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The State of U.S. Ecommerce

The Science of Hitting

The Science of Hitting

230 followers
Comscore recently hosted an event entitled “The State of the U.S. Online Retail Economy in Q2 2012”, with data based upon a global panel of 2 million online users (1M in the United States and 1M scattered around the globe). As I’ve promised some readers, I will soon add my two cents on why I believe Best Buy (BBY) is in a situation that is materially different than that of office supply chain leader Staples (SPLS); this article will highlight some of those differences in terms of consumer behavior (which is tough to pull out in a lot of instances due to the lack of transparency into sales by category at Amazon).

Q2 2011 ecommerce sales were estimated at $37.5 billion (excluding auctions, autos, and large corporate purchases), an increase of 14% year over year. Ecommerce sales over the past decade were strong from 2002-2007 (roughly 20% comps on average), but slowed considerably from 2008-2010 as the economic crisis took its toll (dollar sales were +7%, -2%, and +9% over that three year period); today, it appears to be accelerating again, with low double digit growth in 2011 and through the first half of 2012. In comparison to overall retail sales growth, it is clear that ecommerce continues to take share, as has been the case for years (currently accounts for nearly 10% of discretionary consumer spending in the United States; roughly 9% of that spend comes from mobile/tablets); this data is consistent across a diverse group of consumers, with all income levels showing double digit growth over 2011.

Comscore ranks sales growth as either “very strong” (15% plus YOY) or “strong” (10-14%) across product category, in order of the percentage increase versus the prior year (meaning that Digital Content & Subscriptions reported the strongest YOY increase); here’s the breakdown:

Very strong – Digital Content & Subscriptions, Consumer Electronics (ex PC Peripherals), Flowers, Greetings & Misc. Gifts, Computers/Peripherals/PDA’s, Apparel & Accessories, and Event Tickets.

Strong – Consumer Packaged Goods, Jewelry & Watches, Home & Garden, Books & Magazines, Sport & Fitness, Office Supplies, Video Games, Consoles & Accessories, and Furniture, Appliances & Equipment.

Based upon the number of people visiting the retailer websites, Amazon (AMZN) is the clear leader with roughly 100 million unique visitors per month in Q2 2012 (7% increase from Q2 2011); while far behind, a noticeable follower is Wal-Mart (WMT), which saw a 23% year over year increase in monthly visits at 41.4 million in Q2 (nearly twice as much traffic as Target).

Comscore presents some data that is highly useful for teasing out Amazon’s domination of certain categories; in their slide deck discussing ecommerce results in Q2, they have a chart that shows category share as a percentage of Amazon’s overall sales in comparison to that category’s share of the overall retail e-commerce market – for example, they estimate that AMZN’s Computers/Peripherals/PDA share is in line with the index, or that the category (for Amazon) is comparable to the categories share of overall retail ecommerce (on a scale of 1-5, it’s in the middle at three; one would indicate under representation at Amazon, while a five would indicate that Amazon is particularly strong in that category).

Looking at the data, three categories fall in the upper end of the spectrum (Amazon is dominant): these are Consumer Electronics (ex PC Peripherals), Books & Magazines, and Toys & Hobbies, with the most noteworthy brick and mortar companies in those categories being Barnes & Noble (BKS) and Best Buy.

At the other end of the spectrum, we have companies that are under-indexed to Amazon’s overall share, meaning that they’ve held up relatively well (in comparison to other retail categories) to the threat of Amazon; the categories at this end of the spectrum are Apparels & Accessories and Office Supplies, which bodes well for a company like Staples.

There’s some other interesting data to come out of Comscore’s survey; one example is the importance of free shipping. From their research, 55% of consumers said that if they got to the end of an e-commerce transaction and they were not offered free shipping, they would cancel their purchase at that retailer. In addition, they noted that 95% of consumers would choose free shipping over free in-store pick if given the choice; however, if forced to pay for shipping, more than 60% would choose free in store pick-up as an alternative.

I find this interesting because (in my view) free shipping is unsustainable, particularly on overnight/two day shipping when online items are priced at or lower than retail. As consumers are forced to either increase ticket or pay for shipping, free in-store pickup becomes an attractive alternative, one that brick and mortar retailers hold over pure online competitors like Amazon; to be clear, I’m not suggesting the impact will be substantial – but I think it’s something to be cognizant of, particularly when you look net shipping costs (as a % of net sales) of nearly 5% at AMZN, a figure that’s expected to increase as customers use shipping offers at an increasing rate (and could shrink their already low 2% operating margin through the first six months of 2012).

I’ll tie some of this back into the Best Buy / Staples comparison article that I’ll publish soon (in addition to further analysis on the state of free shipping and sales tax and the impact those two items have on ecommerce), but I thought this would be a useful starting point; the divergence between these two industries in terms of Amazon’s penetration is only one of the reasons why the comparison is unjustified.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 3.8/5 (16 votes)

Comments

tonyg34
Tonyg34 - 1 year ago
while not meant to be an in-and-of itself criticism, I would at least consider that amazon has scaled into categories in stages. by which i mean that first and foremost they impacted book sales, and then later electronics, and then general holiday gifts like flowers, and are only now starting to have a material competitive catalog of offerings in apparel and office supplies. so in some respects it remains to be seen if they can effectively compete in this space.

I think the more lasting impact for you as a Staples shareholder would be Amazon's willingness to just heedlessly keep slashing margins to drive sales growth and forcing out competitors by doing so. I guess a lot depends on how much of office supply sales are planned ahead of time (thus allowing for shipping time) versus stuff you need right now.

I think in any market where just the price is all customers care about (and don't need to consult a sales person) Amazon can at least in theory change the market by being willing to sell for ever slimmer margins (which they've demonstrated for more than a decade now).

On the other hand

the fact that staples sells lots of cheap items makes it comparatively more expensive for Amazon to ship the stuff (as a percent of sale) than big expensive items like electronics.

And the on line sales tax rules would almost certainly result in the rebirth of brick and mortar stores (except for digital things like books music and movies) - you can't digitize office supplies or clothes that i know of, hence i believe the general thrust of your argument that BBY and SPLS are two different animals

Very interesting series of articles you've put together about Staples
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Tony,

I agree with that; if you go back and look at the timing, they have entered these categories in stages, and are generally stronger in the categories they entered first (like books and consumer electronics).

On the rest of your commentary, I agree 100% - a big risk is that Amazon will simply continue to fight for share (SPLS CEO Ron Sargent alluded to this in his Q2 commentary); I think the funniest thing is that people (meaning AMZN shareholders at this valuation) must assume they will eventually raise prices once they dominate all of ecommerce to drive an astronomical level of sustainable profitability - while my personal thoughts are that they will never be able to pursue such a strategy because Wal-Mart will keep them grounded in this age of increased price transparency (and their gains in ecommerce in Q2 show that WMT is a growing presence in the space). Thanks for the comment!

swnyc2
Swnyc2 - 1 year ago
Science,

With the prospect of AMZN and WMT providing fierce competition for the extended future, wouldn't that be the reason to not buy SPLS at its current valuation? Continuing margin compression from increasing competition will decrease FCF and the stock will continue to fall. SPLS has no moat.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Swnyc2,

Fierce competition has been the status quo for the past decade; in my mind, you must take that qualitative statment and relate it to quantitiative measures (I think 7x FCF more than compensates for that risk). In terms of continuing margin compression, take a lot at margins over the past decade - the breakoff clearly comes in 2008, right where the financial crisis crushed their core business (particularly in Europe). Teasing out the structural vs. cyclial cause is tough, but I would suggest you at least consider the impact of the macroeconomic enviornment (and the $1B+ in FCF being generated despite it).

In terms of no moat, I disagree, particularly with NAD; that's my opinion and others are free to disagree. Thanks for the comment!

swnyc2
Swnyc2 - 1 year ago
Science,

I was wondering why SPLS is having substantially more trouble in Europe than the U.S.?

Is there a competitor unique to Europe?

Is there a structural problem with their European stores?

Any thoughts would be appreciated.

Regards,
swnyc2
Swnyc2 - 1 year ago
Science,

I read a short article in Forbes that suggested that Staples may indeed be struggling against Walmart, Costco, and Amzn. I'm sure you saw it when it came out. However, it inspired me to look at the pricing of some random office supply items on line.I looked at several items that are commonly purchased by businesses (e.g. hanging folders, bic pens,copy paper, etc). And what I found surprised me. While some items (such as pens) are comparably priced. Others, such as hanging folders and copy paper, are substantially more expensive if purchased form Staples than from its competitors.

In one of your responses to my prior comments, you said that fierce competition among these retailers has been present for several years. While this may be true, it seems to me that SPLS eventually will be compelled to lower its prices. In doing so, its margins and earnings will drop -- and so will its price. It may just have taken a while for the consumer to smarten-up and switch retailers. The trend has clearly begun. My fear is that it will accelerate.

With regard to my prior question about Europe, I'm guessing that it's principally the poor economy that is weighing on SPLS, rather than a unique competitive environment. As such, given the Europe will eventually bounce back, shouldn't Staples really just tough it out?

Regards,

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Swync2,

The Forbes article fails to address something that's critically important - how is that any different from five years ago? Costco, Wal-Mart, and Amazon have all been relevant in these categories for a very long time - and there's little to suggest their interest in this one category has materially changed in the recent past (you say the trend has clearly begun - care to point to what makes you believe that?). With that being said, these three competitors are certainly relevant and having an impact on the industry - as noted by the author, "it doesn't take much to wonder if the world is big enough for three different office supply retail chains".

I agree with that statement 100% - industry consolidation is a key part of my thesis (OMX & ODP have announced closures/store downsizing that will eliminate roughly 100+ stores per year from the North American portfolio through 2016). I also look at the delivery business, a segment that accounts for more than 50% of Staples' operating income, and has no comparability to the retailers often listened as comparable to SPLS (Radio Shack, Best Buy, etc). Add in the current valuation, and I believe that the market has become too pessimistic on Staples.

In terms of pricing, I agree with you; Staples has price match with the competitors mentioned, and needs to do a better job at communicating their price comparability with other retailers.

In Europe, it's harder to get a view of the industry due to lack of transparency; as with the United States, the economy must be considered (look at results in the region prior to the crash); but new investment should be scrutinized with a watchful eye - any excess cash that will not create incremental shareholder value should be returned to the owners of the company. Whether or not they should tough it out will be answered by management on the Q3 call - it will be interesting to see the changes announced as a result of recent weakness.

Thanks for the comment!

swnyc2
Swnyc2 - 1 year ago
Science,

I looked at the profit margin of SPLS over the last several years and I found that prior to 2008 it ranged from 4-6%. However, since 2009 the range has been from 2-5% (see graph below). This represents a 30% decrease in profit margin. Your thesis is that this margin compression is temporary and will be solved by store closings (especially by ODP and OMX). I believe many bears contend that the margin compression is primarily due to increased competition with WMT, COST, and AMZN.

The distinction is critical. If ODP and OMX are principally the culprits, they (along with SPLS) will be motivated to close stores because they are in the same retail space, in which case, margins should bounce back for each of them.

However, WMT, COST, and AMZN are different animals. They have a much broader retail space. If you look at the retail line of WMT or COST, they generally have lower profit margins than SPLS. I can only assume that they are quite happy competing in the office products space where margins are likely better than for many of the other retail products that they sell. And, as for AMZN, their corporate strategy of late seems to be to pursue sales growth at any price, even if there is no profit. If WMT, COST, and AMZN are the real competitors which have caused SPLS to drop its profit margin, SPLS stock may never recover.

I was thinking about how to distinguish between these scenarios and I don't have a good answer. However, I did notice something concerning. The annual revenue growth for SPLS prior to 2008 was 10%. However, since 2009 SPLS revenue growth has essentially been flat. And since 2009, annual revenue growth has also been flat for ODP and OMX. (By comparison, annual revenue growth since 2009 for WMT, COST, and AMZN has been ~5%, ~10%, and ~40% respectively). Either there has been no growth in the office product market for the last few years, or SPLS, ODP, and OMX as a group are loosing market share to other competitors.

Any thoughts?

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The Science of Hitting
The Science of Hitting premium member - 1 year ago
Swync2,

Three thoughts:

1. Delivery - what you are talking about is all retail; just remember how important this business segment is.

2. The impact of international of overall company operating/profit margins. I would recommend that you breakout margins by quarter, by business, and drawn a trend line - this is very revealing.

3. The impact of the economy - WMT, COST, and AMZN compete in many, many categories that are essentially recession-proof; the comparison between the office supply retailers' sales and these retailers is essentially meaningless from my perspective (if they broke out numbers by category I wouldn't be saying this...)

Just remember: I don't disregard what you're saying; I simply believe that the three things I mentioned plus the tailwinds I outlined in my value contest submission will outweigh the impact of WMT, AMZN, COST, etc.

Thanks for the comment!

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