Evolution in retail: Survival of the fittest

Retail is not one of those sectors in which things typically revert to the mean. Rather, it’s in a state of continuous evolution with the old being replaced by the new. Shoppers tend to gravitate towards the retailers with the most effective business models, but they do so slowly—one person at a time—so the trend can take years or even decades to unfold.

Two generations ago, Walmart’s store was the retail innovation of its time. Its stores offered an unmatched selection of goods and were just a short drive away for most Americans. On its way to becoming the dominant retail franchise, Walmart consistently exploited its cost advantages, gaining market share from weaker rivals and squeezing its suppliers relentlessly. Shareholders were richly rewarded for decades.

Today, the ongoing shift from offline to online is once again reshaping the retail industry, with significant investment implications. In the initial stages of the migration online, many argued that e-commerce retailers would become less attractive investments as they gained market share, because it’s harder to grow off a larger base. But it’s now increasingly clear that there comes a tipping point in online market penetration where so much pressure is put on traditional retailers that their economics begin to break down.

Indeed, traditional retailers today are seeing their profits pressured, as they increase investments and continually slash prices to retain clients. Their online sales have risen, but often at the expense of their own off-line business. As stores become increasingly deserted, they become worse and worse places to shop. Products take longer to sell, leaving goods to go stale on the shelf, and store managers respond to that by ordering lower quantities, which can create holes in product availability and leave the stores looking bare.

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The UK and US are two of the most highly penetrated e-commerce markets in the world, so on a global basis this trend towards e-commerce dominance is still relatively immature and will likely continue to spread. There is of course no guarantee which online retailers, if any, will rise to claim the profits lost by the decline of traditional retail stores. But as the largest and most technologically advanced online retailer in the Western world, Amazon certainly looks like the front runner.

Amazon’s current US market share is roughly where Walmart’s was 20 years ago. But, as an investor, what’s just as remarkable as the similarity in fundamentals is the similarity in share price performance. Apart from the late 90s “hump” in Amazon’s share price—a manifestation of the bubble euphoria at the time—investors have often been offered the opportunity to purchase Amazon shares at a price of around one times the total annual value of its customers’ purchases, the so-called GMV (Gross Merchandise Value). That’s equivalent to the one times revenue that Walmart typically traded at—a price which proved extraordinarily attractive for investors with the benefit of hindsight. When adjusting for the value of Amazon’s cloud computing business, a multiple of one times GMV is still about where Amazon’s share price trades today.

But is it contrarian?

Is there value to be seen that others are missing? Well, one common belief is that Amazon’s retail business doesn’t make money the way that Walmart’s always did. That’s a widely accepted view which turns out, on closer inspection, to be flawed because of a critical difference between the online and offline business models: the way the cost of growth is accounted for.

Walmart grew its business by building new stores whereas Amazon reaches new customers via digital marketing. While both forms of spending represent investment in the future, marketing expenses are taken as a charge on the profit and loss statement, while capital expenditure only hits the cash flow statement. That means that Walmart records higher accounting profits, but its business model is naturally more capital intensive. Accounting profits are one thing, but in terms of generating all-important cash flows, it’s Amazon’s business model that turns out to have been the more profitable.

There’s no doubt that changes in retail are fast upon us, but unfortunately successful investing isn’t quite as easy as just picking the companies with the wind at their backs. Not every traditional retailer will survive, and likewise not every e-com retailer will thrive. When we buy a company’s shares, our job as investors – just like shoppers – is to compare the price we’re paying with the true value we’re getting. Not everything in the luxury aisle ends up worth the premium, while not everything in the basement will turn out to be a bargain. 

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