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Jul 17, 2016

The Amazon Effect

Since Amazon.com launched as “Earth’s Biggest Bookstore” in July 1995, the internet has dramatically and permanently changed a host of consumer industries. For the better part of two decades, while the internet was disrupting niche categories like books, music and electronics, conventional wisdom held that broader categories like food and clothing would be immune from online disintermediation. Over the past few years, that assumption has proven to be fragile.

Despite a relatively benign environment for the US consumer (low interest rates, oil prices at decade lows, rising employment and wages), the US retail industry has had rather lacklustre performance over the past year. A number of highly visible retailers, including Radio Shack, American Apparel, Aeropostale, Sports Authority and Quicksilver, have filed for Chapter 11 bankruptcy protection. And the share prices of US retail stocks have followed: the S&P Retail Select Industry Index, a diversified index tracking US retail stocks, has lost 14% of its value over the past year. Judging by this sorry performance, one might conclude that US consumers have gone on strike; however, that is not the case – the U.S. Census Bureau reports that retail sales have grown by 3% over the past year. So, it’s not that consumers aren’t shopping, they’re just shopping differently.

The bulk of the growth in retail sales is captured by Amazon. Although e-commerce represents only c.7.4% of total US retail sales, the internet is overwhelmingly responsible for any growth in sales, and at an accelerating rate. Analysts from Wells Fargo estimate that Amazon accounted for 22% of all the growth in retail sales in 2014, 42% in 2015, and 51% in the fourth quarter of 2015. That is a statistic worth reflecting on – more than 50c out every additional dollar spent in the US is collected by Amazon.

This is compelling evidence that the industry has reached an inflection point in categories previously thought to be immune from online competition. Amazon is already the second largest clothing retailer in the US, and looks set to become the largest within a couple of years. An entire generation of consumers has come of age with no memory of a world before the internet. Initiatives such as Amazon Prime (a subscription service that offers, among other things, free shipping to customers), same-day delivery, and ordering via mobile apps have systematically eroded customer resistance to trial.

This is of course not a passing phenomenon, and few categories remain immune. It has already played out in categories ranging from books (where Borders was a notable casualty and Barnes & Noble is today a shadow of its former self), music (e.g., HMV) and electronics (e.g. Circuit City). In other categories, such as office supplies, retailers are anxiously aiming to consolidate in an attempt to stave off the Amazon threat (where bizarrely, the FTC recently blocked a proposed merger between Staples and Office Depot).

The Amazon effect has far reaching implications throughout the value chain:

 Retailers across the board are facing direct competition, and need to reinvent themselves to remain relevant. Their customers increasingly demand that they be “omni-channel”, in other words be able to shop within a physical store, online or on a mobile device – all offering the same products, prices and user experience.

 Landlords will have to rethink the appropriate amount of space needed to be devoted to retailing. Traffic to shopping malls has steadily declined over the past few years, and this is unlikely to reverse (the “Mallrat” generation have been supplanted by the Facebook generation). As a consequence, landlords, smaller line shops, food courts etc., all of whom rely on footfall for their survival, may see deteriorating economics.

 Suppliers may have mixed fortunes – one of the defining characteristics of e-commerce is the enabling of near infinite inventory. Whereas the range of products sold in a physical store might be constrained by its available floor space, Amazon (and its merchant partners) has no such practical constraints. As a result, barriers to entry for new brands and products may fall, as retailers no longer act as gatekeepers for new products to reach the market, but conversely might require additional marketing investment on the parts of brand owners to allow their products to stand out in the crowd.

 Payment processors (e.g., VISA) and logistics providers (e.g., UPS) could be the clear net beneficiaries from higher transaction and delivery volumes. But even here Amazon is investing with the aim to disrupt and disintermediate (for example, Amazon have recently started its own logistics division, already operating 20 Boeing 767s)

These tectonic shifts may suggest the death of traditional retail (as it has been suggested at various occasions over the past 20 years). While the challenges are real, we continue to see a role for traditional bricks and mortar retailers that offer their customers a compelling value proposition. Seamless omni-channel capabilities are non-negotiable. Pricing, product assortment, location and service levels will continue to be key factors. And retailers that delight their customers in-store, that can differentiate the shopping experience from a bland commercial transaction, will continue to serve a role. Players with undifferentiated offerings are likely to struggle. Top tier and flagship malls will likely continue to thrive; second-tier malls may not. There will be winners and losers.

What are investors to do? While the obvious answer might be to just buy Amazon (a strategy that would have returned 65% over the past 12 months), we think there are also some interesting opportunities amidst the carnage of the traditional retail space, where fear has been the market’s dominant emotion, and some great companies have been marked down aggressively.

One of example of these out-of-favour stocks is Macy’s, the largest department store chain in the US. Its shares are down 51% over the past year. It’s had a torrid year, along with other retailers, that has seen a deceleration in sales growth, and a decline in earnings. While the challenges it faces are real, we think Macy’s shares offer compelling value for a few reasons.

Firstly, unlike most mall-based retailers that rent their stores, Macy’s owns the bulk of its real estate. This real estate portfolio alone, which includes highly coveted sites such as its Herald Square flagship in Manhattan, is conservatively worth more than the current enterprise value of $16.5 billion. By implication, the market is ascribing no value to Macy’s retail operations. Despite industry travails, Macy’s is still one of the largest apparel retailers in North America, generates $2 billion in cash from operations annually, and has strong management, brands and locations. Furthermore, we think a significant contributor to recent weakness is a decline in sales to tourists in its flagship stores – the rapid strengthening of the dollar over the past year has dampened the appeal of the US as a shopping destination for many international consumers. This we believe will normalise over time, and does not represent a permanent impairment of the core business. Lastly, Macy’s is today the 6th largest online Page | 3 retailer in the US. While not immune to the Amazon effect, it is further along than most in leveraging its offline scale into a credible and compelling omni-channel offering.

retailer in the US. While not immune to the Amazon effect, it is further along than most in leveraging its offline scale into a credible and compelling omni-channel offering.

The Amazon effect is real, it is material and it’s not going away. While the retail sector is in the midst of undergoing permanent and, in some cases, painful change as a result, the market’s vacillation between fear and greed also creates, as it is wont to do from time to time, some interesting investment opportunities.

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