Re-Think Retail: The Store Must Do More - Ahead of the Curve

April 6, 2018

How To "Breakthrough" In The New World Of Retail? Profound shifts in customer expectations are forcing retail business models to innovate and change or risk long-term failure. Stores are vital to retail; however, the fundamental purpose has changed to become a customer acquisition point. Retail needs to maximize a customer's experience & minimize tasks. We lay out Cowen's 3Ps & 3Cs below.
Fundamentals: Our New Customer Engagement Model Requires Accelerating Investments
For retailers to evolve their business models to adhere to the new consumer engagement model our expectation is that retailers will need to accelerate investments in:
.         Customer relationship management in order to drive data collection, analyzation capabilities, assistive personalization, and brand and product communities: "Engaged Data Driven Personalization."
.         Re-allocate marketing spend dollars inclusive of a combination of traditional formats and data- and customer-driven targets: "Social, Targeted, and Novel Media Programs."
.         Both close and repurpose existing stores to embrace a mobile-driven customer in need of Cowen's 3C's of Convenience, Curation, and Culture: "Re-think the Store."
.         Digitize the entire supply chain making it faster, conditioned for more direct to consumer shipping, and having flexible replenishment models: "Understand the Need for Speed."
.         We also believe retailers will need to support a combination of variable and fixed technology, digital, and IT spending needs; variable costs which will be expensed versus capitalized are likely, given utilization of cloud-based technology which benefits from greater flexibility, adaptability, and change, but may be less leveragable given variable vs. fixed pricing: "Transformations Yielding Both Income Statement and Balance Sheet Investments."
Fewer Stores Will Support New Consumers In A More Experiential & Engaged Manner
We highlight four key data points:
1.       More malls will close or be repurposed: Cowen believes we have seen the high water mark of new mall openings and anticipate up to 30% or 328 malls will likely be either closed or re-purposed over the next decade.
2.       Consumers continue to prefer shopping in-store: According to Cowen's Consumer Tracker, ~68% of consumers "agree" or "strongly agree" with the statement "I Enjoy Shopping in Stores".
3.       Millennials shop at malls more than any other age group. Cowen's Focus Group suggests major department stores are the most preferred set of stores at ~40% when shopping for apparel, shoes, and accessories.
4.       Retailers understand the importance of the store and will continue to invest. We believe the future is physical bricks plus digital clicks. In the last fiscal year, over 50% of our covered companies' (on average) primary usage of capital expenditures were allocated towards "Stores" - with about 28% of mentions indicating they spent on Existing Stores and 26% spent on New Stores.
In Cowen's View, Which Public Players Are Best Positioned?
While we believe there will be a continued shake-out of retail over the next few years, winners will emerge. Based on our qualitative analysis through attending industry conferences, conversations with both public and private management teams, and tapping industry consultants' expertise, in our view, we categorize the best positioned to adapt public retailers as follows:
Favorite Stocks From This Ahead of the Curve: We like the intensity of innovation in "convenience" factors such as curbside pickup, Shipt personal shopping, mobile geo-location, and leading loyalty and payment programs at: WMT, TGT, JWN, & KSS. We also appreciate leading "cultural" experiences through physical in-store services (ULTA, PLNT), grass roots brand ambassadors and influencers at LULU and ELF. We prefer merchandise and "curation" expertise through advanced buying organizations, vertically integrated design talent, and supply chains at JWN, COST, TJX, & LVMH.
Developing Capabilities (Most Cautious) From This Ahead of the Curve: We are most concerned about LB and their lack of a digitally-sophisticated loyalty program and need for direct mail to stimulate store traffic. We also worry about SBH's continued quest for marketing programs that will both appeal to their diverse customer base and also work to acquire new customers. We acknowledge luxury stocks (LVMH & CFR) have considerable opportunity to improve their "experiential" offerings, as well as improve their convenience capabilities (ex/offer buy-online, pick-up in -store). Lastly, we believe Macy's assortment stands to improve from a depth vs. breadth perspective.
We Raise our Price Targets on ELF, KSS, LULU, PLNT, TJX, & ULTA. We Lower our Price Targets on LB, M, & SBH. See Page 59 for additional details.
We believe customers need to be engaged with retail prior, during, and post-purchasing an item. This engagement should drive loyalty and community as retail moves from transactional to experiential. We believe the new store needs to prioritize Cowen's 3Cs of offering customers Convenience, Culture, & Curation. Customers require an easy shopping experience, a focused product assortment, and an experience which connects them to the brand, retailer, or other people.
Mobile is the new mall & maximization of experiences and minimization of shopping "tasks" are the future of retail. As stores become customer acquisition and experiential points we believe the number of malls could decline to 880 vs. ~1200 currently as we expect in-store transformation, continued mobile and smart speaker adoption, negative mall traffic, and customer preferences for other shopping formats to drive a combination of mall repurposing and closures. Full price department store chain sizes (Macy's and JCPenney) should be in the range of 570 to 750 as online penetration increases to over 40%+ or higher over time.
Fundamentally, re-thinking retail requires a new perspective in investments. Variable digital expenses include fulfillment, delivery, and digital marketing. Capital expenditures and associated depreciation include new fulfillment centers and technology projects; meanwhile, variable operating expenses are likely as retail shifts to software as a service based solutions. We believe that software as a service and cloud based technology is most conducive to rapidly changing marketing, customer relationship, and supply chain needs.
1. Cowen's New Customer Engagement Model: 3Ps
Our take is that retail needs to be engaged with the customer pre-purchase, during the purchase, and post-purchase. Touching the customer throughout all phases in a digital or physical manner should drive loyalty and is central to customer relationship management. Engagement should also drive a combination of personalization and connect the individual to the community. At each of the phases, there's an opportunity for customers to share information and retailers to offer assistance, discovery, or advice. We believe retailers should approach customer relationship management with these phases in mind as customers complete research in advance of purchases online; engage with social media, influencers, and their personal tribes when making purchasing decisions; and expect retailers to have an integrated and contextualized view of their shopping habits and interactions.
3Ps Are Relevant For A New Generation Of Shoppers
The new generation of shoppers, or Generation Z (born between 1995 and 2010) have different values and therefore behave differently vs. their older Millennial cohort. Rising values in this cohort, as per GfK Consumer Research, include: creativity, internationalism, ambition, equality, knowledge, and learning. We believe this generation is less concerned with materialistic goods & flashy logo-ed brand names. Rather, we view their interests in consumption as "capital-light" (ie: Uber, Airbnb, sharing economy) and also experiential (music festivals, going out to eat, anything "instagram-able"). Therefore, we believe the marketing demand model has shifted, with much more significant percentages of overall marketing spend being shifted towards social media and influencer campaigns. Additionally, we believe Generation Z appreciates and craves feedback along their purchasing journey. Not only do they research their purchases prior to transacting online via peer views, but after purchasing we think feedback in the form of social media "likes" and comments are important drivers of loyalty. Through constant interaction with peers, brands, and retailers via social, underscored by in-store gatherings, we believe "tribes" and "communities" are built, which is an appealing part of retail to the new generation, in our view.
The elements that drive each part of this engagement model have shifted as generations age and consumer preferences become modernized. Our report considers Generation Z, the younger cohort versus Millennials, who are more creative, ambitious, diverse, and are set to represent ~1/3 of the U.S. population by 2020.
Capital Expenditures Vs. Operating Expenses In The New Retail
As both the store does more and the consumer engagement model changes, we believe companies will need to invest in digital and physical changes, making both fixed and variable cost investments. New projects and people will lead to a combination of incremental expenditures on the income statement and/or capital expenditures and the related multi-year depreciation.
Cowen's Views On Key Trends And Thoughts:
Operating Expenses: Cowen believes retail will continue to see an ongoing shift in capital investments from capital expenditures to operating expenditures as an increasing number of retailers shift to the cloud and partner with software-as-a-service (SaaS) providers. We believe this has been an ongoing phenomenon over the past several years but anticipate to see an acceleration given retail's greater use of the cloud, given its improved flexibility, speed, and security features.
Fundamental Analysis Sensitivities: Based on our analysis, if we estimate income statement related capital (cloud and other) spending could pressure SG&A and EBIT margins by an additional ~20bps to ~30bps this would imply a total amount of spending of ~$30mm to ~$120mm or higher for larger retailers, and on a per store basis of at least $50k to $150k.
Fixed vs. Variable Considerations For Digital Expenses: Looking ahead, we anticipate the majority of capital investments will remain fixed (~75%) costs, and will include continued technology, fulfillment centers, and supply chain expenses. Meanwhile, we believe variable expenses will be approximately 25% and predominantly consist of fulfillment, delivery, and digital marketing.
Accelerated Depreciation To Pressure EBIT Margins: Meanwhile, we anticipate a majority of capital investments will remain in capex and will only impact P&L through depreciation, although given the need to accelerate investments in stores, we anticipate accelerated depreciation will pressure EBIT margins (at TGT accelerated depreciation was more than a ~20bps headwind FY17, and we anticipate will be a similar headwind in FY18).
Retailers Will Need To Shift Capex And Invest In Retrofitting Stores: As retailers continue to embrace experiential retail, we anticipate incremental dollars will be used on maintenance capex given the need to retrofit stores. Our analysis indicates retailers will likely need to invest at least $50k to $100k per store with some retailers needing significantly higher investments.
Top Investment Needs: In our view, top areas of focus include: (1) creating space for buy-online, pick-up in-store; (2) adding refrigeration for grocery curbside pick-up and buy-online, pick-up in-store; (3) self check-out counters; (4) tools for self-checkout; (5) investment in food & beverage; (6) endless aisle technology; (7) improving cabinets and shelf space; and (8) lighting & floors.
2. Are The "Store Wars" Over? A New Dawn For The Purpose Of The Store
At over-sized chains, we now expect ~15-25% of stores to close (83 units or 13% at Macy's, 125 units or 14% at JCPenney, 28% at Gap Div/Banana Republic, and 14% at SIG). Our prior 2017 Ahead of the Curve Report, Retail's Disruption Yields Opportunities - Ahead of the Curve Series + Video forecasted closures of 20% at select over-sized chains.
As Retailers Rethink the Store, Internet Players Buildout Their Own Capabilities (John Blackledge)
As the lines between brick and mortar and eCommerce continue to blur, we see both GOOG and AMZN expanding their positions as they establish meaningful partnerships and make necessary acquisitions in order to better serve the consumer. AMZN's purchase of WFM and the launch of their fully automated Go Store have helped to position them closer to the customer than ever before. They are also working tirelessly to build an unparalleled customer experience through the use of cutting edge technology. Meanwhile, GOOG is making a push to partner with retailers to be their go to technology provider. GOOG has continued to build out its offering, from Google Express to the newly announced Google Shopping Actions, which retailers can leverage as they try to both capture some of the extensive growth potential that eCommerce has unlocked and to stave off the omnipresent threat posed by AMZN.
Below we outline our expectation for store base contraction over the next five years, with the department stores contracting by ~13-14%, or shedding a total of about 208 units. We believe the most over-sized chains in our coverage universe include JCPenney, Macy's, Gap division, Banana Republic, and SIG (Jared, Kay, Piercing Pagoda, Sterling, Zales).
Meanwhile, over the longer-term, we believe additional closures may be necessary. Factors which would drive additional store closures include the growth of digital penetration and/or out-sized revenue growth at higher productivity stores. Over a 10 year horizon we believe M's store base could contract to 500 to 550 or -20% at midpoint from the current 653 and -29% from 737 in 2015. Meanwhile, at JCP over the same time horizon we think the store base can further shrink to 650 to 700 or -23% at midpoint from the current 875 or -34% from 1,021 in 2015. This view is in-line with our estimate that ~30% of Malls will close over the next 10 years.
This Is More Important Than Closures: Retailers Need A New Store That Will Do More
Closures will happen; however, we believe what's most important is changing existing stores to engage customers in a customer-centric manner which minimizes the "task" part of shopping and gives customers back time. We do believe the store will always play an important role in the context of retail. Despite the headline of additional store closures on the horizon, Cowen is encouraged, optimistic, and hopeful for the future of the store. We believe in the future, "the store will do more" and will also remain a key cornerstone for retail. Traditionally, the store has served as only a location for consumers to browse and transact for specific product, with a certain inventory stocked in the back room. Now, we believe the store is much more. The store has to be redefined in a customer-centric, more relevant manner. The store can be a place for consumers to be inspired, to be educated, to be entertained, and to socialize. The store can also be a place for retailers to collect data on their customers and their products, and to build and maintain loyal communities of customers. In addition to the shopping task, discovery, inspiration, socializing, entertainment, and aspirations are important mindsets and the "store needs to do more" to address these dynamic needs of the new customer, in our view.
Our analysis is based on a number of macro factors that we believe will continue to pressure the U.S. mall space. We highlight a number of key drivers to our mall closure forecast:
.         Continuation of online sales penetrations reaching 30-40%
.         Persistently negative mall traffic, a headwind we believe will not abate over time
.         Shrinking department store footprints, as we estimate ~200-300 units will shutter over the next few years
.         Transformation of the purpose of the store to customer acquisition vs. transaction execution
.         The rise of different store formations including: small formats, "cool streets", lifestyle centers, etc.
.         The continued adoption of smart speakers and voice-enabled commerce
.         Market share gains at deep value retailers including warehouse clubs.
Cowen's New Store Will Do More
We believe stores can adapt and thrive through addressing Cowen's "Three C's": Convenience, Curation, and Culture along Cowen's "Three P's" of the purchasing journey: Pre-Purchase, Purchase, and Post-Purchase.
Cowen's "Three C's" And "Three P's": The New Purpose Of The Store
For the majority of our coverage universe, there are opportunities to both overhaul select parts of the business models, as well as tweak existing programs in order to keep pace with the quickly changing landscape. We highlight four key strategies which can allow traditional, public retailers to compete in an increasingly sophisticated, tech-heavy retail world: (1) Implement a loyalty program; (2) Focus on Customer Relationship Management programs (CRM); (3) Embrace Data; and (4) Align with a "Retail Superpower".
Over the long term, our view is that traditional retailers will ultimately fail if they do not quickly embrace data, loyalty, CRM, or align with a huge retail player who is best-of-breed in these capabilities. We present Cowen's Retail "Rules of the Road" for the long term. As companies strategize and adapt, we believe key questions in relation to Cowen's matrix of the "3 C's and 3 P's" for retail management teams need to be considered:
1. Convenience: Does my company offer "Buy-Online, Pick-Up In Store" or "Car Pickup"? Can we offer tracking capabilities for orders purchased online? Is the shopping experience personally friction-less and does it minimize task time which can then be reinvested at the leisure of the customer? Can it begin or end seamlessly across mobile, stores, desktop, or automobiles? How do you help customers improve their lives and drive their own version of "value?"
2. Culture: Did you create, inspire, and foster an interactive and personal community? Do customers think about you before, during, and after a purchase and why and how? Which events should you host to connect you to local communities?
3. Curation: Are you a brand, a house of brands, or an everything-store? Does your identifiable or iconic lifestyle vision inspire trust, aspirations, and emotions in a consistent yet innovative and dynamic manner? Does your assortment help customers personally navigate a sea of choices? Does your experience soothe or cause anxiety?