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Consumer and Retail Trends

Farm to table whole foods market

Big news today in the consumer and retail space with online merchant Amazon purchasing grocer Whole Foods Market for $13.7 billion while retailer Walmart went in the other direction purchasing online merchant Bonobos for $300 million. Despite Amazon’s share price moving up (and obviously Whole Food’s), this merger activity actually sent the rest of the retail stock universe plummeting as investors look at the traditional retail model having trouble competing with the advantages of an established technology firm with ample customer data with the ability to use that data to their advantage.

It has been tough for retail over the last while as the costs of real estate and a large physical footprint keep them behind dis intermediaries such as AliExpress or Amazon. Previously seen as cash cows that were private equity darlings for leveraged buy outs, retailers from Nordstrom to Hudson’s Bay are finding themselves far too levered and this is weighing on the price of their bonds as well as their equity.

So before the space changes any more, we would like to highlight some current trends in retail after our posts on power and mining.

Technology and Retail

The Internet of Things, the Cloud and Big Data are and will continue to be more relevant for retailers as they improve data accuracy (what items sell to what demographic and at what margin) and automate processes. Big Data and the Internet of Things (IoT) can help with inventory management and space optimization. Modeling and forecasting requires planning for seasonality, as certain quarters may spike sales (Q4 for Christmas) – adding precision through data analytics can therefore be an immense boon for owners.

IT infrastructure and enterprise resource planning (ERP) are becoming more important in driving growth and optimizing operations (working capital and supply chain management). IT and the rise of apps and the penetration of apps also allows for optimizing the user experience through rewards programs and ease of purchase. An app can have the product available for pickup without wait time. An app can boost sales and capture trends in consumer behavior – if anyone has been to LVMH’s Sephora, there are many incentives to continue to shop at Sephora on a regular basis. They even offer what is perceived to be a quality free birthday gift every year (which speaks more to their margins than their charity).

Real Estate Spin-Offs

It was very popular in the early 2010’s for retail companies (Canadian Tire, Loblaws) to spin-off their real estate as Real Estate Investment Trusts (REITs). Real estate as a business, assuming a known tenant base and prime property, is much more like fixed income in nature compared to equity. If the tenant is known and an owner in the real estate, the probability of defaulting on the lease is low – as such, these real estate companies trade at a much higher multiple. Forming them as REITs also meant that they were not subject to double taxation, further boosting the multiple (dumb money, or retail/mom & pop investors love REITs). All in all, these retailers unlocked a lot of value by spinning out the real estate because the real estate traded at a higher multiple outside the firm than inside the firm.

Also, as a tenant, retailers will get tenancy improvements (where the landlord will allocate money or rent reductions for the tenant to improve the space).

Amazon, Alibaba and the Rise of Online Shopping

The biggest shift is consumer spending habits, especially as the purchasing power shifts in terms of demographics. Most millennials are acquainted with online shopping, and for many millennials, online shopping has become the preferred medium for shopping. From a retailing perspective, online shopping is much better for margins because of the disintermediation of the physical store.

With a smaller physical (traditional brick and mortar) footprint and centralized warehousing, costs that would be otherwise passed on to the customer (labor, energy, prime rent, inventory) translate into savings and stimulate demand. This is Alibaba and Amazon’s world, and malls will struggle – the traditional concept store needs to add value that exceeds the convenience of shopping online (and in Alibaba’s case, the savings for cost increase consumer surplus more than the convenience). Stores that add an experience to shopping can survive and justify higher margins (luxury, personal shopping), but appliances and household goods may no longer be sold at a department store level.

Food is perishable and as such does not have the same flexibility as non-perishable goods – however restaurants will see opportunities and threats. Food delivery has been centralized by companies such as UberEats, Foodora, and Grubhub, which reduces the need for a dedicated delivery person (and even tips). On one end, restaurants will have to pay a margin to the pooled intermediary – on the other hand, this spread should narrow the higher the penetration and demand that previously was not there now is due to the accessibility of a larger variety of cheap food. Restaurants that can offer service and an experience will continue to be successful, perhaps even more successful as more people do not go out for food – however unpopular fast food joints who benefit from prime location will suffer.

Labor in developed markets will continue to push retailers to automation and e-commerce. Resentment and populism related to minimum wage and organizational behavior challenges threaten margins. Market leaders who have a differentiated product with inelastic consumer demand (Starbucks) can offer above market pay and perquisites, which can lead to lower attrition and better human capital – however most margin restaurants and retailers will look to automation.

Product and Geographic Segmentation

Retail depends heavily on the economy – and with rising incomes, artisan coffee may see an uptick in sales. In a bad economy, Burger King/Tim Hortons may be a safer bet.

Retail is also regional. Once the oil price crashed, nothing in Calgary was selling quite as well as before.

Retail and Restaurant Emerging Markets Expansion

Major restaurant chains and retailers have been aggressively expanding overseas, especially in emerging markets due to the favorable demographic changes forecasted – rapidly rising incomes and urbanization.

This trend has slowed down since a major China boom, with McDonald’s, Starbucks, Burger King (predating the Restaurant Brands International merger) and Yum! Brands (KFC, Pizza Hut) becoming ubiquitous in the country – while tailoring offerings to local tastes (American brands are upmarket versus their fast food status in North America and have very different menus that incorporate rice and soup noodles). Walmart has established a large presence in China while Costco is targeting India.

Yum! has since spun off their China operations while McDonald’s effectively franchised out 80% of their Chinese operations to a consortium led by the Carlyle Group and CITIC. Both operations also suffered profit declines when they ran into quality control issues.

For Chinese markets, a Western brand is synonymous with quality control where domestic players have low public trust – slips and food poisoning incidents can compromise the brand value and leads to consumers putting their dollars elsewhere in droves, as evidenced by chicken meat concerns that plagued both KFC and McDonald’s.

Mergers & Acquisitions in Retail and Restaurants

Given the advances in technology and standard business economies of scale, consumer products (brick-and-mortar retail operations in particular) have been good candidates for mergers & acquisitions. For these mergers, investors are keen to see synergies beyond earnings and cash flow accretion – with attention paid to a platform to accelerate growth and scale (existing operations in emerging markets that the target brand does not have), supply chain advantages such as bulk purchasing, cost cutting from shared corporate costs as well as an acquirer that has restructured costs down successfully before and complimentary brands.

3G Capital, the Brazilian private equity firm led by Jorge Paulo Lemann, has been front and center of several prominent transactions, often working with Warren Buffett’s Berkshire Hathaway. Recent Canadian mergers include Restaurant Brands International’s acquisition of Popeyes and Cara’s purchase of St. Hubert (chicken).

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