Prior to the COVID-19 pandemic, the retail sector was already in the midst of a transition from physical store sales to ecommerce. The lockdown measures in 2020 accelerated that progress by potentially two to three years, with ecommerce now representing 16% of total retail sales. Furthermore, Amazon, the global leader in the ecommerce space, is on track for an aggressive expansion of its U.S. distribution network. They plan to expand their footprint by nearly 45% in the next 18 months – or about as much in one week as many large traditional retailers add in a decade.
We caught up with a number of experts from the RBC North American Equity Team to discuss the impact of this accelerated ecommerce shift on a number of different sectors.
Why is Amazon expanding so aggressively?
Donna Comartin, Associate Portfolio Manager
Amazon is looking to continue to expand its ecommerce share, while also controlling as much of the supply chain as they can to maximize their margins. Amazon has a history of investing in capabilities internally and then selling those services externally once they reach critical mass. So with this aggressive expansion, they could eventually rent out space to other retailers and charge to distribute their product. This would be a similar strategy to what they did with Amazon Web Services – initially the backbone of their own website, before it transitioned into a high margin, high growth business for them externally.
Amazon’s massive expansion also reflects their desire to operate close to large population centres and maintain fast shipping time as a competitive advantage. Ecommerce requires about three times the space as a traditional retailer, fueling speculation that some traditional retail space in populous areas could be converted into ecommerce distribution centres.
Although some classes of real estate have been heavily disrupted by the pandemic, industrial real estate investment trusts (REITs) have fared relatively better as a result of this ecommerce shift.
What is the impact of this growth in ecommerce to logistics firms like FedEx, UPS and even Amazon?
Sean McCurley, Portfolio Manager
With significantly higher volumes of ecommerce sales in 2020, firms like FedEx, UPS and Amazon did a remarkable job of moving all of that product. That success can largely be attributed to investment in efficiency and capacity in previous years.
UPS and FedEx have been ramping up capacity for the last decade, investing approximately US$10 billion per year as they try to better deal with elevated Q4 volumes. Their biggest customer, Amazon, has also invested significantly in this capability. A few years ago, UPS and FedEx investors were concerned about the prospect of Amazon adding planes and building out their own distribution network. However, this move by Amazon has been accretive to ecommerce growth, helping to cap shipping costs and push prices lower. Ecommerce growth has also held down costs – as more packages are delivered to the same neighbourhood, the average cost to deliver each one drops.
Overall, what we’re seeing is all this investment from UPS, FedEx and Amazon is positive for ecommerce growth, as it helps to keep shipping costs low and handle growing capacity needs.
How are brands approaching this ecommerce transition?
Angelica Murison, Portfolio Manager
Amazon’s platform suits a wide variety of products, but isn’t the default for many brands. Consumer brands, such as Vans or Calvin Klein, generally prefer customers to purchase within their own direct-to-consumer ecosystem in order to extract as much value as possible. At the same time, they also don’t want to be reliant on Facebook/Google for customer acquisition.
The player that has arguably executed this strategy the best so far is Nike. They have about 250 million members across their apps, lowering customer acquisition costs. Furthermore, their profitability through direct-to-consumer channels is vastly superior to wholesale. Today, their ecommerce segment generates twice the operating income dollars of their wholesale channel, and costs related to fulfillment should only come down as they continue to scale.
We think that Nike’s playbook is one that other brands will try and replicate in order to retain the profit that they used to share with third-party retailers and/or malls. .
What does the shift to ecommerce mean for the grocery business?
Jonathan Millman, Portfolio Manager
Like other areas of retail, grocery has seen significant growth in their ecommerce offerings. However, unlike other areas of retail, grocery rose off a much smaller base. Ecommerce sales have grown from 1-2% of sales before the pandemic to 5-6% at the peak.
There are two interesting considerations to take note of in the grocery space.
The first is the role of real estate. The pandemic has shed light on the grocers’ expansive real estate footprint and highlighted that there is a real convenience in having locations embedded within society. These locations have provided grocers with stronger growth in click-and-collect formats relative to delivery, at a time where delivery was well positioned to win. Capital expenditure decisions around the build out of networks to support this growth are more focused on micro-fulfillment centers (i.e. repurpose existing less productive square footage into more productive space).
The second consideration for ecommerce in grocery is profitability. Unlike some other areas of retail where direct-to-consumer (DTC) strategies can improve profitability, the shift to ecommerce can be a headwind to profitability. Traditionally, the cost of shopping has been borne by consumers, but in this new model, the grocers have to absorb that cost. When ecommerce was very small, grocers were largely focused on getting the sale. But now the focus has shifted to profitability, particularly considering grocery is a low-to-mid single-digit margin business to begin with.
When we think about developments from here, click-and-collect is likely the most profitable solution for grocers and has the potential to match traditional margins if executed effectively. We’re also looking at the use of loyalty and data to drive a more profitable basket from consumers. Loblaw’s and Walmart have been very focused on this.
What could happen to existing traditional retail space?
Donna Comartin, Associate Portfolio Manager
A lot of retailers are rethinking their physical footprint. Through the combination of store closures and too much real estate (the United States and Canada have the highest retail square footage per person in the world), it’s clear that traditional retail is under pressure and that’s reflected in the price of real estate.
However, we do think there is opportunity in well-located, well-curated retail space as we work through the right rents to charge for this experience. For many businesses, there is a compelling case to maintain a physical store in order to be close to their customer base. Curbside pickup and pickup in store options are desirable for retailers despite paying for the storefront, as customers absorb the shipping cost. Having the customer in person also allows them to exchange or return products on the spot and provides the retailer the opportunity to upsell. We expect that this hybrid model of ecommerce that includes a physical storefront is the retail of the future.
The number of stores that will have to exist going forward should continue to decrease, with only the best locations with the best amenities charging the most attractive rents. However, newsflow is likely to be volatile in the near term, as more retail bankruptcies are announced due to COVID-19.
On the investment side, generally retail REITs have adapted and repositioned their portfolios, focusing on population centres, transit nodes and investment-grade tenants. Balance sheet health is also vital to success in order for landlords to weather changes in the industry, while also investing in long-term viability.
How are companies like Facebook and Google benefitting from the ecommerce shift?
David Tron, Portfolio Manager
Many retailers needed to build out ecommerce capabilities quickly to access their customers. There are two ways that Facebook and Google have benefitted from this.
First, both companies created a marketplace on their platforms. In the past, there have only been two ways to sell online: through Amazon or by building out an ecommerce site. However, Facebook and Google are now offering an alternative on their own platforms -- and an incredibly enticing one at that. Their websites already have a lot of traffic and they’re essentially making it free to sell. Facebook currently has 200 million businesses with Facebook pages, and 10 million who advertise with them. So the transition for those businesses to sell on their marketplace is seamless. It’s a scary proposition for Amazon, as they gain a competitive threat, but good for the consumer who benefits from choice.
Second, Facebook and Google also stand to benefit on the advertising side, given they operate in somewhat of a digital advertising duopoly. For retailers, they have little choice but to advertise using Facebook and/or Google’s platforms. However, there are a fixed number of advertising slots available. COVID-19 has bolstered demand, while supply has remained fixed, pushing costs higher. This means both Facebook and Google are benefitting from a boost in high margin advertising revenue.
So through the combination of demand for their marketplace and advertising, Facebook and Google are benefitting from the ecommerce shift in multiple ways.
Read more insights from the RBC North American Equity Team