Brick-and-Mortar Companies: A Comparative Analysis

This paper aims to explore potential differences in financial performance of Internet companies and the traditional brick-and-mortar companies. A compressive financial ratio analysis is used to investigate these differences for the period from 1998 to 2003. Contrary to our expectations, the average performance of the Internet companies was significantly worse than that of traditional brickand-mortar companies. InTRoduCTIon Since the late 1990s, buying and selling goods over the Internet has become a common business practice. Forrester research reported that E-commerce sales in 2005 increased 22% to $172 billion from $141 billion in 2004. This trend is expected to continue and according to Forrester, e-commerce sales will reach $228 billion in 2007 (Khan 2006). Even U.S. e-commerce sales in 2004 alone were estimated at $69.2 billion, which represent 23.5 percent increase from 2003 (U.S. Census Bureau 2005). In spite of its importance and contribution to the whole economy, e-commerce is associated with the stock market bubble and the following crash. During this so-called dotcom crash, in 2000 and 2001, many, often very promising Internet companies, went out of business (Javalgi et al. 2004). Practitioners and academic researchers provided a number of explanations for the dotcom crash (Shama 2001; Thornton and Marche 2003). The possible explanations included inexperienced management, absence of sound business model, and lack of attention to financial reality. Prior to the dotcom crash, many business managers and investors followed the assumption that the traditional financial analysis tools are restricted to old economy. For example, a systematic ratio analysis has been rarely conducted for Internet companies. This is very surprising due to the fact that ratio analysis is one of the most common tools used for measuring financial performance (Bharadwaj 2000; Hunton et al. 2003; Kudyba and Vitaliano 2003; Santhanam and Hartono 2003; Motiwalla et al. 2005; Bose and Pal 2006). According to a rich body of research, ratio analysis is a powerful tool in assessing the financial health of companies and predicting business failures (Beaver 1966; Altman 1968). However, regarding the Internet companies, it is not clear whether this method needs to be adjusted and what the reasonable ratios are. This scarcity of financial ratio research in Internet companies provides motivation for our study. Although Motiwalla et al. (2005) examined the impact of e-business on financial performance, the study focused on an intraand inter-industry level of three industries. Besides, the examined firms were not pure “click” companies but “brick and click” companies, which decided to embrace the Internet in order to support their traditional operations and to improve the bottom-line performance. In contrast, our study focuses on the financial performance of pure “click” companies and compares it with that of the traditional brick-and-mortar companies. The structure of our paper is as follows: the next section, based on literature review, introduces a set of hypotheses; research methodology section describes the methodology, the results section presents the empirical results, and the discussion section includes a brief discussion of the results. The final section provides conclusions of the paper and offers some ideas for future research. BACKgRound And RESEARCh hyPoThESES The Internet has changed the way the organizations conduct their business today. The number of firms that take advantage of Internet technology has grown rapidly in the late 1990s. Firms that heavily use the Internet for their business activities are commonly defined as the dotcoms, Internet firms or pure “click” companies. Consequently, many of these companies conduct their business almost exclusively over the Internet. Dotcoms can be classified into two categories: the digital and physical dotcoms depends on the products and services that they sell (Barua et al. 2004a). Yahoo and eBay are examples of digital dotcoms that deliver services directly over the Internet. Amazon.com is an example of physical dotcoms, which are often referred to as e-retailers that sells physical products on the Internet. As described previously, Internet companies are often associated with dotcom crash. During this period, many firms run out of cash, closed their doors for business or become easy acquisition targets. Liquidity, or ability to meet financial obligations in short term, is important factor in avoiding financial difficulties. Thus, Internet companies may be expected to have liquidity problems. However, we argue that most of the Internet companies which managed to survive the dotcom crash and are in operations for several years must have a better position in liquidity. In other words, their liquidity is not worse than the established brick-and-mortar companies. The most well known measure of liquidity of the firms are current and quick ratios (Yang et al. 2001; Pasiouras et al. 2006). Therefore, the following hypothesis is proposed. H1: Internet companies’ liquidity, measured in terms of current ratio and quick ratio, is comparable to the traditional companies’ liquidity. Internet related technologies enable firms to reduce inventory, decrease stock-out situations, and improve response time (Barua et al. 2004b), and organization’s operational efficiency and effectiveness (Chang et al. 2003). For example, these dotcoms can enjoy the benefits of reduced transactions cost, smaller or no inventory, 24/7 access with minimal cost (Motiwalla et al. 2005). Thus, we assume that Internet companies have greater operational efficiency as compared with traditional brick-and-mortar companies. There are several common measures of profitability. Operating margin (OM) is considered as one of important profitability measures since it measure a firm’s core operations by excluding interest expenses, other financing costs, and other non-operating income (Kudyba and Vitaliano 2003). Return on assets (ROA) has been the most commonly used measure of firm performance (Hitt and Brynjolfsson 1996; Bharadwaj 2000) and a useful performance measure since it incorporates organizational profitability and efficiency (Hunton et al. 2003). Return on equity (ROE) is also another performance indicator that was often used in previous research (Hitt and Brynjolfsson 1996; Wheale and Amin 2003; Shin 2006). Regarding the Internet companies, the obvious ability of reaching a large customer base combined with the indisputable advantages of reduced costs should translate into higher profitability. Thus, the following hypothesis is proposed. H2: Internet companies’ profitability, measured in terms of operating margin (OM), return on assets (ROA), and return on equity (ROE), is greater than traditional companies’ profitability. Managing Worldwide Operations & Communications with Information Technology 427 Copyright © 2007, Idea Group Inc. Copying or distributing in print or electronic forms without written permission of Idea Group Inc. is prohibited. Most of Internet companies finance their operations mainly with help of the venture capital and the stock market (Wheale and Amin 2003). More traditional sources of financing, such as bank loans, prevalent in the brick-and-mortar firms, are rather uncommon for Internet companies. Leverage, defined as ability to meet financial obligations in long-term, is also another important factor identifying financial difficulty. Debt ratio is a commonly used measure of leverage (Yang et al. 2001). Therefore, the following hypothesis is proposed. H3: Internet companies’ financial leverage, measured in terms of debt ratio, is lower than traditional companies’ financial leverage. The hypotheses can be summarized into the research model shown in Figure 1. RESEARCh METhodology The “matched sample comparison group” methodology is used to explore the potential differences in financial performance between Internet based and traditional brick-and-mortar companies. This method has also been used in previous studies (Bharadwaj 2000; Hunton et al. 2003). Our sample includes two groups; the treatment and control groups. The treatment group represents a sample of Internet companies and the control group represents companies that were selected to match the treatment group by size and industry. Sample Selection To select Internet firms, we started out with the list from USA Today Internet 100 Index (as of August, 9, 1999). This index consisted of 100 most relevant Internet companies at this time. To be included, the companies needed to have market capitalization of $200 millions and their share price needed to be at least $12 (Smith 1999). The selection from USA Today Internet 100 Index, assured that our treatment group included only firms which can be considered as Internet companies with relatively established business. Furthermore, this selection procedure increased comparability of the firms and minimized selection bias. From this initial list of 100 Internet companies, firms that are not included in Compustat were removed. Furthermore, firms that have merged with another firm or had missing data during the period from 1998 to 2003 were removed. As a result, the treatment group includes 16 firms. To control for confounding changes in industry and the firm size, we followed some steps to select a matching control firm that is comparable to the treatment firm. Initially, firms from the same primary four-digit code as the treatment firm were selected from Compustat as potential control firms. Then, we used total assets and annual sales as the size measure, which are commonly used as proxies for the firm size and chose the firm that has the closest to the corresponding treatment firm’s values in 1998. When no comparable control firms were available, we allowed the size measures to be between 70% and 130% of the treatment firm’s values. Next, we allowed using three-digit SIC codes, and then if no potential firms