Returning the focus to retail
Last summer, we spent a fair amount of time focusing on the troubles of the retail sector, both in our blog posts and in monthly articles. Our May 2017 newsletter focused on the weakness of the business model for traditional retailers while detailing the record number of store closings, showing the breadth of the problem. Our follow up article in June 2017 looked at the whole retail industry chain – the producers, the retail companies, and the owners – and how they were each adapting to the new environment.
It has been more than a year since these articles were written. In the intervening months, our attention has been pulled towards different topics including potential trade conflicts or the impact of the new corporate tax cuts. Since some time has passed, we are better able to report upon the aftermath and current state of retail America. We are better able to see which parts of the industry have successfully adapted and which have not.
A steadier environment, peaking now
To review, the retail sector had undergone some challenges which we enumerated in our previous article series – The New Retail, Parts 1 and 2. Let’s consider the good news. Since those two articles were written in the summer of 2017, a large tax break for corporations and individuals has had the opportunity to mitigate some of the damage. The continued economic growth, low unemployment, and high consumer confidence have continued to promote healthy discretionary spending. The US Commerce Department reports retail sales are up 6.4% from this time a year ago (July 2017 to July 2018), far in excess of analyst expectations.
Next, let’s consider reintroduce some pessimism. Our dedicated blog post readers –those who have read our July Blog “Big GDP Numbers next week” – will know that the maximum impact of the tax-cut bill is probably cresting right now. While there are no immediate obvious threats to our solid, if unremarkable, GDP numbers, nor imminent threats to business and consumer confidence, there are also few reasons to expect an acceleration of growth beyond our current rate – approximately 4.1%.
Put another way, the retailers have enjoyed a reprieve. They have had the good fortune to experience an advantageous economic backdrop, albeit temporarily. Ideally, businesses in this struggling sector should have been using this time to bolster their business models because it’s unlikely the circumstances will improve.
Last summer, we worried traditional big box stores (e.g. Target, Wal-Mart) or shopping mall anchor department stores (Bon-Ton, Macys) would suffer as consumer shopping migrated online, but we also wrote about how some retail giants were adapting to new behavior. Case in point: Nordstrom department store. We noted in an October 2017 blog post how Nordstrom’s diversified business model and defensible ownership structure (they are still publically traded after flirting with a private buyout) had made the store an exemplar among its peers. Last week, Nordstrom continued to best Wall Street forecasts, with a 23% increase in digital sales – which now accounts for more than a third of their total revenue.
Integrating digital storefronts and physical store sales strategies also seems to be a winning tactic. For instance, Target stores are reporting a 6.5% increase in year over year sales – the highest rate of growth for more than a decade. Analysts attribute this jump to a comprehensive strategy shift Target made in early 2017 to integrate digital sales with remodeled storefronts. Target’s new strategy includes lower profit margins and cost cutting, but they seem to be making up the difference with volume. Notable improvements include same day delivery or Target’s new “drive-up” service for online customers which combines the convenience of online shopping with local store pick up, and the additional perk of employee assistance moving items to the customer’s vehicle.
A final example: Wal-Mart. In 2017, we verbalized our concerns about the company’s business model, writing “Wal-Mart has been trimming staff and store locations since last year, while the razor thin margins, food deflation, and high competition are impacting profitability.” On the other hand, we also noted Wal-Mart’s rapid expansion into online sales, stemming from their purchase and integration with the e-commerce operations. (In fact, both Target and Wal-Mart purchased e-commerce sites – Shipt and Jet respectively – to update their digital storefronts.) Last week, Wal-Mart reported their strongest growth in ten years. The core of that expansion was from online sales, which increased 40%.
Companies like Wal-Mart and Target may actually have found an advantage against purely e-commerce competitors, which have poached sales from traditional stores. The purely electronic competitors may have lower overhead, but for high-touch, distributed markets (like groceries), flexible brick-and-mortar storefronts may be marrying the best of both worlds. Indeed, given Amazon’s recent purchase of Whole Foods to augment their physical presence, maybe these two competing styles – digital and physical – have unwittingly, and independently, converged upon an efficient combination of both online and brick-and-mortar storefronts.
This raises an important question for value-focused investors. If the business models of online-centric and physical store retailers ultimately converge, then it’s going to become easier to compare technology heavy, high-growth peers to their previously distinct traditional counterparts. While technology heavy, high-growth companies were treated as distinct from their brick-and-mortar peers, it was easier to justify inequalities because the underlying business models were so distinct; it’s just “apples and oranges”. Consider, even after the technology crash of the early 2000’s, it is still common for digitally oriented companies (like Amazon) to accept low profitability and high valuations as a necessary step towards acquiring competitive scale and high-market share. In real world terms, Wal-Mart’s current price/earnings ratio is 32 while Amazon’s current price/earnings ratio is 171. If these competitors business operations ultimately become comparable (which we acknowledge is not true at the moment), how might investors justify ongoing valuation differences of this magnitude?
Not all traditional retailers have been fairing as well as Nordstrom and Wal-Mart, as a whole. There are still substantial store closings and reformatting occurring. Department store stalwarts like JCPenny have been posting weak earnings numbers and languishing stock market prices. The results are more mixed for other key retailers. For example, both Kohl’s and Macy’s have experienced some stock price weakness in recent months, but we simultaneously recognize improvements in their same-store sales growth metrics.
It’s important to recognize that each of retailers, winners and losers both, have a perfectly viable online storefront, while many of their sites are well-integrated into the underlying business operations. For instance, some of these sophisticated storefronts seamlessly offer consumers the option of receiving items at home or reserving purchased items at store locations for same-day pickup. The problem is deeper than simply lacking an online store. There are strategic problems which may be the product of a variety of factors including company culture, employee incentive structures, store format, strategic partnerships, advertising priorities, channel growth, operational flexibility, brand awareness, technological expertise, and so on.
Let’s consider factors which portend retailer strength. One factor which suggests retailer success is pricing flexibility, as customers become more accustomed to comparison shopping. Second, retailers which offer their own brands (or rebranded white-labeled substitutes) alongside peers can mitigate the losses to profit margins due to cost-cutting. Third, retailers that can quickly (and cost-effectively) negotiate with suppliers – extending private labels while phasing out sales laggards – have a measurable advantage. Each of these factors requires scale, meaning that larger retailers with strong brand identities may be better positioned than mid-sized peers and specialized boutiques.
While the “retail apocalypse” proffered by business news pundits and analysts may have been a little oversold – lurid headlines make for fun stories – we can more safely assert that the forces which negatively impacted the retail industry so strongly in 2017 are not going anywhere. Even if the worst case scenario is avoided, or maybe just delayed, there’s every reason for retailers to adapt quickly. It’s not going to get any easier than it is right now.