Is Retail Inception a Dream or Nightmare?

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The store-within-a-store business model, or as it is currently called, ‘retail inception’ after Christopher Nolan’s blockbuster movie Inception, is nothing new. The concept is commonly an agreement where a retailer (acting as a landlord) allows part of their real estate (their store property) to be used by a different company (acting as a tenant) to run an independent store. It is said to be a win-win situation. The retailer is able to offer prime property for which it can charge high rents and produce a constant predictable cash flow. The company within the store makes a higher profit than it would through a wholesale model since they don’t need to split profits with a retailer, and additionally, there is a significantly reduced overhead expense. In the end, customers are supposed to get lower prices and better service. However, is ‘retail inception’ a dream or a nightmare?

Best Buy’s Dream?

Downward trends continue to plague Best Buy (NYSE: BBY) as recent first quarter 2014 FY results show revenue is down 9.6% both domestically and internationally, operating income dropped 36.4%, and EPS came in at nearly half the number from the same quarter a year ago at $0.24. On top of that, Best Buy has been in the process of closing stores.

Year-to-date, however, Best Buy is up over 135% in share price as it is now at multi-year highs. Much of this is due to shareholder anticipation and speculation on Best Buy’s transformation from being a failing big-box retailer to a retailer of smaller boxes – an electronics department store. Earlier this month, Best Buy made an agreement with Microsoft (NASDAQ: MSFT) to add their mini-stores in half of Best Buy’s big-box stores. They will be the third store-within-a-store, joining their competitors Apple and Samsung.

The burden, though, is clearly on Best Buy to make these partnerships succeed. All three companies – Apple, Samsung, and Microsoft – have businesses that are thriving and will continue to with or without Best Buy’s accommodations. Microsoft, in particular, posted increases across all their divisions in their recent third quarter results as cloud computing is only expanding their earnings potential on already existing products and services. The Microsoft Business, Servers & Tools, Windows, Online Services, and Entertainment and Devices divisions posted revenue increases of 8%, 11%, 23%, 18%, and 56%, respectively. EPS for the company also beat the same quarter a year ago ($0.61) coming in at $0.72.

The Kick

When it comes to the store-within-a-store model, at least in recent years, there have been many ‘kicks’ available to wake Best Buy up on potential warning signs. Among their many problems that led to bankruptcy, Best Buy’s ex-competitor Circuit City tried the retail inception model by partnering with Verizon Wireless in 2004 to include full-service sales and service centers in each of their Superstores. Before that, Circuit City had a semi store-within-a-store model for gaming manufacturers. At the turn of the millennium, they had an exclusive partnership to feature Sony PlayStation gaming in their stores with dedicated floor space and excluded Nintendo, Sega, and Microsoft’s Xbox from this ability until the Sony agreement ended. 

J.C. Penney (NYSE: JCP) had Ron Johnson turn the store into a landlord of a ghost town during his tenure before being fired on April 8, 2013. The implementation of his concept could foreshadow what is to come for companies like Best Buy. Perhaps, the change that Ron Johnson was so hopeful for just needed more time to see a success. Maybe results take much longer as you have more and more stores within stores. Last year, J.C. Penney took a $1.5 billion loss before taxes and this year shareholders aren’t as confident as they are with Best Buy currently. J.C. Penney stock has declined over 13% this year, and they have lost nearly 80% of their market value since their 2007 peak.

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BBY Total Return Price data by YCharts

Entering Limbo

In the movie Inception, ‘limbo, ’ or the point where the dreamer enters a dream state permanently, occurs when you go beyond three levels of dreams. In this situation, one could say that you can stay in control by having up to three stores within a store. Best Buy is at that level. The pros of the model like neutralization of competition by the stabilization of prices among different brands are historically outweighed by many of the cons. One of the biggest problems is alienating the core shoppers of the main store. It is falsely assumed that shoppers like both the main store and the stores within the store equally. However, this is usually not the case. Different brand affiliations and loyalties can wind up backfiring on the main store’s consumer base. Window’s customers may not necessarily be Best Buy customers, for example.

There is also the issue of different age groups. This problem is now being shown at J.C. Penney where some of the individual shops geared towards teenagers have turned away the older customer base that prefers the old J.C. Penney model. The win-win situation, therefore, is more of an ideal than a reality. Is Best Buy benefiting equally to Microsoft, Samsung, or Apple? If you glance at the earnings reports, it looks like the latter three companies are experiencing much of the success at the cost of Best Buy.

Lastly, the store-within-a-store model works for places like gas stations and supermarkets because of the economics involved. The supermarket is already profitable and renting off some space for the local bank is just an added bonus for the supermarket’s customers. The model typically fails for electronics-based establishments due to many options for which consumers can buy the same product elsewhere. It also fails because the transformation mostly occurs as a last resort to save the company. Overall, Best Buy looks like it is surrendering its old self, similar to J.C. Penney, and handing over parts of the store for another company to make better use of it.

J.C. Penney’s stock cratered under Ron Johnson’s leadership, but could new CEO Mike Ullman present the opportunity investors have been waiting for? If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround -- or lack thereof. Simply click here now for instant access.

Michael Carter has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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