is easy, though, and it's the path too often taken by journalists and market pundits. It takes work to imagine possibilities, while it's easy to criticize or simply doubt. Surely many online companies will fail, just as many off-line companies do, but there's room for plenty of success, too. It's generalizations like the ones above that are most Wise.

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