Sears Roebuck has thrived on change for the past 113 years. The retailer helped launch the mail-order business in the 1800s. In the 1920s, it reinvented itself as one of the first national department-store chains. After World War II, Sears helped lead the charge into suburbia, setting up stores around the country. Along the way, Sears was one of the pioneers in developing private-label brands, such as its highly successful Craftsman tools.

To shed some light on this all-too-common predicament, Context Editor-in-Chief Paul Carroll and Managing Editor Pegeen Hopkins recently visited Martinez in his offices on the prairie west of Chicago to hear how he intends to make a dinosaur dance.

CONTEXT: What was the situation at Sears when you arrived in 1992?

ARTHUR MARTINEZ: The Sears franchise had been in serious trouble for about 15 years. The task at hand was to restore some fundamental financial health and respectability. It was tough to dream any big dreams at that point.

The restoration occupied the first three or four years that I was here. Since then, we’ve been thinking, How do we bring the fundamental strengths of Sears to more customers in more shopping locations while we keep the base franchise successful and relevant?

Internally, we have these things called BHAGs—big, hairy, audacious goals. One is to have a recurring relationship with every household in North America. You can’t do that by just sitting in a regional shopping center, even if you’re in 850 of them, as we are. So we’ve been working on reaching out to touch customers in more locations and through different channels, to create relationships that may not be possible inside the big store.

CONTEXT: How important is on-line retailing?

MARTINEZ: Some of my peers in retailing see e-commerce as a threat. We’re viewing it as a complementary channel. We hope to find new customers or serve existing customers who don’t have the time, the interest, or the access to stores. To be successful in retailing over the long haul, you have to have an active presence in all the important channels—be it big stores, little stores, catalogs, or e-commerce.

The other thing is that the Internet has become an important way for customers to do research on products, so we have to help them do that.

CONTEXT: How fast do you see your on-line sales growing? I ask because lots of people are assuming that retailing is going to move on-line completely, rendering bricks and mortar irrelevant.

MARTINEZ: E-commerce’s impact will vary greatly by product category, and the future will evolve in ways that we can’t predict right now. But one useful metric is that traditional paper catalogs represent about 8% of what we call general merchandise sales. The forecast I subscribe to is that e-commerce will be twice as big as the catalog business by 2010.

I think that’s a pretty big statement. If you add catalogs to e-commerce, you’re talking about 25% of the market that will go through direct channels.

If e-commerce grows as quickly as I think it will, it will slow sales growth in our stores. But I don’t think sales will decline. We won’t be turning the lights out in our stores anytime soon, that’s for sure.

CONTEXT: Which categories that Sears competes in lend themselves best to selling on-line?

MARTINEZ: We start with a view of what we’re known for by customers. We ask, “Where do customers give us permission, and where do we have authority with the consumer?”

Very clearly, our strongest business is our hard-line franchises, which revolve around the home: appliances, hardware and tools, lawn and garden, consumer electronics. We think we have powerful advantages because of the Sears brand and because of the individual brands, like Craftsman, that nest underneath the Sears brand and that carry a reputation for value and trust. We also have an incredible infrastructure for handling bulky merchandise, and many of these hard-line categories involve complex transactions with big things that have to get moved around, delivered, and installed in people’s homes. We believe those categories are at the heart of our franchise, and at the heart of what we want to do in the e-commerce channel.

We’ll emphasize appliances first. The hardware and tool business is the next. We’ve had a Craftsman site for a couple of years. We’re upgrading it and putting it together with a complete, nationally branded offering. After that will come an extension of all of our lawn and garden products. Then an extension of consumer electronics.

One organizing principle is: Let’s be sure we not only defend, but extend, our franchise with home-related goods through the on-line channel. We want Sears to be the definitive on-line source for the homeowner.

CONTEXT: Where does clothing fit? There’s a debate over how comfortable people are about buying apparel on-line, given that they can’t try it on.

MARTINEZ: Apparel will be one of the last things to move on-line. The issues of taste, fit, style, and color argue that the electronic channel will have a minimal impact on sales, just as paper catalogs had a relatively modest impact. Apparel is also tough economically because of returns. Apparel catalogs experience a 25% to 35% return rate. The consumer often orders two to get one. The consumer says, “I don’t know if I am a six or an eight. I’ll get both and send one back.” Bingo. There’s a 50% return rate.

What the new channel can do is provide access for people who have unusual size requirements, either very small or very large. Those requirements often cannot be satisfied in-store because the retailer doesn’t want to carry that broad an inventory.

CONTEXT: I assume you’ll add services on top of whatever products you sell on-line.

MARTINEZ: We want to be able to sell the related services in the on-line world just as we sell them today through in-store marketing and direct marketing to the consumer. We will soon be able to let people schedule service appointments on-line, by themselves. Later this year, we plan to be able to let customers communicate on-line with our service organization—for instance, to ask questions about problems.

CONTEXT: What else can you do to encourage the integration of the store world with the on-line world?

MARTINEZ: This summer, all our appliance departments are getting Web-based kiosks so customers can do the research in the store that they might have done at home, both on our products and on our competitors’ products. We think this capability adds to the probability that we’ll get the sale. If people do their research at home, they’re in an anonymous environment. If they do their research here with us, we have a chance of holding them and making the sale in the store.

We have lots of anecdotal evidence to support this practice. Consumers are coming in with their research printouts when they’re buying appliances.

CONTEXT: I know that lots of traditional retailers worry about state taxes and the “nexus” issue. In other words, they worry that if they link their stores too closely to their on-line businesses, then states will decide that each store serves as a nexus for the on-line business. E-commerce customers will have to pay sales tax in each state where a store is located. That may mean everywhere in the U.S. Someone who is just an on-line retailer, meanwhile, may have to charge sales tax only in the state where it is based, giving it a major advantage. How are you handling the nexus issue?

MARTINEZ: You’re on to a very knotty problem. There is a moratorium on new taxes on on-line sales for another two years. But I think Congress will then have to revisit this whole question of taxes and create a level playing field for both physical and on-line stores. The answer might be a simplified national sales tax.

It’ll take a while to resolve, but in two or three years we should see some move for reform.

Even in the current environment, I worry less about the nexus issue than about what works for consumers. At the end of the day, consumers will value the accessibility of the physical store as a touch point or return point and will, I think, assign a higher value to that than they will to the absence of a sales tax. I also don’t think it’s right to let tax issues push you to make it difficult for a consumer who bought something on-line to return it to a physical store. I think we’re going to have to get over the nexus issue, frankly.

CONTEXT: I read a few months back that Sears store managers typically declined to let on-line purchases be returned at stores, because the returns would be subtracted from the stores’ sales totals and could cut the managers’ bonuses.

MARTINEZ: There is a lot of dysfunctionality in the system that you have to flush out. We have to set Sears up to be friendly to consumers and worry about accounting later.

CONTEXT: What are some other issues that you have to deal with, beyond returns and taxes?

MARTINEZ: In our appliance business, our salespeople are paid on commission. They’re somewhat territorial, shall we say, about commissions. We are working on a compensation system in which they become indifferent to whether a transaction is completed on the sales floor with their pen or pencil, at the point-of-sale terminal, or through the electronic channel. We want to eradicate the idea that anyone is trying to steal business from the salespeople. What should be important is making the sale for Sears. When the company wins, they win.

CONTEXT: How about compensation at the senior level?

MARTINEZ: At a senior level today, incentive is roughly based 50% on enterprise results and 50% on individual unit results. But I’m beginning to think that, the higher you go, the more you should have the enterprise base. That would make executives indifferent to where a victory occurs.

CONTEXT: Is there a timeline you have for how long it will take for Sears to assimilate into the on-line world?

MARTINEZ: Well, we have a sense of urgency, an itchiness, to defend our existing franchise strengths and to grow them. In the next year and a half, I see an enormous rush to fulfill our promise of being the definitive on-line source for the homeowner. We’ll present the consumer with products and services under the Sears brand and under its derivative brands. During that time there will be high intensity and high spending.

I can’t see beyond that period right now. That’s one of the difficulties with this whole world. You can’t write three-year financial plans. You can’t write five-year strategic plans. You have to try to move with the speed of the market, which is moving far faster than any traditional organization has ever moved.

That’s hard for us. Culturally and systemically, we tend to move on a slower timeline, even though we think of retail as a fast-paced business. E-tail is even faster-paced than retail.

In six months, I’ll probably have a clearer view of what should happen after that. But the opportunity in e-commerce is so tangible in the next 18 months that that is all I want to focus on now.

CONTEXT: How hard is it to find the people you need so you can take advantage of those opportunities?

MARTINEZ: The people issue is by far the biggest single challenge we face. We have to find a way, and we haven’t found it yet, to create entrepreneurial opportunities and rewards for people that are not unlike those they can find at start-up ventures. We also have to have people who understand us and how we do things and who can work inside our company, because our existing infrastructure has to be tied in so tightly to the front-end Web system.

It’s hard to find people with the right talent and create the right environment inside a traditional culture. I don’t know if we need to set up a separate division at a separate location with a separate equity structure and a separate compensation system. We haven’t figured out yet what the right points of connection and disconnection are from our basic business. But unless we figure that out and get the right people, we’re not going to be able to execute our vision here.

CONTEXT: How are your competitors faring?

MARTINEZ: If there’s anything I take away from what’s going on in the on-line world it’s that consumers are self-organizing. They’re organizing themselves into interest groups, or communities, that aren’t defined by traditional demographics, such as women, ages 35-49, with household incomes between $37,000 and $42,000. The communities are defined more by attitudinal and behavioral characteristics.

I think the retailers that succeed will be the ones that can respond to these new market segments, tap into communities of interest, and present integrated solutions to those people. This means engaging in more partnerships than we would have ever thought about before. For instance, if we want to become the definitive on-line source for the homeowner, we need to do deals with sites like garden.com. It provides design services for our customers, while helping us sell related products.

If you’re just an item-oriented retailer in the on-line channel, the long-term prospects are very cloudy. This is why I think Amazon, as a pure product seller, may have a relatively short life cycle.

Actually, I haven’t seen any of our traditional competitors yet move in the direction of addressing communities, either. Most of them are just treating the Web as an alternative delivery vehicle for products.

I think store-based retailers enjoy an incredible advantage because of their store base. Virtual retailers have fewer touch points for the customer. There’s no store to go to to check out the product, no store to go to to return it, no store to go to for help if you need it. The physical presence of the store, I think, reinforces the electronic channel. In the long run—and I don’t know whether the shakeout process is going to be 12 weeks or five years—the advantage should go to the traditional retailers implementing a vibrant and attractive electronic commerce alternative, as opposed to the pure-play on-line merchandise retailers.

CONTEXT: How long have you been thinking about the Internet?

MARTINEZ: My awareness of it dates to 1995. But I will be frank and say that I was a complete skeptic about whether it was going to mean anything for Sears. Let’s get focused on what we’re doing, I thought. Let’s do a better job of what we’re doing. We certainly weren’t spending any money on the Internet. We weren’t spending a dollar on it. I’d say it was probably two years ago that I got religion.

CONTEXT: What gave you religion?

MARTINEZ: Talking to people. Talking to, certainly, [IBM Chief Executive] Lou Gerstner, who I went to school with and see fairly regularly. He was evangelical about the Internet at that point. I also remember playing golf with a friend in Colorado, in the fall of 1996, and he was very persuasive about what the Internet could do. That’s when I began to take it seriously.

CONTEXT: How did you start to get familiar with the Internet once you got religion?

MARTINEZ: I began playing around with it at home. My son, who is now 25, was very helpful. He showed me the power of the Internet as a research and information tool, which was the most impressive thing about the Web early on. At that point, the first commercial application was just beginning.

I also had an understanding about how many nontangible products were being sold over the Web: financial services, travel, and memberships. It was clear that consumers were beginning to use the Web in a transactional way even though not for tangible, physical products just yet. The question then was, under what circumstances would tangible, physical products become practical? That’s when Amazon began to educate us on how that would work.

CONTEXT: I’ve read that you feel Sears customers have an incredible reservoir of goodwill for the company that you’ve been able to draw on in recent years and will be able to tap into as you figure out the on-line world. Is that so?

MARTINEZ: I call it the yellow-ribbon effect. When the hostages were in Iran in the 1980s, people tied yellow ribbons around trees to show they wanted the hostages back. Well, there’s that same kind of effect here. Customers wanted their Sears back. They wanted it to be better. They wanted it to be different. They wanted it to be more relevant. But they wanted it back. Customers had an astonishing patience with the brand and the franchise. If we can activate that legacy in a channel like the Internet, as we’ve had some success doing in our store world, then we’ll really have accomplished something.