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Stock Strategist

Shopping in the Digital Age

Amazon and eBay are the clear online leaders, but brick-and-mortar stores aren't ready to concede the retail battle.

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More and more shoppers continue to go online to find their wares instead of traveling to traditional brick-and-mortar stores. E-commerce retailers that are well-capitalized and that have a strong distribution infrastructure are proving to be a disruptive factor in the retail industry.

In 2012, online sales in the United States totaled $225 billion, with (AMZN) representing almost a third of that in terms of gross merchandise volume. EBay (EBAY) had a gross merchandise volume of about $75 billion. Globally, e-commerce sales are around $1 trillion. But with total global commerce at $10 trillion, e-commerce still only has a small piece of the retail pie. Amazon and eBay both have been enjoying revenue growth of more than 20%, and there's still plenty of room for these and other e-commerce companies to grow.

To find out where e-commerce is headed, and what traditional retail stores are doing to defend their turf, I sat down with Morningstar retail equity analysts R.J. Hottovy, Liang Feng, and Paul Swinand. Our discussion took place June 6.

Basili Alukos: In what areas is e-commerce making the biggest dent in the sales of traditional retail stores?

R.J. Hottovy: The commoditized retail categories--consumer electronics, office products, toys, books, where consumers don't care about the shopping experience and just want the lowest price possible--have felt the most pressure from Amazon and other online players. Amazon is able to undercut pricing of traditional retailers, simply because it doesn't maintain a physical storefront and historically hasn't had to collect sales tax online. These reasons give Amazon and other Internet players a pricing advantage.

Add in expedited shipping, a wide selection of products, and an emphasis on customer service, and you have an extremely powerful force disrupting the direct-retail-sales model in a lot of those categories. Amazon continually scores number one in customer service among all retailers.

Liang Feng: Still, there are pockets in retail where having a store is a benefit. We've assigned a narrow Morningstar Economic Moat Rating to a few of our specialty retailers, because we believe they will be able to generate excess returns during the next 15 years. One question we ask is whether a retailer can still bring consumers into the door. Some items are more obvious than others-- clothing, for example. Many consumers still prefer to try clothes on, and shopping for clothes is a leisure activity.

What specialty retailers tell us is that once the consumer is inside the door, they're willing to pay a modest premium. It is still inconvenient--although that is changing--for consumers to take a picture on their smartphone, go back home, and order it online. So, they are willing to pay a modest premium to buy the product in the store.

Where "showrooming" comes in is for big-ticket items such as a large-screen TVs. People scout out products in a store and then buy them online from another retailer. Being able to save 5% or 10% on a $500 product by buying it online is worth the effort. This is why Amazon has had a lot of success with consumer electronics at the expense of Best Buy (BBY). Conversely, convenience stores and dollar outlets are able to charge hefty premiums because people pay less attention to deviations in prices of things that don't cost that much.

Another consideration is how expensive it is to ship an item and how quickly consumers need it. For example, it's fairly expensive to transport a 30-pound bag of pet food door to door, relative to its value, so online retailers can't undercut physical retailers as much on price.

With auto-part retailers, most people need a customer associate's help, and there's the immediacy aspect. When your car has an issue, you want it fixed as soon as possible. As a result, both specialty pet and auto-part retailers have performed very well despite the growth of e-commerce channels.

With office supplies, however, most consumers can plan their office-supply needs in advance and don't need to browse the items at retail outlets. As a result, many consumers will look for the lowest-priced offerings online; the service impact is not as important to them. Also, the cost of shipping relative to the value of many items, because they're small in size, is lower.

As an increasing percentage of an industry's sales moves online, there's more price transparency than there is in the physical-retail channel. That's why the lowest-cost supplier and distributor usually win. That's one of Amazon's many advantages. It is the lowest cost distributor for many of these items because of its immense scale, and for many consumers, Amazon has become the first place they check for an item. For these commoditized products, where the consumer doesn't need as much service, we think Amazon will continue to capture market share.

Paul Swinand: One area that is not feeling the pinch from Amazon and online competition is the department stores. In fact, even though they're late to the game, they are actually having success online. For the most part, this online success is contributing to success in bricks-and-mortar same-store sales. The reasons are sizing, service, and selection.

The showrooming effect actually helps department stores. Customers go to the store, try something on, get the salesperson to help them, and then they shop online and buy additional items, increasing their total sale with that department store. Customers see a bigger selection online; then, if they need to return something, the store is there.

Alukos: R.J., you've done a lot of work on Amazon. Amazon has 209 million active users, and about 10 million of those are Amazon Prime users, who are very valuable to Amazon. At what point has Amazon been able to get to critical mass? You need to have enough sales to be able to leverage all of your fixed costs. How has Amazon done that?

Hottovy: It's mostly about providing the lowest prices possible, but Amazon was admittedly a key beneficiary of the Great Recession in 2008 and 2009. In the four years since, revenue has grown 22% a year on average, and we believe Amazon capitalized on consumers' need to stretch their household budgets. People flocked to Amazon and companies such as Costco (COST) that can give them the lowest prices.

Amazon Prime added other benefits for customers, such as expedited shipping and streaming video rights. A lot of people look at this as Amazon giving away too much for free, but our analysis shows that Amazon turns a profit on the average Amazon Prime member because of the incremental sales involved. We estimate that the average Prime member spends about $1,200 annually on Amazon. That compares to about $600 for a non-Prime user. That extra $600, plus the $79 Prime users pay in a fee, minus the costs associated with the Prime membership, comes out to about $80 in incremental operating income per Prime member.

The other part of the Prime program that's interesting is that it demonstrates Amazon's strong network effect, which is a part of our wide moat rating for the company. We analyzed the number of consumers shopping on the Internet and the amount they spend. Each online shopper spends about $1,000 per year. If an Amazon Prime member is buying $1,200 a year on Amazon, that says to us that the Prime customer is not even considering making purchases at other places. That is a strong signal that a company has a healthy network effect.

Alukos: With states under fiscal pressure, there's a lot of debate around the country about requiring Amazon and other online retailers to collect sales taxes. What has your research shown about how this would affect Amazon's margins?

Hottovy: Absent online sales-tax collection, we think that Amazon maintains about an 8% to 10% price advantage compared with brick-and-mortar retailers selling online. If Amazon is required to collect sales taxes at the time of the transaction, we think that gap narrows to about 5%, so Amazon will still maintain its price leadership. So, we think the market's concern about online sales tax collection has been overblown. In fact, Amazon is actually supporting a lot of this legislation, because it knows it's coming, and it knows it can maintain its price leadership. It also gives Amazon an opportunity to roll out fulfillment centers in a lot more states. This will make Amazon even more competitive because it will be able to improve the speed of its deliveries.

Feng: Amazon is aggressively investing in new distribution centers. Over the long run, as it starts expanding its distribution centers into sales-tax states such as California, which is already happening, Amazon will be closer to consumers. The free shipping for Prime will be a smaller expense, and Amazon will be able to leverage those costs better, while providing a superior experience for its customers.

Alukos: What are some other names that have caught your attention?

Swinand: The leader in making a success of integrating online and brick-and-mortar retail is  Macy's (M) . It uses its store network as a shipping and distribution center. Another interesting player is Sears (SHLD). It is doing rather poorly in brick-and-mortar retail, definitely suffering in the commoditized businesses such as electronics, but Sears is doing very well in businesses in which there's a high service or value-add, such as appliances, tools, and automotive. It's doing well on some areas online, too.

Feng: Advance Auto Parts (AAP) and PetSmart (PETM) are two names that I like. Both these names generate attractive returns on invested capital and have outpaced the industry's growth by taking share from the mom-and-pop players.

Advance Auto Parts only holds about 5% of the commercial market, and it is aggressively rolling out more stores. As its scale grows and it invests in its distribution infrastructure, it will be better able to serve its customers with a broader array of parts. So, it is better than the smaller mom-and-pop stores, and the mass merchants and online retailers don't have its service offerings. It has been gaining share and is defensible against the online threats.

PetSmart has sustained a great deal of success of targeting the relatively affluent market, which has outpaced the general industry's growth. It has benefitted from the growing popularity of organic consumables. Think  Whole Foods (WFM) for pets. Additionally, PetSmart has rolled out a wide array of services, such as grooming, PetsHotel, and other offerings that appeal to its target audience and differentiate itself from peers. These affluent customers are less likely to go to discount retailers. Almost two thirds of PetSmart's products are not even available at mass merchants, because many of the premium brands don't want to dilute their brand perception.

Hottovy: Best Buy is in jeopardy and a name we think will continue to struggle with increased online competition. We admit that the company is in a much better position than it was a year ago with a revamped management team that is focused on cutting a lot of bloated costs out of Best Buy's structure. Management has also realized that it comes down to being competitive on pricing, that it's not going to be able to win customers by just offering Geek Squad services or whatever services it wants to offer in store. It comes to pricing, and to management's credit, it's realized this.

Unfortunately, for all the improvements it is doing on the cost-cutting side, the company still has a long way to go in terms of in-store and online traffic conversion. It has seen a little bit of improvement in these metrics in recent months, but a lot of that has come at the direct expense of gross margins. Best Buy has had to aggressively discount things to get people in the stores. We think that trend will continue.

We think shares are worth $21 each. Management is forecasting a long-term goal of 5% to 6% operating margins. We think a more normalized margin range is about 4%. That's more comparable with online retailers and other mass merchants. We think that's where the margin should gravitate for Best Buy.

EBay's an interesting story. Whereas Amazon is a direct competitor to retailers, eBay is a partner. It helps retailers with their online offerings. It offers not only a marketplace but also a number of compelling payment options through PayPal and a website through its GSI Commerce segment. It is really trying to help retailers combat Amazon over the long term.

I also think that eBay is going to be one of the prime beneficiaries of the increasing trend toward mobile commerce. More and more people are using smartphones to make purchases and send money, and they're not going to want a phone with a different app for every store out there. They want one central place to make most of their purchases. A lot of the things that made eBay and Amazon so successful in online shopping will also translate to mobile. It will help them maintain their network effect, as well as their wide economic moats.

Basili Alukos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.