How Bricks Compete With Clicks in a New Retail Era

While evaporating margins and shuttering stores at retail mainstays such as Sears, Bon-Ton, and Toys 'R' Us in the wake of Amazon’s AMZN rise have led some investors to believe that brick-and-mortar retail’s decline is as pervasive as it is inevitable, we have long believed that not all sectors are equally vulnerable to the digital juggernaut. We continue to think that home improvement, aftermarket automotive parts, off-price apparel, and discount/dollar stores are well defended. We believe retailers can capitalize on immediacy of need, customer proximity, difficult-to-replicate business models, pricing dynamics, and the store experience to ward off threats, even as e-commerce growth remains robust.

We see the home improvement and aftermarket auto-parts stores as among the best protected, capitalizing on product characteristics and customer demand for services best delivered in store, such as buying advice or virtually immediate access to a vast array of items. Discount/dollar stores and off-price apparel sellers have more focused protections (convenience and small formats for the former; a hard-to-digitize treasure hunt for the latter), but we still expect companies in both sectors to transcend the threat.

While we do not believe it will vanquish all brick-and-mortar rivals--its purchase of Whole Foods and opening of select physical stores suggest that even it sees value in a brick-and-mortar footprint--Amazon does appear attractive, trading more than 20% below our fair value estimate.

Impact of Retail's Digitization Is Not Uniform Brick-and-mortar retailers' response to the rapid expansion of digital rivals continues to evolve, even as customers look online for a broader range of goods. Although the double-digit growth that e-commerce has posted for years makes it easy to assume that the impact of the channel shift is uniform, we contend that the magnitude of the change depends on category and customer-related factors. Still, we expect e-commerce has at least five more years of double-digit growth ahead, making a comprehensive strategy imperative for all traditional retailers, as digital rivals can create direct (item-for-item competition) and indirect (price transparency, changing customer service expectations) challenges for unprepared sellers.

We have built on the e-commerce growth forecasts we outlined last month by analyzing the reasons people shop online or in store, concluding that digital options' convenience, price, and selection can be outweighed by the need to obtain a product immediately, practical considerations related to geography, fulfillment costs, and local market characteristics as well as differentiated store experiences. We also reviewed the penetration of Amazon Prime memberships, identifying a subset of customers who can react differently to digital alternatives (although Walmart's WMT online growth looms large for people who are not Prime members). Our analysis supports our conclusion that certain segments of brick-and-mortar retail are relatively well protected from digital incursion, and that factors such as immediacy of need, proximity, business model replicability, pricing dynamics, and the store experience can create meaningful protections from disruption.

• Amazon and the digital channel more broadly will continue to affect all of retail, particularly as we continue to expect explosive e-commerce growth over the next 5-10 years.
• We believe convenience is the key element enticing people to shop online; additionally, prices and assortment (thanks to an endless aisle) can be perceived as more attractive.
• Immediacy of need, practical considerations, store experience (including returns), and price-related factors can favor physical locations.
• We believe the future of retail is omnichannel, with product categories and customer demographics informing the mix between physical shopping, home delivery, and other alternatives.

How Bricks Compete With Clicks in a New Retail Era Since we used Morningstar's proprietary framework to assess retailers' ability to combat competition from digital rivals in November 2013, with rankings updated in December 2014, online sellers' continued growth has come alongside traditional counterparts' efforts to develop their own ship-to-home capabilities as well as other digital-enhanced shopping and fulfillment experiences that nonetheless rely on physical stores. As we predicted initially, the nature of the product has dictated retail sectors' ability to resist the competitive onslaught, with the original framework pillars--average purchase price/price transparency, product availability/differentiation, immediacy of need, product specialization/the need for expert help, shopping experience/entertainment, and shipping/logistics costs--influencing upstarts' level of success and incumbents' strategy.

We have updated our framework to better incorporate the rise of omnichannel retail, customers’ demand for convenience, and the importance of the retailer relative to the product sold. We believe the companies best suited to meet the digital threat (1) sell products with high immediacy of need, (2) operate in sectors where proximity to the customer matters (due to convenience for in-store orders or to minimize last-mile fulfillment cost), (3) offer a concept or assortment difficult to replicate online, (4) benefit from little price transparency or low consumer price sensitivity, and (5) add value through the shopping experience (such as through expert advice or a differentiated store offering). Applying our framework to some of the standouts in our earlier analysis--home improvement retailers, discount/dollar stores, auto-parts sellers, and off-price apparel chains--still suggests these sectors are relatively well protected.

• Even as digital retailers move toward same- and next-day delivery models, stores' instant fulfillment has value in categories where customers are addressing an immediate need.
• A strong network of stores can provide a level of convenience and proximity to customers that keeps the locations relevant for buyers and as omnichannel fulfillment centers.
• Certain business models are difficult to replicate online because of vendor requirements, listing complexity, or a proprietary assortment.
• Customers' ability to easily compare prices across retailers, need to minimize absolute financial outlays (including shipping and returns), and elasticity of demand influence the ideal fulfillment model.
• A meaningful, value-added shopping experience can justify a store visit in lieu of an online purchase.

Home Improvement Stores' Barriers Unbreached In our 2013 and 2014 studies, home improvement chains topped our list of the companies best protected against disruption from digital rivals. The sector's financial performance since then has been consistent with our view, and we continue to assign wide economic moat ratings to Home Depot HD and Lowe's LOW on the basis of their cost advantage and strong intangible assets. We expected that the sector would be well protected from digital rivals as a result of the high value/weight ratio of many products (which precludes the possibility of cost-effective shipping regardless of delivery time frame) and the specialized knowledge base that the stores' trained personnel provide. Despite heavy competition throughout retail, returns on invested capital have risen markedly. Home Depot's 34% fiscal 2018 mark was substantially higher than its 21% in fiscal 2013; Lowe's moved to around 18% from just below 12% over the same period, and it continues to overhaul its merchandising operation and internal processes and controls to extract further efficiencies under a new management team.

The sector’s strength is also reflected in our revised framework, and we continue to expect the two large home improvement chains to stave off digital encroachment. Their ability to leverage procurement, distribution, training, and other costs while building on their private-label offerings suggests that smaller rivals will have difficulty in meeting the standard of service that shoppers (do-it-yourself customers as well as professionals) have come to demand.

• Scaled home improvement retailers benefit from strengths across our framework, addressing immediate needs with convenient stores that offer value-added advice and skirt uneconomic shipping costs.
• Trained store personnel allow both chains to provide valued advice and consistent service, creating customer loyalty that lifts their importance to vendors while boosting their private-label portfolio.
• Both companies continue to bolster their data collection capabilities and their efforts to target professionals; we expect these initiatives will strengthen their protection against digital rivals.
• Notwithstanding our favorable view, valuations for Home Depot and Lowe's are high, and we would suggest awaiting a more attractive entry point to invest.

Proximity Remains Advantage for Auto-Parts Retailers Our revised framework continues to favor the aftermarket automotive-parts industry, which we have long believed is well protected from digital disruption. We analyzed the industry's defenses in spring 2017, in the wake of reports that Amazon was expanding its vehicle component sales efforts, news that helped to depress share prices. As we suspected, prices recovered as strong 2018 performance showcased the advantages that brick-and-mortar stores have in the sector. Updating our 2017 analysis, we believe the chains we cover (Advance Auto Parts AAP, AutoZone AZO, O'Reilly ORLY, and Genuine Parts GPC, though the last also has a sizable industrial and office product distribution effort) remain poised to thrive in an omnichannel retail era. We expect the companies, each of which earns a narrow economic moat rating, to capitalize on customers' relative price insensitivity, need for high levels of service (for DIY shoppers), demand for rapid delivery across a wide range of slow-turning items (particularly for professional clients), and ability to leverage costs across a dual-market model that enables operational and working capital efficiency that we believe digital and smaller physical rivals are hard-pressed to match.

• DIY motorists are economically motivated and depend on store staff for diagnostics and advice to get back on the road fast, favoring physical chains offering support, broad part availability, and easy returns.
• The professional segment is even more protected as order-to-delivery windows can be less than 30 minutes, necessitating the proximity to customers that chains already have in a price-insensitive market.
• The chains' private-label offerings are robust, with particular applicability for DIY customers who are unfamiliar with national brands and rely on in-store staff for purchasing support.
• Retailers' recent omnichannel investments have leveraged their brick-and-mortar strengths, increasing their protections against digital disruption (consistent with our positive moat trend ratings).

Convenience, Small Tickets Help Insulate Discount/Dollar Stores Though they score lower than home improvement stores and auto-parts retailers in our framework, we believe discount/dollar stores nevertheless enjoy protections from digital rivals. With low-income customers starved for time and funds, convenient physical stores with limited assortments of branded and unbranded items in smaller sizes and other low-cost formats have allure. Stores score well in the value of their proximity to customers, the difficulty in replicating the channel online, and the pricing dynamics they face; immediacy of need also suggests some additional benefits from convenience.

The chains are not equal, and the concepts vary. Dollar General DG capitalizes on its convenient store network because of its skew toward smaller communities that cannot economically support a second sizable retailer. Dollar Tree’s DLTR Family Dollar unit is more concentrated in urban and suburban areas, and while such communities have their barriers, we believe the competitive environment is more intense, though we suspect that physical rivals generate the bulk of the pressure in its target demographic. Although we see the namesake Dollar Tree stores as relatively well positioned (targeting a broader range of customers), Family Dollar’s less attractive positioning contributes to our no-moat rating for Dollar Tree versus our narrow-moat designation for Dollar General. Despite our favorable view of Dollar General, we believe its prospects are reflected in the current share price, leading us to suggest that investors await a more attractive entry point before building a position.

• Convenience and lower-income households' need to limit absolute expenditures should protect discount/dollar stores from digital rivals.
• Shipping costs necessitate fees or large order minimums for non-Prime households, overwhelming the convenience of at-home delivery for shoppers with limited resources.
• While the products offered are not novel (including their private-label offerings), discount/dollar stores offer a way for customers to trade absolute cost for per-unit value, providing margin benefits.
• Dollar General benefits from an advantaged network of stores, often located in areas too small to support another midsize to large general merchandise seller; Family Dollar is less favorably located.

Premium Returns Should Endure for Off-Price Retailers Along with online alternatives, off-price apparel retailers have been one of the prime beneficiaries of department stores' woes, gaining share as they post solid comparable gains and expand their store footprint. We believe there is ample opportunity ahead for the companies we cover in the sector (TJX TJX, Ross ROST, and Burlington BURL), capitalizing on a business model that upends the traditional brick-and-mortar apparel approach by emphasizing a fast-turning, constantly changing assortment of deeply discounted merchandise. We expect customers to continue to respond to the "treasure hunt" experience, with traffic-generating discounts fueled by off-price retailers' flexible and no-frills stores, opportunistic buying practices that capitalize on strong vendor relationships, and volatile apparel market conditions that should continue to make attractive merchandise available at low cost. The unique customer experience and off-price retailers' value to vendors in discreetly liquidating excess inventory leads the industry to score well on our framework, particularly as both elements are difficult to replicate online. Although the discounts the chains offer do not extend to their share prices (which are all above our fair value estimates), we suggest investors particularly monitor TJX, which we believe can use its new furniture chain in the United States and its international presence to capitalize on previously untapped markets.

• Although apparel retail has been disrupted by digital entrants' rapid growth, we believe off-price shoppers are looking for an experience, considering the fast-turning array of brands and available sizes.
• Off-price retailers buy excess merchandise from vendors drawn to their fast, flexible buying practices; manufacturers also appreciate their discretion, as discounts on specific brands are not widely promoted.
• Vendors' need for discretion (to protect their conventional channel pricing power) and rapidly changing inventory make it difficult to launch a full-fledged off-price competitor online.
• The channel is also protected by its efficiency, enabling discounts of 20%-70% off original prices that often overwhelm online sellers' pricing advantage against full-price stores.