Over the last little while, and in particular the last few months, Amazon and its pending entry into the Australian market has been a hot topic of discussion.
A number of consumer companies are feeling the pressure due to expected increase in competition and the resulting margin squeeze.
While Amazon is diversified across its business units, one key component of their retail offering is they maintain a significant third-party marketplace which provides shipping, customer service, payment processing, and return services to independent retailers.
They then use this information to work out what areas are most profitable for them to enter in their own right.
The general consensus is that in the short to medium term in Australia, their penetration will be limited to what can easily be shipped and returned, until the last mile logistics piece is worked out completely.
The US online experience can give us some clues about how these dynamics might work here.
It is clear that some categories have been severely affected, and comes as no surprise that books, music and DVDs are the categories that have been most penetrated by online retailers like Amazon, where bulkier, heavier and perishable goods have been less impacted given the increased cost and complexity of shipping those items.
The one category that is of particular interest for us was office equipment and supplies, which, while not as deeply penetrated as other verticals, has been estimated to transact as much as 40% of the sales online. Total sales are expected to be 60% online by 2022.
Home Depot (HD US) deals primarily in the home and hardware category. Its products are generally bulkier, heavier products which require some specialist help. It has managed to grow its revenue by 6% pa over the last 5 years. It has maintained its gross margin at around 36% and has increased its EBITDA margin from 9% to close to 17%.
Home Depot has also benefitted from an improving ROIC profile, driven through increased asset turn and margins, but it’s ROE has increased mostly through increased leverage.
Its biggest competitor, Lowes has followed a similar trajectory.
Both have weathered the online storm safely, by finding niches that cyber retailers can’t comfortably compete in.
In contrast, within the office equipment and supplies space, Staples (SPLS US) has not been as successful in fending off the competition from online retail.
Their ROE has declined from 18% five years ago to about 7% last year. Their EBITDA margins have declined, while their gross margin has stayed steady — an indicator to us that the likelihood of further deterioration in the business economics is likely as the gross margin comes under pressure.
A recent strategic shift away from business-to-consumer to business-to-business seems warranted but hasn’t yet been effective in warding off the competition.
With those effects in mind, what could happen here in Australia?
Wesfarmers currently operates two large businesses in the Hardware and Groceries (Food and Beverage) categories. Both the categories have been relatively insulated from the shift to selling on line.
However, Wesfarmers also owns Officeworks.
It would appear that Wesfarmers is trying to reduce its exposure to the same trends that Staples has been subject to in the US. The official narrative is that OfficeWorks is too small a business for Wesfarmers to focus on, but we suspect that the trends playing out in the US are playing on the minds of Senior Management which is driving the sale process at this time.
While all the meetings we have had in the lead up to the potential IPO showed a very competent management team, we believe the business is facing a number of structural headwinds and increased competition which make it very difficult to firstly, find a sustainable competitive advantage for the business and secondly, be comfortable that we are able to predict with certainty the earnings profile of the business going forward.
The consumer retail sector will come under increased pressure over the next few years given the increased emergence of online operators.
Amazon will be a large factor in this and perhaps the most important thing to watch will be a company’s ability to deal with the fulfilment and logistical challenges that are faced in Australia.
As active manager’s we need to understand these dynamics and be mindful of their movements when we’re making decisions about our portfolio structure, since we do so with the long-term in mind.
