Dressing for an Amazonian Storm

The apparel and accessories industry is on the cusp of a significant reinvention. As Morningstar senior equity analyst Bridget Weishaar detailed in a recent research report, mall traffic is on the decline, e-commerce is steadily stealing apparel market share, and innovative new entrants are harnessing the power of technology to improve both the shopping experience and the products themselves. Amazon.com AMZN is, inevitably, the largest disruptive force. I spoke with Weishaar to learn more about how apparel companies can develop and maintain competitive advantages in this environment.

Our discussion has been edited for length and clarity.

Laura Lallos: How high overall is e-commerce penetration in apparel sales today, and how much can we expect it to grow?

Weishaar: It's very high. We estimate that more than 25% of apparel sales happen online, and we see this reaching about 40% over the next five years. Despite many retailer claims that people want to go to stores and that they value a brick-and-mortar experience, our research shows that consumers really value the convenience and vast amounts of pricing information and quality that you can get by looking online. Apparel is starting to trend as one of the main product categories bought online.

What is driving Amazon's competitive advantage? Weishaar: Amazon is the gorilla in the online retail space overall. They generate about five times the sales of the next-largest online competitor, Apple AAPL. Even in apparel, Amazon has already made major headways. They have about 25% of all online apparel sales, and we see that growing north of 30% over the next five years.

What’s driving that? First, access to vast amounts of data that allow targeting. When you go online and they tell you what products you may like, that really helps curate the product listings. Second, they have an unmatched distribution capability that allows for quick and easy shipping. And third, they have superior customer service. It’s easy to order, easy to return. People like shopping on Amazon.com.

As you explored in your report, shipping speed and cost are the biggest impediments, perhaps, for e-commerce retailers. But they are continually improving. Weishaar: They are. If you're going to compete with Amazon, you've got to get good in this category. But really, it's a catch-up game. Eighty-five percent of consumers highlight shipping as one of the key components of their decision as to where to buy online, so everybody has to master this, but the results are mixed right now. Speed is improving among the retailers, but Amazon still has about a two-day lead over them. Every time some traditional brick-and-mortar gets faster, Amazon also gets faster. Further, the offers of free or fast shipping both ways have taken a toll on the margins of these brick-and-mortar companies. They're eating a big cost of doing business.

Free returns are key with apparel, as you need to try clothes on to be sure they're going to fit. You noted, though, that concerns about fit are being overcome with technologies such as 3D avatar fitting. Weishaar: It's still in the early stages. For the average consumer, it's not a part of their shopping experience yet. But that said, I think it's going to become important down the road, and it's going to be a major driver of growth for these companies. The ability to see how a particular item fits you and looks on your body and also how the color works with your own skin tone—that's going to make a big difference in making you comfortable to click that buy button.

Against this backdrop, how can traditional apparel companies compete? Weishaar: There's still room for them. You hear that Amazon is going to kill retail, and it's true that they're certainly going to take a lot of share. But there's still space for strong players.

One weakness that Amazon has is curation. If you do a search for “black dress,” you are going to turn up over 100,000 results, and that is an awful lot to leaf through. If a seller can target a person and say, “Here are things that are going to work for you—in your price range, of the quality you’re seeking, in your sense of style”— there’s room for that in the market.

A second way to compete is with differentiated fashion. If a brand comes up with something that no one else carries, then obviously people have to shop for that product. And third is offering a better experience. A store like Lululemon Athletica LULU creates an experience—you can take a yoga class, you can talk to people similar to you, they can share knowledge about the product. There are still areas where companies can compete. These companies are operating outside the “offer everything” model that Amazon has.

Amazon is developing its own house brands; is that significant competition? Weishaar: Their private label is growing, but it's not a huge percentage of their business right now. A lot of companies have had mixed results with private label. You basically are becoming a designer yourself, and you're going to have product hits and product misses.

A while ago, Kohl’s KSS went down that road. They tried to introduce more and more private-label items, and they found that they lost their customer, who was demanding national brands. Since then, they’ve been actually increasing their national brand penetration, and that has been drawing the consumer back. It’s possible for both to coexist, and I think you’re going to see that on Amazon, as well.

As part of your research, you spoke to management teams at up-and-coming players such as Shoes of Prey and Stitch Fix. What innovations are they bringing to the table? Weishaar: We found four key themes among all the companies that we talked to: Big Data, customization, responsivity of the supply chain, and distribution channel flexibility. It's interesting to see what the up-and-comers are doing.

Let’s start with the Big Data. Apparel-maker Stantt has collected massive amounts of data on how men’s shirts fit the body, using measurements from 3D body scans. Instead of just offering small, medium, large, and extra-large sizes, they offer 75 different sizes. You can get a shirt that is almost custom-made. In addition, Stantt has developed a patent-pending sizing technology that fits customers using just three measurements that can be taken from home.

Stitch Fix is as much a tech company as a fashion one, with a large team of data scientists who collect data points through customers’ style profiles. But it also employs thousands of stylists to service its more than 2 million active clients. This combination of data science and human judgment allows the company to best personalize shipments and drives its sustainable competitive advantage. Amazon has introduced Prime Wardrobe, but it is not a direct competitor because customers must select for themselves. Stitch Fix doesn’t provide endless options to clients; it narrows them down to a few.

The other thing that we see is customization. With Shoes of Prey, you essentially design your own shoe. You can pick the color. You can pick the heel height. You can pick how it’s decorated. You can pick the straps. Consumers are now driving the design of the products that they demand, instead of picking from a subset.

On the back end, you must change a lot of things to do this kind of customization. That’s where the responsivity of the supply chain comes in. You can no longer just go abroad and have a factory produce hundreds of thousands of pairs of shoes. You now must have them produce shoes basically one pair at a time as the consumer demands it, while still delivering shoes in a reasonable amount of time. Shoes of Prey built its own factory, which has allowed it to innovate its manufacturing operation and speed the supply chain.

Distribution channel flexibility is also important. People want stores. People want to shop online. They want a mix of the two. We’ve found that companies that can cross those barriers and deliver service both ways are doing best. We see this in companies like Lululemon and Inditex ITX:ES.

So, people do still want stores. Weishaar: They do. Some people like the experience. They like to be able to try something on before they buy it. There's still a place for them.

What kinds of traditional apparel retailers are at the biggest risk? Weishaar: Department stores are definitely at the biggest risk. They've seen retail sales decline over the past few years. Macy's M is the poster child here; it's had negative sales growth for the past three years. The problem with department stores is that they're usually trying to be everything to everyone. If you think about it, they were the Amazon of the past. They're mass market, and they carry a lot of the same products and brands that you can now get on Amazon or any other online sites. When that happens, you're often forced to compete on price, and then there go your margins.

The other problem they have is drawing people into stores. It used to be, you went to certain stores because the experience was great. But oftentimes now, department stores have underinvested in that experience. They’re short-staffed or the staff doesn’t have specialized skills. The stores haven’t been updated in a while. And people are complaining that this isn’t a pleasant experience and that they like shopping online better. Department stores are the ones that are going to be hit the most by the Amazon threat.

Are there any department stores that are managing to do well online? Weishaar: They are doing well online. That's true almost across the board in my coverage. But the problem is that it's often the same customer that they used to have in the brick-and-mortar store. Whatever they gain online, they're losing in the stores, and then that causes the deleverage of those expenses.

Who stands to thrive in this new environment? Weishaar: I can highlight a few areas. One is brands. Again, think about the difficulty of buying on Amazon, where a search returns 100,000 results. The way people are getting around that is they're shopping by brand. Instead of searching for a "black dress," they search for "Calvin Klein black dress." Brands are being used as a search term, and that's working to their advantage. From their standpoint, they don't care if they sell in a department store or Amazon. All that matters is that they are able to reach their consumer.

Then there are the niche players. Lululemon, Nike NKE, Under Armour UAA—these are stores that are cool, that are fun to be in, where you’re learning something, where it’s engaging. They’re still surviving and thriving.

A third area is off-price retailers. That would include stores like TJX TJX and Ross Stores ROST. They offer a value that you can’t get elsewhere, and they also offer a treasure hunt experience. People like going to the brick-and-mortar stores.

TJX and Ross collect large amounts of consumer demand data, and they use it well to direct buying behavior and localization in merchandising. This capability contributes to narrow economic moat ratings for both companies. Further, their supply chains are very responsive. Their inventory levels are lean. By our estimate, they averaged about 60 days inventory in 2016, compared with an estimate of more than 100 days for department stores.

Why is TJX one of your top picks? Weishaar: Ross has been trading above our fair value estimate, while TJX has been trading at about a 9% discount to our fair value. What we love about this company is that it's very well positioned with its low prices. The value space right now is very strong. The consumer wants to buy things at a value, and TJX offers some of the best out there.

Because of its price points, and the treasure hunt experience it provides, TJX has some barriers of entry to the online threat. It’s less profitable to sell at those price points online, so there aren’t a lot of new businesses entering this space.

I’d also highlight that because TJX has such a massive scale, it has a lot of buying power. The top brands want to sell their products through TJX first, because TJX can buy a lot and get the products to the most customers. That’s another advantage. We see low risk in TJX’s strategy or execution given its discounted offerings, scale and inventory management, and experienced management team. It’s an attractive growth story both on the domestic and the international fronts. Also, the company has a record of success in both strong and weak economic environments.

You found that specialty retailers such as Inditex can also maintain competitive advantages against Amazon, if they are well-managed. Weishaar: Inditex is one of the leaders in fast fashion. Zara is its biggest brand; it's about two thirds of their revenue.

This is a company with a best-in-class supply chain. Most of the manufacturing is carried out near the company’s headquarters in Spain, and shipments are made to all stores across the globe twice a week, every week. These stores are getting small bulk purchases of new items. This allows the company to better match the product to the consumer, and the volume to the consumer demand. In the long run, that means that they have a lower risk of discounting and a lot less clearance than most stores. It’s a well-run company with a very distinct, responsive supply chain, Big Data capabilities, and distribution channel flexibility.

Few other specialty retailers have been able to follow suit. Gap GPS is an example of how difficult it can be to develop a responsive supply chain. But our biggest concern for specialty retailers lies within distribution channels. Many remain overstored. We believe that store closures will remain a headwind. While these retailers could partner with Amazon, this would likely result in a lower margin. We are cautious on the subsector overall.

What do you foresee in apparel five years from now? Weishaar: I think it's going to be technologydriven, even for brick-and-mortar stores. If you walk into one of your local stores or malls, it looks very similar to what was there 50 years ago. This is a space that's just ripe for innovation. I think that using Big Data, using different technologies for sizing, for displaying the product— all of that is going to become a very big part of the success story of these companies.

NOTE: Valuation data is as of the date of our conversation, March 22. TJX is currently trading above our fair value estimate.

This article originally appeared in the June/July 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.