Online retail – just the tip of the iceberg

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

The 30-second summary: Online retail is big business. Already $1 trillion is spent online globally, and this figure will likely at least double before the end of the decade. Even then, however, a minority of retail purchases will be made online and so the medium-term growth potential remains highly significant. Growing broadband and mobile penetration, increasing personalisation, sophistication and security will all prove supportive factors. Our approach is to favour pure online plays (such as ASOS), real world businesses with proactive and successful online strategies (for example, Booker or Wolseley) or online facilitators (Jungheinrich).

It is probably not a bold claim to suggest that everyone reading this note will have made some form of purchase online at least once in the last year. In all likelihood, for many, it is part of their daily existence, arguably as commonplace as visiting a ‘real world’ shop. With over a record $1 trillion spent on e-commerce globally last year, online retail would seem to be well entrenched, already a market of significant size. As true as this may be, the reality is we are still just at the tip of the iceberg as far as online retail is concerned: fewer than 8% of all retail purchases globally occur online today. In other words, there is still significant growth potential ahead for the industry and although many listed businesses with exposure to this trend have already performed strongly in recent years, there remains notable scope for a further rerating in our view.

Most readers of this note will recall a world before it was possible to shop online. Indeed, the World Wide Web (or what we now think of as the internet) only opened for commercial use in 1991. Pizza Hut in America claims to be the first business to have offered its services online, in 1994, the same year that the first basic online banking propositions were also launched. A year later, both Amazon and eBay began their services. Wind the clock forward: last year, these two businesses respectively reported revenues of $75bn and $16bn. Amazon highlighted a “record-setting holiday season” at the time of its results, while eBay recorded commerce volumes up 88% year-on-year. Beyond the performance of these online behemoths, a whole host of other data points support the growing ubiquity of electronic commerce. In the UK, for example, some 15% of all grocery sales in the week before Christmas occurred online (versus just 5% the year prior), while department store John Lewis estimated that over 30% of its December sales occurred online rather than in-store.

The factors that have driven the growth in online retail will be the ones that continue to support the expansion of the market going forward. Put simply, the online world offers convenience, flexibility, price and selection: consumers can find information, compare prices and access a virtually limitless range of products, at any time and from any location. Waves of related innovation along these lines – mobile, globalisation, personalisation, expedited fulfilment and new business models – will pave the way for future growth.

Only a decade ago, broadband penetration stood at less than 2% in most developed markets. Today, it is between 30% and 45%. With enhanced speeds, the experience of shopping online has become notably easier. Moreover, the percentage of the population owning smartphones is currently close to 50% in the US (the world’s most developed e-commerce market) and at broadly similar levels in much of Western Europe. According to McKinsey, more than 1.1bn people now own smartphones or tablets globally, yet this figure will double in the next decade on their estimates. Kenshoo, a digital marketing firm, calculates that there is a 60% higher conversion rate of online purchases made via mobiles relative to PCs. eBay added 14m new mobile customers last year, while ASOS, a leading online clothing retailer, notes that more than one-third of the visits made to its website now occur via a mobile device. In other words, it is becoming significantly easier to make purchases online.

Demographics are also helping. The Millennial generation (in other words, those born from 1980 onwards, hence becoming adults in the 21st Century) not only don’t question or distrust the phenomenon of shopping online, often with a mobile device, but are also now entering their prime earning years, replacing a generation that spent much less online. Goldman Sachs estimates that when those Millennials under the age of 25 move into the 25-34 year-old age bracket, their spending typically increases by $18,000 per annum, a large portion of which will likely be allocated online.

This is important especially since there are many segments of the conventional retail world that have barely been touched by the online world at present. Whereas some 34% of all electronic products and appliances and 22% of all entertainment and leisure products (including books and music) are purchased online in the US at present according to consultants Booz & Co, penetration in other categories such as home and DIY products (at just 3%) and groceries (only 1%) is very low, implying significant potential in these latter areas. The growing ability to ‘click and collect’ – which already accounts for around 30% of all online retail orders – will only likely enhance growth prospects, not just in these relatively under-penetrated areas, but also across the broader market.

Retailers (both real world and pure online) are also becoming more sophisticated. Discounts often appear on the web before they do in stores. Personalisation also matters increasingly. Amazon says that over 25% of its sales are now generated by its recommendation engine (“you may like…”), while the e-tailing consultancy group reports that 41% of online shoppers buy more from retailers who have sent them personalised emails based on past browsing and buying behaviour. Moreover, 39% of consumers spend an increased amount than they would otherwise have done on websites that feature endorsements or recommendations from other users.

Against this background, most commentators foresee attractive growth potential for the online market, forecasting a compound growth rate of at least 15% annually for the next five years. If these assumptions prove correct – and historically, estimates have tended to err on the conservative side – then by 2020, the size of the online global retail market will have doubled. $2 trillion spent online may seem like a large figure, but even at this level, it would still imply that only 15% of all retail would occur online.
In other words, the longer-term potential remains highly significant and based on precedents from other industries (from televisions to mobile phones), once the e-commerce industry reaches a tipping point, where the S-Curve begins to slope upwards, then growth will likely be exponential. It should not be forgotten that, while online may already account for some 15% of all US retail (but typically no more than 10% in Western Europe), in most of the emerging world, online today constitutes markedly less than 5% of all purchases. There also appears to be little that may halt growth prospects. Potential concerns relating to fraud (whether over the use of credit cards online or product quality) are diminishing, particularly as retailers (and banks) improve the security of their sites, while customer feedback forums quickly help highlight those less trustworthy online businesses.

Retailers are inevitably responding and it is self-evident that retail success is no longer just about physical stores. As a consequence, both pure-play online retail businesses and more conventional ones are increasing their online exposure, developing and upgrading their web presence. In addition, there is a growing need for investment in ‘dark stores,’ or, put another way, the construction of sophisticated warehouses operated by automated equipment and software, that can be used for home delivery or, increasingly, for click and collect. Amazon paid $775m for Kiva Systems, a robotics business, in 2012 and has opened over 20 new fulfilment centres since then. Meanwhile Tesco, the UK’s largest retailer, recently launched its seventh dark store. Its largest processes 50% more items than its average real-world store.

Although there are clearly attractive growth prospects for the online retail industry, investors need to be mindful of several factors. First, there is the importance of scale and early-mover advantage. In other words, beyond Amazon and eBay (or Rakuten in Japan, Mercado Libre in South America Yandex in Russia and so on), there are few large and successful pure-play online businesses. Next, by definition, the industry is inherently disruptive and so all players need to innovate constantly and successfully in order to stay ahead. By definition, those real-world retailers with lagging online strategies may well end up being left behind. Finally, given the outlook for the industry, expectations and hence valuations for many listed businesses are at elevated levels, implying the risk of potential disappointment, particularly around quarterly results.

Beyond the ‘obvious’ large names, our perspective is threefold: to focus on selected pure online plays; those retailers that have an already successful online franchise; and also on businesses that look well positioned as facilitators. In the first category, ASOS stands out. Founded in 2000 and listed in 2001, the business is now capitalised at $9bn. It aims to be “the world’s number-one fashion destination for 20-somethings” and offers 65,000 products from 800 brands in a purely online capacity. At the end of last year, ASOS had 14.8m registered users, half of whom had shopped in the last month.

Beyond many better-known listed retail brands which have reported online successes (such as Next in the UK or Foot Locker in the US), both Wolseley and Booker have developed notable online franchises. The former, a $14.5bn UK-listed home improvement business, owns www.build.com. This is the fastest-growing online home improvement retailer in the US, and the 80th largest internet retailer globally (according to comScore, a digital analytics firm). Booker Group, the UK’s leading food wholesaler, is led by Charles Wilson, a major advocate of Amazon’s ‘long-tail’ approach. As a result, its website is being scaled to offer a product range more than five times the size available in its conventional retail outlet. More than 50% of its customers already shop online. $2.7bn German-listed Jungheinrich is a leading provider of electric-powered warehouse trucks and integrated warehouse equipment solutions (racks, stackers, cranes, conveyors and software) to the retail sector. The company currently has an order backlog equivalent to 90% of sales. All four of these businesses have notably outperformed the global market over the last five years on a compound basis.

Alexander Gunz, Fund Manager