June 2020 - A little more than a year ago, we published a note discussing the future of retail and the evolution of the industry. With the onset of the COVID-19 virus in the United States and the required closure of non-essential stores, many changes that were already under way began to accelerate meaningfully. Grocery delivery went from a luxury of millennials to a healthcare necessity for those over 50. Large chains had already been slowly gaining market share, but the virus exposed the real gap in technology and infrastructure between those with the capital to invest and those without it. With stores now being allowed to slowly reopen in most states, we again attempt to assess the path forward for retail more broadly and implications for investment opportunities today.
Some people we have spoken to within the retail industry have likened the required changes to safety and sanitation within stores to the enhanced security seen in airports following September 11th. Many travelers noted that taking off shoes and other new security measures made them feel safer and improved their willingness to travel in the aftermath of the attack. But the parallels to retail only go so far, as there are not many options for getting from New York to Los Angeles in six hours.
But in terms of retail, now that more and more people have experienced the myriad of ways that retailers can fulfill their shopping needs through delivery, contactless pickup, etc., will anyone want to return to stores to be greeted by masked employees and temperature checks? This dynamic will create a more significant issue for companies that provide a luxury experience as an aspect of their value proposition, with the most obvious being high-end restaurants and luxury hotels, but even a company like Nordstrom will likely have to rethink the way that its associates interact with customers. In addition, it will be very challenging for independent stores to compete with large chains who have the resources to provide these additional fulfillment options, increased sanitation, and the resources to pay employees more who might now demand higher wages given the inherent risks of consumer-facing jobs.
The question of the future of apparel retail is certainly an intriguing one, given that such a key differentiator of the in-store shopping experience was the ability to try on clothes and assess the look and fit in real time. Given concerns over contaminated surfaces, will people feel comfortable trying on clothes that likely had been touched by other people? However, while online apparel retailers have made the shopping experience far more convenient by allowing free returns, do the same concerns apply to this channel? The clothes have to get in the box somehow, and the box has to be delivered. While people will continue to buy clothing and fashion will remain a priority to a certain subset of the population, an industry that was already facing substantial disruption will have to scramble to find a way to make people feel safe.
The future of malls, which had historically driven a huge amount of discretionary spending on apparel, is very much a question mark. Already struggling and losing share to e-commerce, malls now face the unfortunate distinction of being indoor spaces with large crowds, a taboo in a post virus world. Although incremental reports from companies such as American Eagle, one of the better positioned mall-based retailers, have indicated that there is pent up demand, the durability of mall traffic longer-term should be weaker than before the virus. Time will tell whether the majority of these companies, especially those with large debt loads, will be able to survive, which will have a striking impact on the commercial real estate landscape across the country, the subject for a discussion at another time.
Unsurprisingly, Amazon, which has been the main force disrupting retail over the past two decades, was well prepared to handle the shifts in consumer behavior mandated by the pandemic. The companyâ€™s investments in convenience and infrastructure became even more important in getting needed products to consumers, and the companyâ€™s acquisition of Whole Foods, which had been questioned strategically by some analysts, now appears prescient as on-line grocery purchases surged during March and April.
Competitors that were viewed at risk of becoming irrelevant due to Amazon just a few years ago showed that the right investments can drive consumer adoption and loyalty long term. Target, with its acquisition of personal shopping service Shipt and best-in-class touchless pickup process, has navigated the current environment successfully. Walmart, which in the early 1990s was the first disruptor of the U.S. grocery business, has become a serious competitor to Amazonâ€™s retail offering after years of margin dilutive investments in technology and delivery. Perhaps the biggest winner of the pandemic is the Northeast focused club retailer BJâ€™s Wholesale. Long in the shadow of its much larger competitor Costco, BJâ€™s first-quarter results were remarkable, with comparable-store sales up 27%, digital sales up 350%, and new members up 40%. BJâ€™s CEO called the current environment a â€śonce in a lifetime opportunityâ€ť for the company. It is reasonable to question whether it is fair for these â€śessential retailersâ€ť to be able to sell toys and apparel in certain states while independent stores selling the same items were forced to close. However, as the number of shopping trips are reduced, stores that can offer a one-stop shop, with convenient digital engagement and multiple delivery options will likely continue to be the winners in retail moving forward.
Yet for these relative winners, the simple cost of operating is moving significantly higher, even beyond the investments being made in delivery infrastructure and technology. Companies are forced to spend money to make sure customers and employees are willing to come inside the store. Costco, for example, spent an incremental $283 million on PPE, sanitation, and bonuses for employees in the most recent quarter.
Costco will be an interesting case study in the evolution of customer attitudes towards shopping in-store. The Costco experience is predicated on a treasure hunt within the store, where a consumer buys many more products than originally intended. Costco was the first major retailer to require a mask for all customers and employees, and the sheer size of the store should provide at least some comfort. But Costcoâ€™s industry-leading sales efficiency, which anyone who is a member has experienced trying to fight down the aisles or for a spot in the checkout line, may never be the same in a post virus world. The company is bringing back free samples in June, which should provide at least an incremental boost to traffic.
Market share is the most significant opportunity to come from the current pandemic, especially within specialty retail. Bankruptcies of poorly capitalized department stores that were struggling even in the robust consumer environment of 2019 will drive more and more apparel sales out of intermediaries. Brands like Nike that have invested to make direct connections with consumers will likely see accelerating growth. Cosmetics, long a staple of department stores and one of a few areas that has been slow to transition online, should see a major shift to other channels, likely more focused retailers like Ulta and Sephora. These companies offer a wider range of products in a more convenient setting, as well as additional services like hairstyling. They have also invested in technology that allows customers to see how a new shade looks digitally, avoiding the need to touch a possibly contaminated sampler. Additionally, we believe areas of retail where the majority of the competition is independent stores (a wide range of industries such as optometry, veterinary services, and even coffee) will see well-capitalized chains take market share from independents who have had a hard time keeping the lights on while shut down.
It is important to note that the pandemic has driven long-overdue technology investments at smaller stores (you may have noticed your local mom and pop pizza shop or the boutique down the street rolling out a website recently). Facebook, for example, is aiding small businesses with an online presence with their new Shops initiative. These types of investments, especially in a time of severely reduced revenues, may create a financial strain that will be hard to overcome. While that dynamic is likely not a positive for the broader economy, which is largely driven by small businesses, it has become somewhat unavoidable in a post-COVID world.
Given the severe disruption seen in the labor market due to virus-related closures, there is little doubt that we will see a period of depressed economic activity moving into the second half of 2020. Retailers that have focused on value have historically outperformed during past recessions, which makes sense given the desire for consumers to stretch their spending dollars as far as possible. An area that has been trumpeted as a winner in this environment is off-price retail, with TJX, Ross Stores, and Burlington the largest public players. The opportunity to buy severely marked down inventory from department stores and sell it at a discount has made these companies a popular investment pick. But their models inhibit any sort of meaningful e-commerce presence, as inventory is constantly moving in and out of stores. While TJX has reported that demand was stronger than expected when stores reopened, there is no guarantee that in-store traffic will ever return to pre-virus levels. While these are all well-managed companies, the point is that retail investing in this environment is extremely nuanced, and the winners are far from clear cut.
Consumers will likely return to stores and restaurants once re-opened, as the desire to experience something new after being locked up for several months will outweigh fears of getting sick. Longer-term though, people who have experienced the convenience of delivery and buy-online-pickup-instore (BOPIS) are likely to continue using these services. Stores that can make people feel safe through enhanced sanitation measures will likely also see traffic slowly improve, but there is no doubt that the shopping experience will be very different for the time being.
Here at AMI, we have always focused our retail exposure on large chains with national footprints, those with the financial flexibility to invest in an improved customer experience both in-store and online. We also focus on retailers in fragmented industries, where weaker competition is likely to cede customers over the long-term. We took advantage of the broad-based market selloff in March to add new positions in Amazon and Nike, quality companies that had previously fallen outside of our valuation parameters, and increase existing positions in certain retailers that also check these boxes. While we believe consumer behavior will normalize somewhat as we move away from the virus shutdowns, these trends will dictate the future of retail, and those companies who will be winners and losers as a result.