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Which Stocks Can Combat Online Rivals?

Morningstar's Matt Coffina and R.J. Hottovy dissect the six key factors determining whether retail-company moats will survive technological disruption.

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Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by R.J. Hottovy, who is the director of Morningstar's consumer team, and we're going to talk about which traditional retailers are best positioned for the threat of e-commerce.

R.J., thanks for joining me.

R.J. Hottovy: Thanks, Matt.

Coffina: Your team has identified six key factors that determine whether a company is well positioned to combat the threat of online commerce. Maybe we could just run through these one at a time and you could just provide a brief explanation of why that factor is important for traditional retailers. 

Starting off with price transparency and average prices, why is that important?

Hottovy: Looking at the broader spectrum of retailers and online retail, we felt that in this day and age, with the Internet and mobile commerce, prices are very transparent, it's very easy for consumers to identify prices in some categories. But we found that information is less readily available in other categories. So in those categories where you can't find any pricing data, we found that generally those were more exposed to online competition.

At the same time, the average ticket price is an important factor as well, those categories that do have larger average ticket prices. Think of high-end consumer electronics and home improvement, where consumers go out there and look for the prices and put a lot more research into the actual purchase price.

Coffina: Number two is shipping cost or the value/weight ratio?

Hottovy: That category is important because as we move more and more toward quicker online delivery speeds, we also think that the product itself has to be kept in mind, what product you're actually shipping. Some things are very easy to ship, it could be sent very quickly. Other things that are bulkier or more specialized, that's a more difficult proposition, and so those categories where it is difficult to ship the product or it's heavier to ship, those categories tend to do better against online competition.

Coffina: The third factor: immediacy of need.

Hottovy: There are just some categories and certain products that you need within hours or within a day. That's a very important factor. Even as online delivery speeds have improved, there are certain things that consumers just need to get that day, so that's an important thing for those product categories that, where you do have an immediacy of need, it does give you inherently little bit more protection that we'd find with more commoditized things that you don't need that day.

Coffina: Next up is the in-store experience or the entertainment value of shopping?

Hottovy: At the end of the day, there still is an entertainment aspect to traditional retailing, where consumers will go out in stores, and if it's an enjoyable experience and something that can't be replicated online, I think that's going to give a lot of retailers a better chance of competing with online retailers over time. So, I think that's important to keep in mind when evaluating that retail category or that retailer's ability to compete with online players.


Coffina: Number five, expert help or specialization of the salesforce?

Hottovy: There's just certain product categories where it's either very specialized or just very unique, where you do need that expert help within the store before making that final purchase. Typically something in the home-improvement or auto-parts sectors where we see a lot of that, where having a knowledgeable salesperson is a must. Obviously, that would give retailers with that kind of product mix as well as that kind of salesforce an inherent advantage against online retailers.

Coffina: And lastly would be a differentiated product selection.

Hottovy: This plays into the thought that the more commoditized your product assortment is, the easier it is for people to make that purchase online. If you have a very specialized or unique product mix, you do tend to have at least a better chance of drawing people into your stores. That final purchase may not be made within the online channel; it may actually continue to drive within the store.

So the more specialized, the more unique your product mix is, it's a better chance of driving people within the stores. This also applies to exclusive products where maybe a retailer will do an exclusive offering with a vendor, and that will help to drive people to stores as well.

Coffina: Using those six factors, you've identified certain segments of the retail sector that are better positioned for the e-commerce threat than others. Start us off with home-improvement retailers, why are they especially well-positioned?

Hottovy: Home-improvement retailers scored very well across our entire six-point checklist in terms of resiliency and ability to protect themselves from online commerce for a number of factors: One, I think it's a product that you need immediately. Generally speaking, if something goes wrong in your house, it's a problem you want to fix quickly.

A lot of times it's a specialized product. Think of paints and other lumber-type products that you need to get the right fit or the right qualities about that to make the repairs. So you're going to need that expert salesperson help. They've got a wide variety of products there that you're not going to find at other mass merchants or online retailers. So it's a good combination there.

It's also something that you see a lot of transparency in the pricing. You know what the pricing is going to be by checking out online beforehand. It's also a bigger-ticket purchase, too, generally speaking, so you want to make sure you get the best price possible. And generally speaking, the home-improvement guys can do that for you.

Coffina: How about auto parts? Would you think that those retailers are relatively well-positioned as well?

Hottovy: Auto-parts retailers are similar in respect to the home-improvement retailers where, again, it's a product mix that you're not typically going to find online or with other mass merchants. It's a specialized product, where you're probably going to need some input from the salesperson associate before making that final purchase. It's another one where we do see some immediacy of need, where if your car breaks down you want to fix it as quickly as possible. So, it does score very high on our six-point checklist, as well.

Coffina: Luxury goods?

Hottovy: Luxury goods fit a little bit more into the categories where it's more of a want. Certainly, there is a level of in-store experience where people enjoy looking at the luxury goods in-store, a lot of times will make their final purchase there, or if they make the purchase online, at least it'll be through the brand itself and not one of the other major players out there.

That's really what we're looking at there, that there's just a high level of experience with or entertainment value with going in stores. There's also a differentiated product, because a lot of the luxury products you're not going to be able to find with the mass merchants or the online players.

Coffina: And last one I wanted to highlight, another retailer that's relatively well protected from online commerce would be pet supplies?

Hottovy: That's another category that we do see some protection. Not ultimate protection, but there's an interesting aspect with the pet-supply retailers wherein the services component of the business model, namely the boarding, the grooming, and even veterinary services, that's something that you can't replicate online or within generally even mass merchants.

I do think that that gives them inherent protection against online retail. That being said, a lot of the hard goods and soft goods, you are seeing competition from a lot of the online players. But I think the traditional pet retailers have recognized this threat and have moved more upscale to the organic and higher-end products to give them a little bit more protection from the commoditized side of the equation there.

Coffina: For investors who are interested in investing in the traditional retail sector but who are concerned about this threat of e-commerce, keeping in mind also valuation, are there any specific stock picks that you would recommend?

Hottovy: I'd highlight four names right now at current valuations that are particularly attractive not only from a relative valuation standpoint but also from their protective attributes against online commerce.

Two of the names in the luxury and apparel space that we find attractive right now are Swatch and Urban Outfitters.

With Swatch, we think it's got a great portfolio of luxury brands, has been somewhat underappreciated. Again, I think people are going to make a lot of times the final purchases through Swatch's own websites as opposed to other mass merchants. And I think that they've got an interesting portfolio of technology tools as well to compete with online players down the road.

A name like Urban Outfitters, we think that there's some real pricing power in some of the brands and some really niche shopping experiences with particularly the Anthropologie and Free People brands, but also the Urban Outfitters brand we think is something that can bounce back from a few recent fashion mess-ups as well.

Within some of the other categories, a name like PetSmart is a name that we do think is attractive at current levels, and think that the idea that you will see more mass merchants and online players get in the space is already been fully priced into the stock, and if not so, probably excess will be penalized the stock. We do think that the services portfolio's attractive. We do think that the move to more organic products is certainly something that sets PetSmart apart from other players.

And then in the home-improvement space, we find U.K. home-improvement retailer Kingfisher undervalued at current levels. We think this is a name that's particularly well-levered to housing-market recovery in the U.K. It means a lot of the same things that we find attractive in the Home Depot and Lowe's in North America but apply to another region, and we think that it does certainly have a lot of protection from online players as well.

Coffina: Great. Thanks for joining me, R.J.

Hottovy: Thank you.

Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

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Matthew Coffina has a position in the following securities mentioned above: LOW. Find out about Morningstar’s editorial policies.