Retail Sector Insights – Brick-and-Mortar Loses Relevance

Uncertainty in buying sentiment and foreign currency fluctuations pose headwinds to growth

The U.S. retail sector, which is the largest private employer supporting 42 million jobs, provides $1.6 trillion in labor income and contributes $2.6 trillion annually to U.S. GDP, has rapidly evolved in recent years due to the e-commerce boom that has changed the way consumers make purchasing decisions. By far, this has prompted industry observers to predict the extinction of brick-and-mortar stores. The growth of the retail sector in 2016 has been influenced by an uptick in employment growth, housing starts, wage rises, lower oil prices, and rising consumer confidence. However, the Brexit issue, and the ensuing global turmoil, has added an element of choppiness and uncertainty to consumer buying sentiment, not to forget foreign currency fluctuations, which has deterred consumers from shopping abroad.

Source: McKinsey
Source: McKinsey

Almost all the big-box U.S. retailers such as Wal-Mart Stores Inc. (NYSE: WMT), The Kroger Co. (NYSE: KR), Costco Wholesale Corp. (NASDAQ: COST), Target Corp. (NYSE: TGT), Macy’s Inc. (NYSE:M), Best Buy Co. Inc. (NYSE: BBY), and Lowe’s Companies Inc. (NYSE: LOW) reported a fall in foot traffic due to the soft buying sentiment among consumers as well as a negative impact from foreign currency fluctuation. The change in shopping habits of consumers from physical stores to online stores has contributed to the fall in traffic. Surging ahead are online merchants like Amazon.com Inc. (NASDAQ: AMZN), eBay Inc. (NASDAQ: EBAY) as well as deep-discount stores and dollar stores, which have reported healthy revenue and same-store sales.

Some of the important trends witnessed in the U.S. retail sector in 2016 are described below:

r2Store in your pocket: U.S. e-commerce has grown at an impressive clip of almost 18% annually, accounting for more than 10% of total retail sales. With the accelerating adoption of smartphones, digital commerce is poised to explode, and is a huge factor for most retailers. For fashion apparel retailer Gilt, mobile accounts for about 50% of daily traffic and more than 30% of total sales. Mobile technologies will increasingly influence every stage of the customer’s shopping journey, from personalized promotions prompted by geotargeting to in-store research and price checks, as well as to payment capabilities that offer better checkout options.

Personalized marketing: U.S. retailers are doing away with mass advertising and are shifting increasingly towards personalization, powered by sophisticated algorithms and predictive models that analyze transaction data and digital-media trends. For example, 35% of what consumers purchase on Amazon come from product recommendations based on such algorithms. Retailers are increasing their spending on personalized marketing to facilitate and influence peer connections about brands through paid ads and branded pages on social-media platforms.

r3Same day delivery: Amazon.com started the trend of same-day delivery in some cities at no additional cost at the consumers’ doorstep and already offers same-day delivery in major cities across the U.S. Consumers can expect to avail same-day delivery in at least the top 150 metropolitan statistical areas, which hold nearly 75% of the population by the end of 2017. Furthermore, retailers are expected to offer shipping free of charge to their most loyal and profitable customers, as opposed to providing it only for those who make minimum purchases. Retailers are also expanding third-party distribution services, making big investments in distribution infrastructure and sell it as a service to other retailers, as Amazon and eBay do now. Others are beginning to invest in infrastructure to provide convenient and secure package-delivery locations in groceries, convenience stores, and drugstores nationwide, and new services are sprouting up to let retailers ship packages for pickup at other retail locations or self-storage facilities.

New retail business model: Intense competition in the retail sector is blurring lines between formats and sectors as retailers try to steal shopping trips and share from one another. For example, fresh food, once found only in supermarkets, is now increasingly found in convenience stores, pharmacies, and even dollar stores. Furthermore, players across the value chain are encroaching on what used to be the exclusive turf of retailers. More manufacturers are selling directly to consumers, for example, Apple Inc. (NASDAQ: AAPL) and Nike Inc. (NYSE: NKE). Tech players are also fighting for consumer space, for instance, Alphabet Inc.’s (NASDAQ: GOOG) Google offers more than one billion products for sale on Google Shopping and may soon open retail stores.

r4Physical stores in a Growingly Virtual World: The above trends have put considerable strain on the traditional brick-and-mortar retailers’ economic model, with challenges to both the top and bottom lines. On the revenue front, the biggest obstacle will come from a channel shift: in-store purchases will grow by only about 2% to 3% per year, and some formats should see in-store sales decline by 5% to 7% annually. Gross margins will come under pressure from both high discounting (retailers will need to keep prices low to stay competitive) and a reduced share of trade spending (vendors will allocate fewer trade dollars to secure shelf space in physical stores and more to promote brands in the digital realm). Despite the changing retail business model, Forrester Research and McKinsey predict that despite the e-commerce boom, brick-and-mortar stores should still account for approximately 85% of U.S. retail sales in 2025.

To increase revenues and remain profitable, retailers are focusing on the following aspects:

Expanding revenue and profit pools: Retailers are reinventing themselves by investing in multichannel capabilities in order to enhance revenue generation. For example, retailing behemoth Amazon.com, which most retailers view as their main competitor, acts as a traditional retailer in only 35% of its customer transactions. On the other hand, a majority of the products bought by Amazon’s customers flow through its marketplace or its fulfillment services for third-party sellers.

Cutting costs: The retail industry’s growth has slumped over the last few months mainly because of inefficient inventory and wastage. With the growth outlook now dimmed considerably, retailers must take a hard look at operating costs in three realms – direct product costs, the indirect costs of goods not for resale, and labor costs. By effectively reining in costs, retailers can save up to 20% to 30% in operating costs, which makes a huge difference in an intensely competitive environment.

r5Reconfiguring real estate: As purchases migrate to digital channels, most retailers will need less physical selling space in stores. While some formats such as groceries may be relatively unaffected, others such as consumer electronics and toys will be hit profoundly and could require square-footage reductions of half or more to deliver a compelling customer experience and economics. Retailers are already rebalancing their real estate as they reassess what should be sold through physical space; major departmental chains such as Macy’s have announced the closure of 100 stores by early 2017.

Investing in data analytics: Retailers are leveraging the vast amounts of data they possess and building analytical muscle to enable targeted marketing, tailored assortments, and effective pricing and promotions. Gathering and analyzing data to understand the needs, preferences, and attitudes of growing consumer segments will be especially important to understanding individual consumers and customizing offers on a one-on-one basis. Many retailers are using data analytics to tailor assortments at the store level, to anticipate changes in customer traffic patterns, and to determine optimal distribution routes, inventory levels, and allocations, simultaneously enhancing the customer experience and improving unit economics.

r6Increasing assortment and product offerings: Consumers prefer retailers that provide value in new and different ways and are seeking a retail experience that is often related to deep product expertise. Additionally, retailers must do these things in an environment that is increasingly experiential. Shoppers who prefer physical stores are gravitating toward more specialty retailers or malls that offer experiences such as outdoor entertainment and dining. Macy’s, for example, has embarked on a major effort to court millennials, including the launch of 13 segment-specific brands, new destination zones within physical stores, and a marketing mix that includes social-media programs.

**Retail sector performance**

Departmental stores in general have lost their luster over the years and are witnessing shrinking footprints, with consumers increasing turning to online shopping in a big way. For example, J.C. Penney (NYSE: JCP), Target, Tesco PLC, Lowe’s, and Macy’s, which reported dismal sales, are changing their department store model by resorting to digital and omni channel retailing. J.C. Penney is focusing on creating a seamless experience for shoppers across its online stores, jcp.com, and all its digital channels. Macy’s is looking to enhance sales through tie-ups with private brands, enhancing omni-channel presence, and improving revenue per customer. Target is working on different initiatives such as redesigning its mobile app to allow users to pull up products easily, integrating wallet features for easy payment, and capability to save coupons and offers. Wal-Mart is improving its website capabilities by enhancing desktop experience, allowing greater personalization, and introducing analytics to better understand customer preferences.

r7Kohl’s Corp. (NYSE: KSS) has started to offer same-day delivery of general merchandise and groceries to customers in major cities. Retail behemoth Wal-Mart is looking to close the last-mile delivery gap with online merchants like Amazon.com by partnering with ride-hailing companies Uber Technologies Inc. and Lyft Inc. to launch a pilot grocery-delivery service. Wal-Mart has been leveraging on its ability to combine its brick-and-mortar store sales with online shopping. Alongside pilot projects with Uber and Lyft, Wal-Mart has also expanded its curbside grocery delivery to 14 new markets for a total of 54 markets and in over 200 stores, as of April 2016. Many retailers, including Wal-Mart, are also investing billions of dollars in building new fulfillment warehouses to speed up delivery time and increase the number of product categories sold on its website.

Discount retailers such as Ross Stores Inc. (NASDAQ: ROST), Five Below Inc. (NASDAQ: FIVE), Fred’s Inc. (NASDAQ: FRED), Dollar Tree Inc. (NASDAQ: DLTR), The TJX Companies Inc. (NYSE: TJX), and Dollar General Corp. (NYSE: DG) have reported positive sales growth since they mainly target the low- and middle-income groups that witnessed wage rises during the first quarter of 2016.

On the other hand, high-end departmental stores such as Abercrombie & Fitch Co. (NYSE: ANF), specialty retailer Nordstrom Inc. (NYSE: JWN), Coach Inc. (NYSE: COH), luxury brand Vera Bradley Inc. (NASDAQ: VRA) and Fossil Group Inc. (NASDAQ: FOSL) reported dismal sales owing to the strengthening dollar and a fall in tourist spending at their flagship stores. Nordstrom is trying to keep its clothing relevant to shoppers in part by selling popular brands that have limited distribution elsewhere. Global luxury lifestyle brand Michael Kors Holdings Limited (NYSE: KORS) was among the luxury retailers to report a jump in revenue due to growth at its digital e-commerce flagships.

Convenience-store and gas-station operators Casey’s General Stores Inc. (NASDAQ: CASY) and The Kroger Co. (NYSE: KR) reported revenue growth due to better sales of fuel.

r8Among pharma retailers, Walgreens Boots Alliance Inc. (NASDAQ: WBA) reported positive sales growth and has agreed to acquire Rite Aid Corp. (NYSE: RAD) for $17.2 billion. The proposed deal, which is pending approval by antitrust regulators, is expected to be completed in the second half of 2016. The combination of Walgreens and Rite Aid would create the largest pharmacy chain in the U.S. with more than 12,800 stores across the U.S., giving it an edge over rival CVS Health Corp. (NYSE: CVS).

Apparel retailers such as The Children’s Place Inc. (NASDAQ: PLCE), Sears Holdings Corporation (NASDAQ: SHLD), Burlington Stores Inc. (NYSE: BURL), and Tilly’s Inc. (NYSE: TLYS) have resorted to superior product, business transformation through technology, global growth through alternate channels of distribution and store fleet optimization to combat a challenging retail environment and the continued weakness in store traffic. Many departmental apparel retailers are also making efforts to launch exclusive product ranges with celebrities as a means to do away with standardized inventory that has reduced the appeal of departmental stores.

Electronics retailer Best Buy Company Inc. (NYSE: BBY) rose above the retail rubble, surpassing expectations on both sales and earnings, as shoppers are spending more on big-ticket items such as electronics and cars than on apparel.

Home improvement retailer Home Depot Inc. (NYSE: HD) and Costco Wholesale Corp. (NASDAQ: COST) reported strong sales, supported by a number of economic tailwinds such as low unemployment and steady job growth, higher wages, and cheaper gas, which in turn has enabled consumers to channel funds to new house constructions as well as home improvement projects.

Sports goods retailer DICK’S Sporting Goods Inc.’s (NYSE: DKS) sales jumped 8% benefitted from a retail environment that favored sporty clothes. Sports good retailers are poised for further growth since consumers continue to become more health-conscious and drive the need for sportswear and sporting goods in general. Rival Sport Authority filed for bankruptcy in March 2016 and closed all 450 locations in May 2016. DICK’S acquired Sports Authority Holdings Inc.’s brand name and other intellectual property with a bid of $15 million.

In all, with the U.S. market reaching saturation, retailer chains are eyeing overseas expansion as a means to spur growth as well as planning opening of experiential stores to attract footfall.

This space is going through transformation phase, most probably the biggest it has seen in years.

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