The U.S retail sector of late has been much maligned. While dramatic headlines suggest online retailers will be the death of traditional brick and mortar stores, the evidence suggests otherwise. A look at U.S. Economic Census numbers for retail during the last seven years (excluding food service and automobiles) shows growth averaging about 2%, well below GDP growth, which averaged 2.9%. In looking at the data for the sector one thing is clear, we are in the midst of a massive transformation. This is driven by the rise of the millennial and the transformation towards e-commerce. The change has been a gradual one. While there have been and will continue to be casualties along the way such as Sports Authority, in the end the consumer will win, and those that survive will be stronger for it.
For perspective, in 2009 e-commerce represented only around 4.8% of retail sales, whereas the latest numbers, on a seasonally adjusted basis show that about 9.3% of shopping is conducted online. While the overall growth trend should assuage any fears of major trouble in the retail sector, Q1 numbers were abysmal. Typically, economic indicators are strong and consumer spending is above average in election years, which makes the Q1 weakness in retail even more troubling. In 2012, Q1 total retail spending was $22 billion below the seven-year time series trend, while in 2016, the value was $92 billion less, 4.2x larger and the largest absolute below trend value seen for Q1 in the last seven years. Before discounting the Q1 value as an outlier, it should be noted that outliers are more often than not harbingers of marketplace shifts.
What to buy?
So what is behind the performance issue and why, given other key factors driving retail, are we not seeing better performance? Gas prices tend to have a significant impact on retail spending, where just a few cents decrease in price pumps billions of dollars into the pockets of consumers. With the average price of gas down from 2015 levels, consumers have traditionally used the excess on discretionary spending, the kind of spending that helps fuel retail. “Discretionary spending,” (below), provides a good overview of the changing priorities of U.S. consumers. The chart compares 2014 data (latest available) to 2009 levels.
The data shows that Americans are allocating much less cash to savings and basic necessities, while spending more on experiences, health care and transportation. Over that time period, we see that a large portion of the incremental changes in transportation (41.2%) are devoted to the purchase of vehicles. The disparity is revealed in the fact that new vehicle spending increased by 60.3% (9.9% annually), while used vehicles grew a modest 9.5% (1.8% annually).
The other large increases in consumption are seen in healthcare and what we would refer to as experiences: Recreation, food service, and accommodations. The change in sentiment in spending is something that all industries in the economy need to be aware of and must respond to strategically. Savings and general necessities spending has decreased; consumers are now allocating those funds toward improvements in quality of life through healthcare (or just being able to stay alive) and having fun and making memories. Given the rise of the millennial, consumer attitudes toward savings, and healthcare policy, we would anticipate these trends to continue. While early yet, current estimates for 2017 indicate double digit growth in healthcare costs, which could further hamper consumer spending. With regards to the retail sector, this data would suggest that to reverse the trend in wallet share, retailers will be required to be more adept at creating memorable experiences.
Despite these challenges in the sector overall, there are areas that are quite healthy and stable, and bode well for future growth. While mall traffic in general is down and struggling, reports suggest that outlet mall traffic is outpacing traditional mall traffic. Outlet malls have been growing in popularity with consumers as they provide a high density of stores, with typically higher-end brands at discounted prices, yielding a much greater perceived value in the eyes of the consumer. Today’s consumer is a value shopper and outlet malls meet this need in a major way. There are more than 30 retailers with in excess of 100 outlet locations, including Gap Inc. (GPS), 394 locations including Baby Gap, Banana Republic, Gap Kids and Old Navy; Tommy Hilfiger with 109 locations; Dressbarn, with 184 locations; Carter’s (170), and Gymboree (163). While outlets locations themselves are not necessarily an indicator of success, they provide another channel or distribution point in which to engage with consumers and grab wallet share.
Specialty softgoods (apparel) retailers have embraced this trend much more quickly than department stores, where all but Nordstrom’s (JWN) have been slow to respond. Nordstrom’s recognized that outlet malls are where some of their traditional mall traffic has transitioned to, where it provides a venue to liquidate some merchandise at price levels above where they might be discounted at their first run stores. Macy’s Backstage (13 locations), Find @ Lord & Taylor (3), Off/Aisle by Kohl’s (3), Nordstrom Rack (178), Last Call by Neiman Marcus (28), Saks Off 5th (61) and Sears Outlet (10) all have outlet offerings. The tenuous dance these retailers do, risks alienating product suppliers, and the potential exclusivity perception that certain high value brands may suffer from when either overly discounted or sold at an outlet store location. Apparel stores are much better insulated from this potential conflict since many carry their own branded products, thus we expect specialty retailers to be more effective with this strategy.
Somewhat along the same vein, TJ Maxx and Ross Stores (ROST) have been tremendously successful over the last five years, as they offer the same, but with an added twist. Both TJX Companies (TJX) and ROST provide products perceived to be higher quality at discount prices with a high variability in assortment. In one sense they are brick-and-mortar’s version of a flash sale. Customers feel they get great value, enjoy the thrill of the hunt, but most importantly are drawn to the store due to the ever changing assortment and premium brands often available. As we see in “Quality & affordability” (above), both companies are far outpacing performance of the S&P 500 and the S&P Retail ETF (XRT) since 2011.
Retailers with great store experiences are well positioned to weather the long haul. While the concept of store experience can be very broad, typically these are retailers that marry great technology, with great customer service and consistency. Furthermore they are companies that invest in employees as a valuable asset and will tend to be highly ranked as great places to work. In almost any survey of great store experience retailers such as Amazon (AMZN), Publix, PetSmart and Chick-Fil-A will emerge. These are all household names that the simple mention of creates an emotional reaction and throngs of loyal customers with stories of notable and consistently positive brand interactions. In “Customers come first,” above the customer experience leaders (blue line) represents the top five publically traded retailers: Amazon, Bed Bath & Beyond (BBBY), Costco (COST), Lowe’s (LOW) and Advanced Auto Parts (AAP), according to Temkin’s Customer Experience survey. While they are not as strong as ROST and TJX (see “Quality & affordability”), we see that customer experience pays as they performed almost twice as well as the S&P 500 and about 60% greater than the S&P Retail ETF (XRT). Also note that if AMZN is removed from either the customer experience or IT leaders’ index, the remaining companies still easily outperform XRT.
The next, and perhaps least obvious category that we believe is a core indicator for a successful retailer is those companies that have a consistent track record of, or are in the midst of a significant investment in their Information Technology (IT), and are rapidly transitioning their IT infrastructure into one that can support unified commerce. These are shown as IT leaders in “Customers come first,” (below) and include Amazon, Wal-Mart (WMT), Starbucks (SBUX), GameStop (GME), Kohl’s (KSS), Canadian Tire (CTC) and Home Depot (HD). We define Unified Commerce as the holistic technology stack that provides one version of the truth for data pertaining to customers, products, pricing and sourcing, that in turn enables the procurement, sale and delivery of merchandise independent of channel. Those retailers that move most rapidly in maturing their IT capability to support the tenants of unified commerce are those that will both be more successful and better equipped to compete with retailers such as Amazon. In its most simplistic terms, unified commerce is about creating commerce continuity across channels, and is a step beyond omni-channel retailing.
The challenge that retailers currently face actually rests in their history, and is graphically highlighted in “Unified Commerce maturity,” (below). When a given retailer launched their first channel (typically bricks and mortar), they established a technology silo that was focused solely on that first channel. In their rush to bring subsequent sales channels on board (catalog, e-commerce, mobile, marketplaces, etc.), they established additional silos rather than attempting an integration with the first silo. The resulting siloed view of products, customers, orders, customer data, etc. was not only expensive to establish and maintain, but it offered little in the way of data integrity cross-silo, and no way to unify a customer between channels. This is one of the built-in disadvantages most traditional retailers face, as most e-commerce companies are relatively new creations and were able to architect their systems with a much more holistic view of today’s retail environment.
This is where unified commerce is key, as it acts as an architectural construct to overcome the constraints caused by channel evolution. The payoff is significant and measurable, yet given the very thin IT budgets traditional retailers work with, this transition is occurring much slower than necessary. Of all discrete industry verticals, retail has the unenviable distinction of spending the lowest percentage of revenue on IT. This is something that must be resolved if traditional retailers hope to compete effectively.
This is a vital area for the investment community to understand. IT spending is never mentioned in a 10K/Q, and almost never mentioned in investor presentations or calls, excepting an occasional footnote as a major capital outlay. While IT spending is one of the least spoken of metrics in retail, it is perhaps one of the most important. In looking at arguably the two most successful U.S. retailers, Amazon and Wal-Mart, significant IT investment continues to be at the forefront of each organization, and the major driver of both their initial and continued growth. While many of us may be familiar with the approach that Jeff Bezos has made to differentiate Amazon, turning back the clock 15-20 years, students of retail innovation will be quite familiar with the contributions and investments made by Wal-Mart during their growth. WMT birthed the concept of Big Data and learned how to make actionable decisions with terabytes of data at a time when many of their peers were just beginning to scratch the surface around analytics and business Intelligence. These in turn led to innovations around the supply chain, store technology and a litany of other improvements.
“Dynamic pricing,” (below) represents price data on selected items from: Amazon, Wal-Mart and Target. For both items we observe the dynamic and competitive nature of pricing. Amazon sometimes will, but not always wins on price, but with consumers they lead in price perception. Pricing leadership is driven by a combination of systems supporting business intelligence, analytics, CRM, loyalty and supply chain leadership. In comparing the charts one begins to understand pricing strategy on each product. Both Amazon and Wal-Mart’s investment in IT has helped position them as marketplace leaders. In the same manner we see essentially no price movement for both items at Target, even leading up to Christmas. These examples demonstrate one of the many areas of investment necessary for traditional retailers to compete with their e-commerce counterparts.
Based upon 20 years of research from IHL Group, traditional retailers spend 0.8% to 2.5% of their revenue on IT, with the industry average around 1.5%, while e-commerce-only retailers’ spending levels can be in excess of 10% with an average of 6% to 7%. While there exists a significant disparity in IT spend, marketing spend allocations are quite similar. According to a CMO Survey, around 13.9% of revenue is spent on marketing for those companies with 1% to 10% of their sales online, increasing to 16.8% for those with greater than 10% online sales. In a 2015 survey conducted by the National Retail Federation (NRF) surveying CMOs, respondents reported their marketing budget split had 62% of the spend allocated for traditional marketing media and the remaining 38% for digital marketing. This same research suggested a continued increase in the marketing budget. As we had noted earlier with regard to store traffic in general and especially mall-based store traffic, it continues to struggle, so in spite of increasing marketing percentages, store results have not followed. In looking at the factors in totality we believe this is yet another sign of shifting marketplace drivers which were highlighted earlier.
One of the ironies of this research arises when looking at the cost and effectiveness of marketing, and the ability to measure ROI between the two major allocation divisions. While there can be much variability depending upon the medium selected, the cost to reach an audience of one thousand via digital marketing can easily be less than one third of the cost via traditional marketing, with the added benefit that digital is often much easier to measure. In a survey of 200 retail marketers in January by RetailMeNot, 75% of respondents agreed that digital marketing was much more effective than traditional marketing. Couple this with the fact that millennials, one of the most influential demographics in retail today, typically do not interact with, nor are influenced by, traditional media. The shifting sands of influence are validated by research from Experticity, which found that 83% of marketers believe that traditional advertising is the most effective means to influence buying decisions, yet advertising was among the least trusted sources with only 47% trusting brand advertising and favoring family or community reviews by over 75%. These results lead us to ask why retail is not moving more rapidly away from traditional marketing, and accelerating some of that allocation towards digital.
Given the huge disparity between IT spend at traditional vs. e-commerce only retailers, with similar marketing allocations, why is traditional retail comfortable with current IT spend levels? Unlike marketing, IT spend rates have not grown commensurate to the shifting shopping patterns in today’s retail environment. The growth in IT spending over the last seven years has averaged less than 5% per year. When you examine modern retail at its core, you find that the traditional store products’ mix and experience has not changed all that appreciably in the last 10-20 years for far too many retailers. As a mental exercise, just compare the stores you shop in today with how they looked one or two decades ago. If you have a hard time differentiating the two images, that is an indicator that the digital transformation that is impacting our homes, devices, automobiles, entertainment, healthcare and virtually every aspect of our lives has not been adopted in our stores. In a somewhat simplified example we would neither invest in, nor shop an online retailer whose website looked 10-20 years out of date, but when we apply that same standard of digital maturity to the store, should we then wonder why traditional retail is having a hard time competing effectively. While there is no requirement for a level playing field, the store is a vital asset that should receive attention. We believe that retail can and will continue to be a major driver to our country’s economy and that traditional retail can be competitive with their online counterparts.
Not only are these compelling observations with regards to spending accountability and ROI, but the investment community can play a significant role in both understanding these allocations and investing accordingly based upon the market dynamics we have highlighted. Retailers to be considered investment worthy moving forward should include:
- Those that create shopping and store experiences
- Those that provide perceived above-average shopper value
- Those that are rapidly transitioning from traditional to digital marketing and radically considering all investments in traditional marketing
- Those that invest heavily in IT systems that support a unified commerce customer experience
For the remainder of the year we see a lot of uncertainty in the retail space. Both capital markets and consumers hate uncertainty. As we had noted that the typical bump in election year spending has not occurred, we believe this will continue through the end of year and is amplified by the differing aspects of uncertainty brought about by both presidential candidates. Only when the election is complete will retailers have an idea of where things will go. Until then, we see a rather tepid remainder of the year for consumer retail spending and the sector as a whole.