Amazon: May the best prepared win

Amazon’s planned entry into the Australian market has generated intense speculation about the outlook for incumbent players. While Amazon will undoubtedly take some retail share, our research suggests the major impact of Amazon will be to accelerate fundamental changes in the ways companies interact with their customers. These include:

  • price transparency will increase;
  • cost to serve will likely need to fall for those facing direct competition; and
  • the customer experience will be enhanced.

The experience of retailers offshore has been highly dependent on their response to a changed industry structure driven by Amazon’s entry. Much like a season of ‘Survivor’, the winners and losers in this new competitive landscape will be determined by the strategies they choose and their ability to execute on these plans.

With Amazon preparing to launch its Australian domestic operations in late 2018, the pace of innovation and change is set to accelerate in a range of sectors across the Australian market. Companies will need to evolve to remain competitive in this new environment. There has been plenty of notice that Amazon is coming and companies can learn from experiences in foreign markets: to do nothing is not an option.

From our perspective, there are four key aspects in assessing the impact of Amazon across the retail, consumer staples and REITs sectors. These four key aspects are:

  1. Assess incumbents against our framework for the future.
  2. Understand Amazon’s business model to see how customer obsession drives disruption.
  3. Look at the key variables that will shape Amazon’s Australian expansion.
  4. Consider the risks Amazon faces in penetrating the Australian market.

Points one and three are detailed below.

Assess incumbents against framework

Amazon’s impact on an incumbent retailer, product provider or retail landlord will be highly dependent on how the incumbent responds. As a result, we assess the outlook for an incumbent in two stages.

First, we form a view around valuation, with key assumptions guided by international experience. Second, we assess a corporate’s delivery on the changes required to realise our valuation. This section explores this second stage in more detail.

From our analysis of Amazon’s business model and its strategy and success offshore, we have identified five key strategic pillars of change (see Table 1) that will assist companies to adapt to the new competitive landscape and three underlying capabilities necessary to implement these changes. This framework will allow us to assess the quality and viability of a company’s response to Amazon and hence, form a view on its future market position and ultimately, its valuation.

  1. Management capability

We need to assess whether management has the capability to evolve its strategy and execute on plans to adapt to the shift in consumer habits. Companies able to adapt and innovate will survive and even prosper after the arrival of Amazon. In contrast, those that are unprepared may be forced out of the market.

  1. Price transparency

Amazon’s arrival will give consumers a tool to instantly cross-check prices to ensure they are getting a fair deal. While retailers may not need to match Amazon’s prices, margins may need to reduce to create a competitive market price. Where consumer branded products have sought to hold Australian pricing above that in other markets, we would expect Amazon to assist in breaking this down for the benefit of the Australian consumer. However, it will likely reduce the gross margin of Australian retailers.

  1. Logistics

Amazon’s delivery capabilities have revolutionised the retail industry and have driven a virtuous circle of increased sales, which are reinvested in the supply chain to offer better service, leading to more volumes sold. The introduction of Kiva robots has reduced warehouse operating costs by around 20 per cent. The next step is last mile delivery, with ‘Prime Air’ already delivering parcels via drones.

To compete with Amazon, brand owners and retailers will need to collaborate to create faster, flexible and more reliable supply chains to reduce costs and meet new delivery expectations. Companies may choose to leverage Amazon’s fulfilment capability to drive sales, in which case, actively managing inventory and optimising product design will be key to success.

  1. Route to market

Amazon will drive changes in how consumers shop, presenting both an opportunity and a risk for traditional retailers. A combination of a strong online and physical presence will be critical for retailers and consumer packaged goods providers.

Online and in-store sales will become increasingly interdependent as customers may choose to ‘look and feel’ in store and buy online, or vice versa. A company’s digital interface, delivery capability and online range will be increasingly important, while store footprint is likely to be consolidated.

Prime real estate will become increasingly sought after, as companies move to flagship-style physical stores to engage consumers. Further, consumer packaged goods companies may choose to leverage Amazon’s scale to grow sales and/or to develop their own direct-to-consumer online platform. Each of these approaches offers opportunities if done properly; we will monitor which approach companies choose to take and how they seek to achieve this.

  1. Data analytics

Through its huge data warehouses and sophisticated analytics capability, Amazon knows its customers better than anyone else and makes rapid, data-driven decisions. For instance, it is estimated Amazon changes its prices tens of millions of times globally every single day.

To keep pace, retailers will need to invest in their own ability to collect, analyse and apply insights from data to increase loyalty, create personalised experiences and make quick decisions based on what their customers want.

Australian retailers have data – the question is whether they will be able to use it.

Companies that already have sophisticated data analysis capabilities should be able to defend against Amazon’s arrival; others will need to increase their online presence and invest in the area to remain relevant in a landscape where data is critical to success.

Shopping centres will be able to harness data on how customers spend to engage customers, allowing them to optimise the physical shopping experience to defend against the convenience of online retail.

  1. Customer service

Amazon’s ‘customer obsession’ will force companies to adjust their strategies in an environment of increased price transparency, decreased margins and higher customer expectations.

Given Amazon’s broad goal of becoming ‘the everything store’, traditional retailers need to specialise and differentiate to engage their customers. This may be done through a focus on premium or private label offerings, investment in the in-store experience or targeting products and consumers unattractive to competitors.

Bricks and mortar retailers have a natural advantage in service and experience, which can be leveraged to create an engaging buying experience, both in-store and online.

Whatever approach is taken, a strong focus on customers will be essential.

  1. Capex and working capital

A flexible capital structure will be required to close surplus stores, reconfigure supply chains, invest in online presence, increase data capabilities and improve the overall retail experience.

The short-term focus of equity markets is a clear disadvantage for listed companies competing with Amazon, which is prepared to lose money for over five years before becoming profitable in a region.

A company’s financial health and capability to implement the major changes required will be key determinants of its ability to survive.

Further, companies with negative working capital cycles (i.e. those that receive customer payments before paying their suppliers) are more of a concern, if their sales revenue declines as Amazon captures share.

These are critical factors we will look at in assessing a company’s ability to adapt to the new environment.

  1. Talent acquisition

Amazon’s teams of PhD mathematicians, economists and behavioural scientists have been a key driver of its success.

To establish an online presence, optimise logistics and understand data on their customers, companies will need to attract and retain the necessary talent from a limited pool.

Existing capability in these areas will be a major source of competitive advantage and we will monitor the focus placed by management on this area going forward.

Table 1: Five key strategic pillars

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ANDREW STANLEY 
Head of Australian Equities
Ralton Asset Management

 

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Key variables that will shape amazon’s australian expansion

After deciding on the locations of its first two Australian warehousing sites at Eastern Creek in Sydney and Dandenong South in Melbourne, Amazon looks set to build out its logistics network and begin sales in Australia in 2018.

The way in which Amazon moves into a new market is highly region-specific and has exhibited varying levels of success. This suggests its roll-out in Australia could follow several paths.

In entering Australia, key variables we will monitor are:

Product roll-out – timing and range

Releasing its full range of products has been key to Amazon’s success in new markets. Its roll-out in Canada was very slow, with significantly less products launched over a much longer period than more recent entries into Italy and Spain, which led to poor take-up of its platform. The most recent expansion into Mexico was aggressive, with the full range rolled out at once.

Having learnt from the Canadian experience, we expect Amazon to follow a similar pattern to its European launches.

The Prime offering is particularly important in driving sales, with subscribers spending more than double the amount spent by non-members. The launch of Prime has historically been a key point of inflection for Amazon’s sales and online retail.

Online penetration of product categories

Amazon’s success to date has also been highly dependent on product category. It has traditionally taken the most share in relatively commoditised categories, such as electronics, sports, apparel (predominantly socks and undergarments) and physical/electronic media, such as books.

Australia’s department store and electronics industries are significantly over-stored on a global basis. Electronics and fashion are also relatively consolidated. This is negative for large retailers, which have more share to lose and less to gain as smaller retailers are driven out.

Amazon has been seeking to move into under-penetrated product categories, such as clothing retail and grocery, by removing frictions for customers. The recent Whole Foods acquisition represents a major step into the previously unsuccessful fresh grocery market, which could herald the arrival of a hybrid online/physical offering.

However, we believe Amazon will struggle in the Australian grocery market, given the strength of the Coles and Woolworths duopoly. Their 70 per cent combined market share provides them with a lot of capacity to compete.

In addition, supermarkets can gain an insight into how Amazon intends to attack the market from its offshore approach, giving them time to innovate and adapt. Amazon’s non-perishables offering, Amazon Pantry, is likely to be rolled out quickly, however, this has not significantly impacted grocery retailers elsewhere.

Geographic reach

Australia’s low population density will be a key challenge for Amazon in establishing its delivery capabilities. As a result, Amazon is likely to focus on the east coast, with fulfilment centres expected in Sydney, Melbourne and Brisbane.

It has been reported that Prime Now will be launched in Australia, however, given the relatively low population density even in key cities, the geographic reach of the one-hour free delivery service is likely to be very limited. 

Consumer take-up

Australia has the third highest retail spend per capita in the world, behind only the U.S. and Japan, and the third highest online spend per capita in Amazon’s current markets.

Amazon typically drives increased online penetration in its new markets. This high online spend prior to Amazon’s entry may make Australian consumers particularly receptive to Amazon’s offering. However, growth in online retail in general may be lower than in other new markets, due to the high starting point.

Competitive response

The way in which retailers respond to Amazon’s entry will determine the amount of market share Amazon is able to gain and whether it succeeds or fails on an individual level.

Australian businesses can learn from mistakes made offshore, where retailers have typically waited several years before consolidating their store footprint, leading to margin declines for several years.

Retailers that exhibit high levels of gross margin selling products available elsewhere, combined with high costs, are particularly vulnerable and need to significantly reposition themselves to avoid being crushed by Amazon’s pricing model.

However, Amazon will not have everything its own way, as it faces several risks in entering Australia, given the nature of our business and economic landscape.

 

Andrew Stanley is Head of Australian Equities at Ralton Asset Management.

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