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[Originally published 8/15/2014]

The retail sector has lagged behind the averages this year. Just take a look at the SPDR S&P Retail ETF’s (NYSEARCA:XRT) performance – down almost 4.5% year-to-date. The S&P 500 Index however has risen 5.7% over the same time period. This data seems to contradict the growing feeling of economic recovery and it’s clear that the reasons for retail’s sluggishness are more than skin deep.

According to the Fed’s Beige Book, a collection of anecdotal economic information, regional banks saw moderate to modest growth in their local economies. Consumer spending, while not necessarily robust, has certainly seen a boost from its levels back in 2009 and has increased each year since. Yet despite this positive news, major retailers are reporting consistently disappointing earnings and lowering forward-looking guidance.

Target Disappoints, Again

One of the kings of retail, Target (NYSE:TGT) has been suffering for a while now. The company’s recent 2nd quarter results weren’t completely unexpected with higher expenses and lower EPS guidance for next year. All seemingly related to the major security breach that occurred in 2013. Costs have risen exponentially since its computer network was hacked and customer’s credit card information was compromised.

Digging a little deeper though, we find that an information breach isn’t the only thing dragging down numbers.

Same-store sales figures are the go-to fundamental statistic used as a gauge for how a retailer’s stores (that have been operating for at least one year) are experiencing growth. In Target’s case, the figures are flat, meaning growth isn’t happening at all. If the slump continues, Target may even reduce its dividend, drop share buy-backs, and suffer another drop in its credit rating. With doubts being raised about other major retailers like Wal-Mart (NYSE:WMT), it seems that the entire retail landscape is experiencing difficulty.

The Face of the Retail Industry

The notion of shopping by physically going to a store location, browsing through the aisles, making selections, and making purchases is quickly becoming an antiquated one. In truth, shoppers are less and less likely to visit a traditional brick-and-mortar location as time goes on based on some alarming figures by ShopperTrak.

Foot traffic data for the months of November and December, generally the biggest shopping months of the year, reveal a trend that is quickly spiraling downward. In 2010, there were around 34 billion visits to retailers; in 2013, that figure dropped precipitously by almost half to 17.6 billion. Retail visits have fallen by at least 5% every month for the past 2 years. The amount of new retail space being opened up has changed as well. In 2008, just over 300 million square feet of space was opened. Flash-forward to 2013, and only 43.8 million square feet were opened. The numbers are beginning to paint a grim picture for traditional retail stores.

Aggressive discounts and rebate prices aren’t enough to keep shoppers interested either. The competition isn’t coming from other similar retailers – it’s coming from the shopping experience itself.

Shopping in the Digital Age

It should come as no surprise that the proliferation of online stores constitutes the single biggest threat to traditional retail companies. The convenience of point-and-click shopping has been taking market share away from retailers that require parking lots, traffic, and lines for a number of years now, but that shift may finally have reached a critical shifting point.

Where retail stores suffered in 2013, online vendors flourished. Forecasts by the National Retail Federation project a 4.1% increase in retail sales for 2014 compared to 3.7% in 2013. Online sales will lead the way with growth between 9% and 12%.

Online retail shopping grew 14% last year. This year, total global e-commerce sales are estimated to climb 20.1% to $1.5 trillion. U.S. e-commerce sales were $263.3 billion in 2013 and expected to reach $304.1 billion this year.

The web will account for 11% of all retail sales in 2018 as compared to 8% last year according to data from Forrester Research. In the U.S., online sales will grow 57% in the same time period with a compound annual growth rate of 9.5%.

The internet is making shopping much easier for consumers and the trend of shopping online is expected to carry over into other areas. While the majority of shoppers, nearly two-thirds, are doing so on personal computers, there’s a growing trend of shopping with mobile devices. By 2018, global e-commerce sales just from mobile devices is expected to top $638 billion – double the size of the entire e-commerce market in 2013.

Big Retailers are Slow to Adapt

The transition of shopping in brick-and-mortar locations to online ones isn’t lost on big retailers like Target, but there are a number of headwinds facing them. Target’s security breach becomes even more of a concern for shoppers when brought into the context of digital transactions. Investors and consumers alike wonder if the company can offer adequate protection for purchasing products online going forward given the large infrastructure needed to meet the high demand area.

Wal-Mart is another big brand trying to adapt to change. It has upgraded its online store and attempting to shift the focus away from its physical locations to keep its customer base. Even with these mentality shifts, big retailers have an uphill battle to fight.

Other retailers are able to change their focus better than their sluggish counterparts. Zulily (NASDAQ:ZU) is an example of an online retailer that’s perfectly positioned for the new digital consumer. Last year the company generated $695.7 million in sales, up 110% from $331.2 million in 2012. Nordstrom (NYSE:JWN) is another retailer making significant strides to engage tech-savvy consumers. The company’s focus on more “convenient” shopping has led to it participating in a $55 million investment round into Bonobos, an online men’s retailer. This is the second investment it has made into Bonobos. This latest round is intended for a certain “spin” on the brick-and-mortar shopping experience where customers try on clothing but have the items shipped to them vs. carrying them right out of the store.

Undoubtedly, the king of digital retailing is Amazon (NASDAQ:AMZN). A company that’s well established for consumers as the go-to online store, its performance speaks for itself. In the past two years, Amazon has risen 40% compared to Target’s loss of 4% over the same time period. Amazon is attempting to further its lead and integration into everyone’s shopping experience with the company’s recent addition of a mobile payment app and card reader. Investors are continuing to get a little impatient with the company and it’s never-ending capital expenditures as per the market reaction to the latest earning’s release. However, this is just helping the 800-lb gorilla of the online retail space tighten the noose around it’s less nimble brick-and-mortar counterparts.

Online retailers have the advantage of having far fewer debt liabilities due to not having to support physical stores and the costs associated with them. This means possessing a greater ability to reinvest into the business or employ stock buy-back or dividend programs for investors. It also means being able to discount prices to a greater degree than retailers with store locations giving them a competitive edge both on price as well as convenience.

The Future of Retail

While storefronts may not disappear entirely, technology will still keep shaping the way consumers shop. A concept of hybrid stores may soon be in malls across the country. These stores will have touch-screen windows where shoppers can scroll through inventory and add items to their cart with a swipe of their finger. Payments will be just as easy with funds being deducted out of PayPal accounts, credit cards, or bank accounts by simply clicking on the link sent to shoppers’ mobile devices.

The “instant” culture developing means that even online shopping may not be fast enough in the near-future. One company called Instacart provides a service for shoppers where orders are placed online and a personal shopping assistant actually goes out and physically purchases the ordered goods and delivers them to the purchaser’s doorstep. The idea of instant gratification in shopping means that consumers will be able to purchase anything online and have it delivered in the same day, hence the more recent focus into drone technology and the potential paradigm shift we may see in the skies above us.

While the idea of personal shoppers and hybrid storefronts haven’t yet gone mainstream, the digital marketplace is undoubtedly transforming the industry as a whole. Big name retailers such as Target or Best Buy may find themselves phased out, if they can’t adapt quickly enough, by smaller online-only companies that are better suited to meet the growing demand of consumers.

Source: Target's Problems May Signal The Beginning Of A Paradigm Shift In The Retail Industry