The Internet’s Degrading Impact On Margins

I hate to be the one to break the news, but you will have to work harder to make a profit on the Internet than you do in your brick-and-mortar operation.

What’s that, you say? What about the crazy valuations of Internet startups like Amazon.com and Yahoo?

All temporary and all based on, among other assumptions, the false belief that the advantages of the Internet will translate into higher margins. I’m talking about after the smoke has cleared from the current Internet gyrations and discombobulations—what economists refer to as a “long-run equilibrium.”

The perception on Wall Street—and just about everywhere else—about the Internet generating more profits per unit of sales is simply wrong. The margins for Internet businesses will be lower, consistently lower, than for brick-and-mortar operations.

The reason, though it seems paradoxical, is that the Internet lowers the cost of doing business. Wall Street analysts like to drool over Internet startups because they see that virtual storefronts are less expensive to create than the real thing. These storefronts do not require real estate, plumbing, showrooms, dressing rooms, heating or air conditioning. Virtual storefronts can be scaled up without having to hire additional employees and build many locations to house them.

Most analysts have assumed that because companies doing business on the Net will have lower costs, this will translate into the ability to generate higher markups and higher margins than their brick-and-mortar counterparts. They often apply these margins to projected sales figures to determine future profits and investment potential. At one level this seems to make sense. After all, companies that have managed to achieve a cost advantage over their competitors, everything else equal, do earn higher profits and margins.

But what is true for individual companies is not true for markets consisting of many companies.

To understand this we have to dig a little deeper. Economists consider markets competitive when easy entry keeps the typical company in the industry earning only normal returns on investment—in other words, returns unimpressive enough to keep potential new market entrants interested.

If all the companies in a competitive industry achieve a reduction in costs, their profits, after an initial and temporary rise, will return to normal when new capacity and new entrants suck up any excess profits. Memory chip manufacturers, for example, constantly have falling costs, but new investment in fabrication plants at every uptick in profits eventually pushes profits back to the low levels that plague very competitive industries.

How do we know this model of competition is not just some aberrant creation from academics who’ve spent too long in their ivory towers? Because there is overwhelming evidence to support many of its implications, including the one that industries with lower costs per dollar of sales also have lower margins.

My point is that even if the level of competition within Internet industries is equal to that of their brick-and-mortar counterparts, the typical Internet company will earn lower margins on sales because it will have lower costs.

Grocery chains, for example, are famous for their low margins, only pennies on the dollar. They often trumpet this fact to demonstrate how competitive their market is. But these low margins have nothing to do with any extra competitiveness of the grocery industry. They are due instead to the low value added per dollar of sales. (Restaurants have margins 10 times those of grocers, even though the restaurant business is just as competitive, because chefs add so much value to the offerings.) The grocery business is the final distribution stage of the food industry, after most of the value has already been created. Low-wage clerks scan the price into a computer after consumers carry the product to the checkout. Since the value added by the supermarket is very small relative to the price of most of the items, the theory correctly predicts that the markup will be very small.

More generally, in competitive markets, if companies in industry A have a smaller investment relative to sales than those in industry B, then the margin on sales will be smaller in industry A.

Which brings us to the denouement of this little story. If Internet retailers have lower costs than brick-and-mortar retailers, there are two possible long-term outcomes, but both of them portend that stores on the Net will have lower margins than brick-and-mortar companies.

First, let’s assume that consumers find brick-and-mortar companies and Net companies to be perfect substitutes for one another. So, for example, consumers might be completely indifferent about whether to buy a book online or in a physical store. As a result, all the brick-and-mortar booksellers will be driven out of business by the more efficient Internet sellers, just as horses and buggies were driven out of business by automobiles. This may take a while, but eventually the industry would consist only of Internet booksellers, and their margins would be lower than was the case for the previous generation of booksellers since their costs, investments and value added per dollar of sales are lower.

Far more likely, in my opinion, is a scenario where some consumers prefer to buy online and others prefer to buy in brick-and-mortar stores, just as some consumers prefer shopping by mail order and others by traversing shopping malls. Competition in each segment will occur largely between companies in that segment, just as convenience stores largely compete with other convenience stores and supermarkets with other supermarkets. Assuming that each market is competitive, every drop of excess profit will be squeezed out of the market for the typical company, but since the investment per dollar of sales is lower for Internet companies, so too is their average margin on sales.

This is not to say that some Internet retailers will not have higher margins than others. Those that lower their costs below those of other companies in their industry or that find a niche that is difficult for other potential competitors to imitate will earn above normal returns, just as superior brick-and-mortar companies earn above normal returns.

Therefore, when estimating future profits, use lower margins for Internet businesses if lower costs are a benefit of the Internet model. Don’t get suckered by the claims to the contrary. Otherwise, you will overpay if you are purchasing an Internet stock or business, or you might overestimate the benefit to your bottom line if your Internet business is developed in-house.