The Mighty Amazon

We have fielded numerous questions about the impact of Amazon’s imminent entry into the Australian retail market. Given most Australian Superannuation Funds will have some exposure to Australian retailers in their portfolios (Wesfarmers, Woolworths, Harvey Norman, JB Hi-Fi etc), we deem it important to address the issue.

In this note we look at Amazon’s impact on Australian retailers and how investors could potentially position their portfolios. The Amazon threat is very real and, given the US experience (significant job losses / earmarked store closures), we believe some retailers are better placed than others.

In any case, we do expect redistribution of revenue and margin pressure among existing retailers as Amazon builds up scale, but there are also mitigating factors which the incumbents can utilise to buffer their businesses.

Global consumer trends…lessons for retailers?  

A recent global survey conducted by Mckinsey & Company provides interesting insights into the changing behaviour of consumers. These insights are also relevant for the domestic market but also provide some insights to how existing retailers could approach the Amazon threat. The Company conducted a global survey of over 22,000 consumers from around the world (26 countries) to better understand changing consumer buying behaviour, as relevant for retailers and packaged-goods companies.

The main message from this survey is the desire for “value for money”.  The key points for consideration are:

• Consumers have considerably shifted their spending towards online (some just pure online plays) – both for getting the best deals but also convenience. Companies must have a credible online presence and offering to compete in the world of the new consumer.
• “Generic” retailers no longer work. That is retailers must have a very clear value proposition and know exactly who their target consumer is.
• Brands matter but at reasonable price. The survey indicates consumers are not necessarily shy of paying up, but they need to see value. If the price is not justified, then as the survey indicates, once consumers trade down (or to an alternative) companies will find it difficult to bring them back.

Who is Amazon?

Amazon (or Amazon.com) is a US based e-commerce company founded in 1994 by current CEO Jeff Bezos. The Company sells a wide range of products – beauty, electronics, jewellery, appliances, books, toys, pet supplies etc – through its website directly to consumers (Business-to-Consumer). Essentially, if the product can fit in a small box and easily be transported, Amazon.com is likely to have it. Among its significant product range, the website offers customised buyer experience and value for money (low prices) – Amazon prides itself on being an “obsessively” customer centric company.

The Company operates its own warehouses and while Amazon.com sell its own products, it is also a re-seller of other brands. That is, large and small retailers can utilise Amazon.com as a distribution channel.  Amazon receives a commission on each sale – between 10 to 15% – and can also charge additional listing or subscription fees.

Why is Amazon coming to Australia?

Amazon already makes between A$500-700m in revenue per annum from Australian consumers, therefore it already has a captured market in Australia. Additionally, Australia is an attractive market given a high proportion of middle class, concentrated population and increasing internet penetration. However, it should also be highlighted that from 1 July 2017 Australia will levy its 10% Goods and Services Tax on online purchases made overseas. Previously the A$1,000 personal consumption exemption meant it was very attractive for consumers to purchase from overseas websites and not incur an additional tax (GST). We wonder if the change in legislation has fast tracked Amazon’s plans to protect its existing revenue base in Australia and the maturing penetration in its key global markets has meant it is looking for new markets.

A recent survey conducted by Neilson of ~1,500 Australians, indicated 27% of respondents were aware of Amazon Prime (online video streaming service) and 38% of respondents were aware of Amazon. Further, 75% of the respondents said that they were interested in Amazon Australia and 56% are likely to purchase from this site.

When is Amazon likely to open in Australia?

We have done some snooping around (e.g. industry experts, consultants carrying out potential impact studies) to gauge an entry date, but at present any date appears to be speculative (most investors would have heard by now how Amazon is “hiring hundreds of people”). In our view, it is safe to assume at the earliest it will be December 2017 (the all-important Christmas shopping period), however it is more likely to be sometime in 2018.

How will Amazon hurt the Australian retailers?

Amazon’s significant product range and focus on low prices will likely impact the Australian retailers in three main ways – increased competitive pricing, revenue leakage in exposed categories and impact on margins from high fixed costs.

Electronic goods appear to be the most likely impacted category from Amazon’s move into Australia. According to the survey, products which are most likely to be bought on Amazon’s Australia site are: electronics (67%), books (61%), clothes (59%), shoes (42%), music (36%), videos (32%), packaged groceries (18%), fresh vegetables (9%) and fresh meat (7%).

Category specific comments and our rating of exposure to the Amazon threat (High / Medium / Low):

• Electronics, books & media (HIGH). These categories are typically Amazon’s go to segments when entering most markets. In this regard, JB Hi-Fi and other electronics retailers are most exposed. Harvey Norman also has a substantial electronics’ offering. We expect price competition to increase within this category, as consumers will likely shop for value and compare price discrepancies across channels.
• Bulky goods (LOW). In our view, the least exposed to the Amazon threat is the bulky goods category. Not only are these much harder to transport, they also require significant distribution channels. Also, given the price point for these products tend to be higher relative to other categories, in our view, consumers generally want to ‘look and feel’ before purchasing. With its recent acquisition of The Good Guys, JB Hi-Fi is well placed.
• Discount Department Stores (DDS) (MEDIUM). We think the impact to DDS will be mixed and will come down to value proposition. We note most DDS have moved to everyday low price business model (such as Target, Big W and Kmart) and, in our view, are not over-earning. We see companies such as Myer (MYR) at greater risk – especially in the cosmetics category (which is a higher margin) – who don’t own all their brands but act more like a brick and mortar ‘marketplace’. Myer introduced Myer Exclusive Brands (MEB) for this very reason, however we note at its 1H17 results, MEB sales were down 11.6%. Further, the Company has struggled to get its online offering right and remains less than 5% of group revenue.
• Consumer staples – food (LOW). In our view, this category is less exposed to the Amazon threat. It is our understanding that Amazon will look to offer packaged groceries and eventually move into the fresh segment. However, the survey conducted by Neilson indicated that there was less enthusiasm from consumers to purchase these products from the Amazon Australia website – packaged groceries (18% of respondent said likely to buy online), fresh vegetables (9% of respondents) and fresh meat (7% of respondents). Further, we note the major supermarkets have a strong loyalty and fuel card programs, which provided some buffer.
• Auto-parts (MEDIUM). We are not totally convinced that all auto-part retailers (including aftermarket parts & accessories) are equally exposed to this threat. In the case of Bapcor, which derives a large part of its business from trade sales (that is selling parts to mechanics) the ability to talk to an expert on specific parts over the phone and then have them delivered within hours is a highly complex distribution model. Further, the costs of these parts are a straight pass-through to the client, hence the cost of the part is not a major consideration in the purchasing decision.              

What is the likely response from Australian retailers?

Amazon’s significant product range and focus on low prices will likely impact the Australian retailers in three main ways – increased competitive pricing, revenue leakage in exposed categories and impact on margins from high fixed costs. We discuss each below.

• Increase / improve respective online offering. Online retail penetration remains very low in Australia relative to other key markets. Australia has penetration of less than 4%, which is much lower than 14% for the U.K. and 12% in China. Within our coverage, JB Hi-Fi’s online penetration is actually equivalent to the national average.

Figure 3: Online retail penetration for key regions (%)

Source: BTIG, Bloomberg

• Adapting business model for the new world. Many retailers supplement organic growth (like-for-like sales) with a store roll-out strategy. In our view, the Amazon threat should provide management teams of incumbents to re-evaluate indiscriminate “land-grab” strategy. As we are now finding in the US, household names such as Macy’s is looking to shed 10,000 jobs and close hundreds of stores as consumer shift online. We expect local retailers to take a proactive approach to store network rationalisation, rather than a (forced) reactive one.

• Strong sourcing capabilities. In our view the better placed retailers already have strong product sourcing teams in place.     

Who is best placed among Australian retailers?

In our view, companies which are vertically integrated players (Premier Investment Group), low cost producer (JB Hi-Fi) and more focus on bulky goods (The Good Guys) should be well placed to weather an increased competitive environment. However, we note they will not be completely immune.

Low cost producers. JB Hi-Fi (JBH) already operates an attractive operating model from a cost structure perspective, which should put the Company in good stead for increased competitive landscape. Further, we would highlight JBH’s operating margins are not overly high, which would allow a competitor to significantly under-cut to gain traction. In the figure below, we have outlined the operating cost ratio for key global players: Amazon (31.8%), AO World (19.4%), Best Buy (19.7%) and JB Hi-Fi (16.4%).

Figure 4: Operating cost ratios as a % of Revenue (8-period moving average)

Source: BTIG, Bloomberg

Vertically integrated. That is, companies who manufacture and market their own brands are better placed to withstand increased competition, such as Premier Investment Group (PMV). PMV’s management pointed out that they believe they are well placed relative to peers for the imminent entry of Amazon to the domestic market. They noted that PMV designs, sources and supplies all its own brands. Therefore, it will all come down to its brand power. Further, PMV has a growing global exposure (away from Australia) which should also provide it with some buffer. PMV already competes with Amazon, given the Company’s strong online sales growth in Smiggle in the UK where Amazon has a strong market position. PMV sells its strong market brands of Smiggle and Peter Alexander via its distribution channels (and not eBay or Amazon), which should provide buffer to the Company.

In summary Woolworths, Wesfarmers, Premier Investments and JB Hi-Fi are better positioned than Harvey Norman and Myer to face the challenges of Amazon’s arrival.