Consumer Cyclical: Amazon Reshapes Retail in Real Time

• Despite making inroads into grocery and apparel the past several years, we believe Amazon's Whole Foods acquisition and Amazon Wardrobe represent the most significant moves to date in removing key barriers to accelerate growth in these large retail categories, adding credibility in fresh food through Whole Foods' suppliers and making apparel returns an effortless process.
• That said, we believe there are a handful of traditional retailers offering some combination of product specialization, convenience, and experience that have been excessively punished by the market.

On the surface, consumer cyclical sector valuations remained relatively flat this quarter, with a market-weighted-average price/fair value ratio of 1.01, coming in just ahead of last quarter's 1.00. However, price movements varied widely across the cyclical categories, with restaurants and travel-related stocks helping to offset the Amazon-related carnage across the retail sector.

Although no consumer cyclical name is completely immune to Amazon's disruptive potential--a consideration behind the company's wide economic moat rating--we also find a handful of retail concepts that can withstand this competitive threat that may have been excessively penalized by the market.

Amazon's $14 billion acquisition of Whole Foods marks its most significant push into the grocery category, but likely left some investors scratching their heads after more than two decades of building an e-commerce empire without physical stores. What's more, Amazon followed this announcement with Amazon Wardrobe, a service that will allow Prime members to try on clothing, footwear, and accessories at home and return unwanted items using a prepaid box.

Despite Amazon making inroads into grocery and apparel over the past several years, we believe these are the most significant moves to date in removing key barriers to accelerate growth in these large retail categories, adding credibility in fresh food through Whole Foods' suppliers and making apparel returns an effortless process. We also view these developments as more than just an expanded push into the new categories, offering new sources of customer data that Amazon's rivals can't match while enhancing the network effect underpinning our wide moat rating.

In our view, Amazon's Prime membership platform is why these developments have a high probability of success. As of the most recent quarter, we estimate that there were close to 100 million Prime members globally, with more than 60 million in the U.S. With this level of engagement--our analysis suggests that retention rates for Prime memberships exceeds 90%--we believe Amazon will use services like Wardrobe as a new Prime membership tool while using Whole Foods to migrate existing Prime members to Prime Fresh memberships (which run $14.99 per month in addition to the $99 annual fee for traditional Prime members). We've discussed the importance of Amazon Prime membership fees and adding new third-party vendors in driving the company's retail profitability in the past, and we believe this shift will help Amazon's retail margins move to mid-single-digit operating margins over time (compared with 3.0% in 2016).

Like Amazon's other physical store tests, we believe Whole Foods and Amazon Wardrobe offer intriguing outlets to showcase Amazon's existing and future private-label brands. While Amazon's AmazonBasics and Amazon Essentials platforms are relatively well-known and could find their way to Whole Foods shelves in the near future, we believe the greater opportunity will ultimately be in Amazon's packaged food and household product private labels, such as Happy Belly, Mama Bear, and Wickedly Prime. Combined with the ability to sell Whole Foods' 365 label to existing Prime customers, we believe Amazon could develop a grocery private-label presence that rivals other leading retail defensive competitors over the next decade. With respect to apparel, Amazon has quietly built out a portfolio of brands spanning women's, men's, and children's apparel, each of which will likely have key placement on the Amazon Wardrobe platform.

Although we don't anticipate wholesale changes to Whole Foods stores--especially since Whole Foods management (including CEO John Mackey) will remain largely in place--we expect them to become testing grounds for many new Amazon products and services in the years to come. The most likely examples of new retail technologies implemented will be the "Just Walk Out" technology piloted at the Amazon Go test store in Seattle (which detects when products are taken from shelves and tracks purchases via a virtual shopping cart on the Amazon Go mobile app, which is scanned as consumers enter the store), greater in-store targeted marking opportunities via mobile devices, and showcasing Alexa/Echo products within the stores. However, we believe Amazon has near-endless optionality in which it could use Whole Foods stores, including developing new payment solutions, expanding its meal-kit offerings, or even developing virtual restaurants.

With our positive outlook regarding the Amazon/Whole Foods transaction and Amazon Wardrobe, the natural question is which competing retailers are most at risk? We believe

That said, we suspect that Target, traditional grocers without gas operations, and even dollar stores have already begun to rethink their online strategies, as it is becoming clear that Amazon will be a more disruptive force in grocery over the next several years. We also believe department stores and other traditional apparel retail stores could find it difficult to replicate a program like Amazon Wardrobe given the logistics costs, making Amazon Prime an indispensable channel to reach consumers (which likely explains rumors that

Not surprisingly, we believe the U.S. retail category may be overstored in light of these disruptive moves from Amazon. According to the International Council of Shopping Centers, the United States has 23.5 square feet of retail space per person compared with 16.4 square feet in Canada and 11.1 square feet in Australia, the next two highest. This does not appear to be sustainable, and CoStar Portfolio Strategy believes that retailers need to rationalize nearly 1 billion square feet of U.S. store space (10%) in order to reverse the trend in declining sales per square foot. This could be done through rent reductions, closures, or conversions to other categories. American retailers are closing stores at a record pace, with 2,880 announced as of April, more than double the number from the same period in 2016. If the pace continues, more retailers will close shop than during the 2008 recession. At the start of the last decade, a basket of publicly traded retailers produced retail sales of more than $350/square foot versus less than $330/square foot today.

That said, we think there are three ways traditional retailers can compete with Amazon: specialization, convenience, and experience. Although it's not easy to implement each of these qualities into a retail concept, the companies that can combine a specialized product assortment (including home improvement and auto-parts retailers, which offer unique, often hard-to-ship products), a convenient omnichannel (in-store, mobile, and online) approach to ordering and fulfillment, and experiential retail environments are the best positioned to at least keep Amazon at bay over the immediate future. For this reason, we believe the market has overreacted on names such as

Top Picks

TripAdvisor

TRIP

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $67.00

Fair Value Uncertainty: High

5-Star Price: $40.20

We believe near-term growth headwinds resulting from TripAdvisor's global rollout of its Instant Booking platform and increased metasearch competition have presented a sufficient margin of safety for investors looking to take a position in this narrow-moat company. Despite recent headwinds, we contend the firm is poised to benefit from industry online travel bookings growth longer term, which we expect to average high-single digits annually over the next several years. TripAdvisor faces a few near-term challenges. To begin, the company's sales growth in the second quarter of 2017 will likely see negative impact from temporary testing of a new website user interface, which can cause conversion disruption. Additionally, the company will be transitioning away from some marketing channels during the second quarter, ahead of a TV campaign launch. Other headwinds include competition and educating customers on the company's network capability, resulting in higher near-term marketing expense, which we model to average 57% of total revenue the next three years versus 46% reported the previous three years. Also, revenue has slowed recently as there is a learning process to improving Instant Booking conversion, and the direct booking platform shifts revenue recognition out until a stay has occurred versus the company's core metasearch platform, which records sales upfront. That said, we believe Instant Booking enhances the user experience (no re-entering of information and more accurate pricing and availability), which, along with TripAdvisor's solid network advantage, should lead to accelerating revenue in 2017 to a low-double-digit level that is sustained over the next several years. We believe our forecast is supported by resumed platform revenue growth in the United States after the region lapped the Instant Booking launch in August 2015 and management's commentary of improving conversion.

Williams-Sonoma

WSM

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $76.00

Fair Value Uncertainty: Medium

5-Star Price: $53.20

Narrow-moat Williams-Sonoma's shares have declined about 10% over the last year, as high-end home furnishing peers have forced an increasingly promotional environment, pressuring the firm's ability to generate higher merchandise margins. Coming off inventory mismatches due to West Coast port delays in 2015 and increased discounting in 2016, Williams-Sonoma appears better positioned than its peers to meet consumer demand, thanks to its robust trove of consumer analytics that allows the company to forecast unit demand on a more localized level, but margins remain compressed from industrywide discounting. Although some pricing pressure from peers could persist, we believe Williams-Sonoma's evolving real estate strategy, supply-chain optimization, and still-growing global reach will help returns on invested capital rise to 19% over the next five years (versus our weighted average cost of capital of 9%). We expect store sales will be able to rise roughly 2%-3% on average over the next decade, while e-commerce grows at a faster clip, around 6% on average. These growth rates bring us to top-line growth of 4%-5% over our explicit forecast, in line with the mid-single-digit outlook of the company (but lower than the high-single-digit they would like to reach). With operating efficiencies building as scale ticks up, low-double-digit earnings growth persists throughout the majority of our outlook.

Tractor Supply

TSCO

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $84.00

Fair Value Uncertainty: Medium

5-Star Price: $58.80

In our opinion, narrow-moat Tractor Supply shares have fallen out of favor with investors after reporting earnings shortfalls four of the past five quarters, leading to wavering confidence surrounding execution at the firm. We don't think the brand is tarnished, however--rather, the focus on improved analytics may not be matching the speed of changing weather patterns the company is competing against. We think the leadership team is reacting smartly, following in the footsteps of other successful big-box retailers by focusing its strategic initiatives on the consumer, improving its omnichannel presence, and investing in its supply chain, leading to operating margins that expand to 10.7% over the next five years, from 10.2% in 2016.

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