- The number of bankruptcies in retail is increasing and the probability of new bankruptcies is still high.
- In the online environment, the competition is intensifying their efforts precisely at the moment when Amazon has finally reached some kind of profitability.
- Price wars could make the whole online growth story a bad experience for investors. We’ll use Wayfair as an example.
We’re seeing significant structural shifts in the retail environment where companies that were once considered blue chips are slowly going bankrupt, think Sears Holdings (NASDAQ: SHLD), while online retailer Amazon (NASDAQ: AMZN) is crushing it.
The question many ask is: are retailers cheap now and online retailers expensive, or is it the other way around? To answer this question, it’s extremely important to look at how the competition in the online space will affect margins. We’ll look at some situations and try to come to the best option for your portfolio.
The Retail Sector
The number of bankruptcies in the retail sector year-to-date has already come close to 2016 numbers.
Figure 1: Number of U.S. retail bankruptcies. Source: S&P Global Intelligence.
The main reason behind the high number of bankruptcies is that the U.S. is over-stored, especially now that consumer behavior is shifting to online, and millennials don’t spend their days at the mall.
S&P 500 Global Intelligence calculated the probability of default for some retailers, and unfortunately for SHLD shareholders, it tops the list.
Figure 2: Probability of default for U.S. retailers. Source: S&P Global Intelligence.
This doesn’t mean the companies listed above can’t be a good investment because as others default, the remaining will see their market share increase. Additionally, retailers are really cheap now compared to the levels they used to trade at before the shift in consumer behavior became significant.
Now, if consumer behavior is shifting toward online, does it means that investing in online retailers is the way to go? Well, if brick-and-mortar retailers are cheap and competition is decreasing, online retailers are expensive and competition is constantly increasing.
Online Retail’s Competitive Environment
AMZN is crushing it. For Q1 2017, the company reported revenue growth of 23% with net income growth of 38% compared to Q1 2016. Such numbers are staggering and clearly explain AMZN’s stock performance.
Figure 3: AMZN’s stock is more than a 20-bagger since 2008. Source: Yahoo Finance.
On the other hand, general retailers like Wal-Mart (NYSE: WMT), haven’t done that well.
Figure 4: WMT is up just 34% since 2008. Source: Yahoo Finance.
The reason for the underperformance is slower or non-existent growth if you account for inflation, and the fear that AMZN is going to take over the retail world, both online and offline.
The market seems to agree that AMZN is going to grow indefinitely and therefore the triple digit price earnings (P/E) ratio, while the market is skeptical toward old fashioned retailers which therefore explains WMT’s P/E ratio of 17.16 with a dividend yield 2.71%.
The reason for the divergence in valuations is coming from the fact that the market always has a short-term view and plots the current situation into the future. However, old fashioned retailers aren’t standing still on the online front and will go after AMZN’s profits by copying its systems and technologies. You might wonder why didn’t they go after AMZN earlier? Well, AMZN and the whole online shopping industry wasn’t profitable. A look at margins helps define the issue.
Figure 5: Growing margins in green, declining in red. Source: Morningstar.
As you can see, AMZN’s margins have only turned positive in the last two years and since then, competitors like WMT, Costco (NASDAQ: COST), and Kroger (NYSE: KR) have intensified their online efforts. More competition means lower margins and a potential scenario for investors like the one that has hit brick and mortar stores in the last few years described at the beginning of this article.
How important competition is and how easy it is for it to take market share can be understood from the story of Marc Lore. You might not be familiar with Marc, but he was the founder of diapers.com, which was sold alongside other similar websites to AMZN for $545 million in 2011. Lore continued to work for AMZN for another two years and then left. AMZN is now shutting down diapers.com showing that it bought Lore’s company to eliminate dangerous competition in the first place.
Soon after leaving AMZN, Lore started another company, jet.com, which was recently acquired by WMT for $3.3 billion and he was appointed president and Chief Executive Officer of Walmart eCommerce U.S. The two main points here are that nothing prevents someone like Lore from starting similar companies and competeing with other online retailers, and that WMT has an online shark ready to compete with AMZN.
A good example of how new competitors can easily gain online market share is Wayfair (NYSE: W). W’s sales have grown exponentially in the last few years, but its losses have grown even faster. However, $3.3 billion in sales is a nice piece of the online retail pie that everyone wants. W is currently losing almost $200 million on the $3.3 billion in sales.
Figure 6: Wayfair is growing fast but losing money even faster. Source: Wayfair.
I don’t know who the winner will be in online retailing, but I know that the price wars will be ongoing. Apps like WMT’s Savings Catcher mean only one thing, lower prices, which is good for buyers, but not for investors as lower margins mean lower profits.
The main point of this article is that we shouldn’t expect things to remain stable in the retail sector, both for online and offline retailers. Just think about how today’s largest companies by market capitalization were practically nonexistent or insignificant 15 years ago.
We can’t know which of the companies in the current online-offline retail environment will succeed, but we can easily guess that margins are going to be squeezed. Lower margins mean lower profits and lower dividends, which isn’t a good trend for investors. This will be especially true for online retailers that have stretched valuations. Be careful out there!