Independent Thinking^®

Evercore ISI on Retail Stocks

Editor’s note: Evercore ISI is a leading provider of sell-side research in the United States and one of the range of Evercore Wealth Management research providers. Here, Matt McGinley discusses the outlook for the retail sector.

Craig Menear, CEO of The Home Depot, recently noted that the current rate of change in the retail sector has probably been greater over the last three years than in the last 50 – and the pace of change is likely to accelerate. The models most likely to succeed over the next decade will be those with barriers to e-commerce penetration, membership models, and the structural characteristics to support the incumbents.
 
One way we view consumer spending is by “share of wallet” or how much the average American spends on a category as a percentage of his or her total expenditures. The single largest increase in share of wallet, as illustrated on the next page, has been medical spending. This includes not just personal spending on over-the-counter medication, but also the costs associated with healthcare on behalf of a household, such as employer-paid health insurance and government-financed medical care. While Americans are buying more clothing and eating more food, they are spending less per item on an inflation-adjusted basis, freeing up funds for home and healthcare expenditures.
 
While the composition of spending has changed, the underlying drivers of retail demand have remained relatively constant for decades. Employment is the most powerful driver of retail demand, as higher employment rates and payroll growth result in increased confidence and discretionary spending. Household asset value is also important, as wealthier people consume more, generally speaking. A measure of taxation on the consumer from the standpoint of higher energy costs or inflation in excess of wage growth also has consistently had an impact on retail demand.
 
Retail formats continue to evolve in response to meet changes in consumer demand.
 
E-commerce is now rapidly changing the way that retailers operate their businesses. In many categories, e-commerce has created price transparency and won customers away from retailers that only offered physical locations.
 
Early in its evolution, purchasing goods on the Internet came at the expense of the traditional retailer – generally in categories where the products were commoditized, didn’t need to be touched, or had a high price-to-weight ratio, such as in books, music, and event tickets. As shoppers became more comfortable with online shopping, and perhaps more important, began to trust the online review process, retail capital expenditures became increasingly directed toward building out the e-commerce infrastructure required to compete with online-only retailers. By 2014, most traditional retailers were growing their online sales at a pace equal to the overall growth in total e-commerce spend of 15%, and much higher than the 4% pace of growth experienced in the retail sector as a whole.
 
Auto parts, paint, and cosmetics retailing are examples of models where the threat of online disintermediation is limited due to the need to see the product or the immediacy of the purchase. If a car is broken down, most people are not willing to wait days for a replacement, nor are they able to match paint colors online, at least not yet.
 
Membership models such as Costco are profitable based on membership fee income, rather than the traditional retail model of generating profit on the product. The model provides the customer tremendous value and the retailer tremendous volume. Amazon Prime is another membership model where customers pay $99 a year for free shipping and digital streaming content; we estimate that 40 million U.S. households, about one-third of total households in the country, have signed up for the convenience of this disruptive retail model.
 
In the home improvement sector, stores such as The Home Depot or Lowe’s offer a breadth of products and an in-store experience that makes it difficult for both online-only retailers and new physical retailers to compete. The bulky nature of many of their goods and the consumer need to purchase a basket of items to complete a project also provide a substantial barrier to entry for online-only retailers and physical retailers alike.
 
The key to investing in U.S. retail is to understand how shifts in spending will impact growth and free cash-flow generation across the space. Without significant investment in e-commerce, the retail models that worked for the last half-century will not be the retail models that succeed in the future.