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Zara Gap: Amazon, Walmart and the First Mile

In commentary to Berkshire Hathaway investors for 2017, Warren Buffett said, “Retailing is tough for me to figure out.”

He’s not alone, except perhaps in candor. What can be said about the state of fashion that does not repeat industry consensus for declining sales and traffic, closing stores, management changes and Amazonian pressures?

A decade ago, I was optimistic when beginning work with Warren H. Hausman, professor of management science and engineering at Stanford University. As a former retail CEO, I was about to get schooled in another industry’s transformation and triumph–electronics. The challenge was this: could fashion adapt innovation from electronics manufacturing and improve speed-to-market, inventory and profit performance? What was potential for postponement in the fashion industry, including for Zara/Inditex? Could we identify and measure a link of supply flexibility to market capitalization?

The result of our research and analysis was industry case studies published as “Fast Fashion: Quantifying the Benefits,” and presenting a model known as the Zara Gap. Our conclusion was a conservative estimate that increases in market capitalization due to adoption of supply flexibility solutions range from 30 percent to nearly 40 percent. For a low tech, low profit and low growth industry, I could not imagine better news or opportunity. Fashion volatility eviscerates initial margins from 60 percent to 80 percent to net modest single digits. Does any other industry work so hard and inefficiently?

In Zara Gap metrics, the question is: How well have the original public retailers and brands performed since 2005? And how do new retailers perform? Unfortunately, the 10 year movement of the industry’s opportunity gap has not been much, or surely, not enough.

The new Zara Gap insights recall another Warren Buffett observation: “When the economic tide goes out, we see who is swimming naked.”

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That tide went out in 2008 and consumer traffic and sales have never really returned. The so-called cycle of fashion is disrupted–permanently.

What has changed is executive language, with speed-to-market now promoted to analysts and investors more than colors and styles of the season. Countless business cases and consulting reports have been written, yet there is little evidence of performance to close a gargantuan financial gap in market values. That is true in general and it’s also true by segment. Here are new 2005-2016 data insights:

Over 10 years, no global retailer is near Inditex in the Zara Gap’s upper right quadrant. There is, however, segment change worth noting: fast fashion retailers perform unevenly and with wide disparity. International retailers outperform U.S. retailers and brands, luxury is a weak performer (and dividing along see now/buy now directions), and athletic shows progress largely because market share is more concentrated among brands with innovative cultures and footwear production is more consolidated. For athletic, that means change meets less resistance, but it is still far from optimal or “upper right quadrant.” General merchandise, another category, is the most interesting, since it is large scale and high stakes versus Amazon and Walmart. The full Zara Gap analysis by segment is a very specific financial mapping of competitive position, distance and potential.

Why is performance of the past decade so lame? Every executive knows Zara, H&M and now Uniqlo, so why has the Zara Gap widened?

Zara’s entry to a market such as the U.K. more than a decade ago, was foretold and broadly anticipated by Marks and Spencer, yet they failed to defend their apparel share and sales. Years later, M&S is still on the defensive in fashion in their home market. Similar cautionary tales can be told about Gap, Inc., L Brands, Macy’s and, lately, Ralph Lauren. The latter is instructive, choosing to separate from Stefan Larsson, its CEO, because Larsson insisted on direct reporting from the merchant and design team. Larsson understood, as few do, that product speed and flexibility are issues in merchandising, not supply chain operations. Thus, he would be unable to deliver Ralph Lauren’s corporate turnaround without that authority. That theme is consistent in the other retail tales, which chose different strategies, systems and leadership while fully aware of rapidly changing consumers, channels and competition. None have succeeded. Beware when you hear one more CEO speech about “operational excellence,” which is code for “we’re going to do what we do, only faster.”

These board stories and executive case studies are trends of a decade that are quantified and clear: retailers are defending merchant cultures built on lowest cost, volume sourcing and promotional selling.

That embedded industry model is failing, completely outgunned by low (but not lowest) cost, and frequent and fresh assortments that drive seasonless traffic flow. The industry’s well known merchant and design primacy is not yet recalibrated to be responsive to accelerating demands of Internet-driven consumers in stores or online.

Why is the fashion industry so intractable? Why is “see now/buy now” a publicity strategy not meaningful to financial performance? The industry is resistant to change not because of inflexible manufacturing, but because of front-end product decision-making that is slow, duplicative, hierarchical and measured by cost and control. The digital consumer is served by an analog supply chain.

This is harsh, but Zara Gap metrics mock the language, claims and promises of executives and analysts. There is movement (such as in athletic and international sectors), but largely, speed-to-market has been achieved by press release. Inditex, H&M, Uniqlo, Primark, and very few others are a small subset in a global, supposedly low-tech industry. U.S. retailers, meanwhile, are retreating internationally, closing or resizing domestic stores and are necessarily concerned about both traffic and sales shortfalls.

The sound and fury of “disruption,” are everywhere, but signifying little.

Innovation must be measured beyond PR or a venture round. Zara’s fashion performance is really a business model to sell at high margin with lower risk. It is worth noting that when the Zara Gap analysis was initiated, Zara was outperformed in margin and turn by American Eagle, A&F and H&M. What happened? Zara’s fashion model excels by operating at lower inventory risk and working capital. That is a structural difference, and not the same model the rest of the industry insists on defending. Operational and incremental improvements of weeks of response time reduction will not succeed versus a superior capital model.

Warren Buffett’s partner, Charles Munger, provides the relevant take on industry status: “Mimicking the herd invites regression to the mean.” Munger did not know he was reflecting retail, or even the essence of Nobel Prize-winning behavioral economics, but he does help to explain the reason why fashion retail doesn’t maximize profit and is so resistant to opportunity.

So what is the way forward?

To learn about strategic options and reasons to be optimistic, it is instructive to consider Amazon and Walmart alongside Zara. Each is meaningful as an example of creating substantial market value. The dominance of each is explained by the “mile” they choose for capital advantage in their total value chain.

Last mile (ex-factory to DC/store to consumer)

Amazon has determined that the “Last Mile” wins the customer. Analysts estimate that in 2016, Amazon spent $16 billion in delivery costs, receiving roughly $7 billion in charges. The net is nearly $9 billion of spending. How many retailers can afford to match delivery capabilities of two days to four hours?

Amazon can generate disproportionate investment capital because it owns product cash flow but not inventory. It is a formidable model, even without a few Academy Awards for its films this year. The company is capturing nearly 50 percent of the only growth channel in retail, and the most expensive.

Middle mile (DC to store)

In 1962, Walmart began to build its distribution network through small market hubs, enabling an unequaled DC-to-store delivery advantage. It is a strategy that drove Walmart to create a $500 billion giant with efficiency that at one time accounted for 50 percent of American economic productivity. Unfortunately, Walmart finds that it is a store-driven model, and to counter Amazon, it must invest in online capabilities, such as with For service, convenience and loyalty, Walmart has to divert capital to compete in the essential and only channel of retail growth.

First mile (concept to design, source, forecast, order & make)

Here is where Zara learning is instructive and accessible. Zara mobilizes the financial metrics of speed and flexibility, valuing both over (or alongside) low cost. This is a working capital equation, enabling it to source and sell with lower risk and investment. The “First Mile” is a significant source of value, exceeding profit potential in Last and Middle Mile strategies. Efficiency is doing more with less cost, productivity is doing more with the same cost, but Zara actually produces superior returns with higher costs.

In Zara’s case, that includes owning 11 factories in Northwest Spain, flying goods twice per week to all global stores, and choosing the foremost High Street locations. Profitability is unparalleled, capitalizing on high margins without high markdowns.

Magic mile

In our quadrant analysis, the fourth graphic box is the Magic Mile. It is magic because it is required to sustain a margin model in decline, or, worse, relies on hope that the fashion cycle will return to something near normal. Examples of Magic Mile strategies abound: reinvention of the store experience, celebrity and co-brand collaborations, personal styling apps, big data analytics, automation, innovation offices and officers, etc., etc.

Each of these has value in chasing parity, but en masse represent innovation theater, and the hyperactivity of technology over lasting advantage. Retailers are in two camps: those who choose a major defining value focus–i.e., first, mid or last mile–applied decisively across an entire culture and network; and, those who have no grand economic vision but lots of motion, if not momentum, to race the pace of change.

There are other ways to focus, such as customer or product segment, but these are likely the largest and make the point that real strategy is differentiation. New technology may be engaging, but it must be fundamental more than fun, and it must be as physical (inventory) as it is digital (Instagram).

Which is the way to go? Fortunately, the untapped economics of fashion are significant.

It is an industry considered 30 percent less productive on average, according to McKinsey, than leading industrial sectors. The under-leveraged landscape of advantage is the First Mile, the best opportunity for superior consumer and capital returns. First Mile strategies shift first cost to first mover, representing process innovation of the first order. If we learn from other industries, like electronics or autos, consider Toyota and JIT as the industrial machine that changed the world in the 20th century. That change in culture, organization and process took U.S. auto market share from 80 percent to less than 20 percent today.

Is culture destiny? Certainly fashion industry resistance is largely explained by its high mark-up, high markdown culture. It is very, very difficult for product organizations to adapt to process competition.

The past decade has been lost and the Zara Gap is widening on a global basis, but the industry’s transformation is an epic opportunity. Unglamorous and unfamiliar to many in retail, process innovation is the only sustainable basis of competitiveness.

To respond effectively and rapidly, the place to begin is value (strategy) and values (culture). Together, they are either twin barriers or advantages. Value, because the Zara Gap tells you the financial upside achieved by very few retailers, and values, because top down, lowest cost merchandising is a failing formula.

Trust, decisiveness and entrepreneurship are Zara’s values in a flat, highly personal and democratic organization where service to stores and sales matters more than cost and control. It is Zara’s obsession with these values that creates its market value.

Will Warren Buffett figure out retail? What Berkshire Hathaway and any investor look for is “economic castles protected by unbreachable ‘moats.'” That is Buffett and Munger’s language for creating value and protecting it over time. The Zara Gap tells us the magnitude of economic value, where it resides, and what values are required to achieve and defend it.

In 2017, we know the next few years will not be like the last 10.

John S. Thorbeck, chairman of Chainge Capital LLC, is an expert on the application of Fast Fashion business principles at retailers and brands. He has collaborated extensively with industry leaders, including Warren H. Hausman, professor of management science and engineering, Stanford University. Thorbeck is a former CEO of Rockport (Adidas) and G.H. Bass & Co. (PVH), and senior marketing executive for Nike, Timberland and the Aspen Skiing Company. He is a graduate of Harvard Business School.