Embrace Digital Innovation Else Face Extinction; Sports Authority Went Bankrupt, Whose Turn Is It Next?

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Includes: AMZN, JWN, KR, SBUX
by: Shilpa Khire

Summary

Online retailers are posing a serious threat to existing businesses. It is necessary to understand the challenges faced by brick and mortar retail stores.

In this article, we will be discussing examples of innovative strategies that some of the retailers have adopted using technology.

This should allow investors to review their investments and take corrective actions at the right time.

The news of Sports Authority's bankruptcy petition was looked upon as an unforeseen event in the retail industry. On one hand, we are talking about an increase in health awareness among the public and an increase in consumer spending on health and fitness related goods. We are also discussing regarding the growth prospects for companies such as Nike (NYSE:NKE), Under Armour (NYSE:UA) and Lululemon (NASDAQ:LULU). We have also seen that competition from online retailers is affecting every business severely. However, when a giant store like Sports Authority having around 450 outlets throughout the United States brings in news of bankruptcy, it does make us wonder, why exactly did this happen and who is likely to be the next in line?

Online retailers are posing a serious threat to existing businesses. Factors such as low barrier of entry and lower upfront capital requirement further facilitate the entry of new players in the market. What are the factors then, which could make customers, keep coming back to the conventional stores?

In this article, I have tried to look at some of the solutions, which the conventional stores can implement in order to keep consumers coming back to the stores. I have also highlighted some of the companies, which have adapted well to these changing demands resulting in high in-store sales and an overall revenue growth. As investors, we should also learn our lessons in time, review the existing investments in order to ensure that they are conforming to the upcoming trends.

a. Pleasurable customer experience

Although ordering stuff online is the preferred norm, people are definitely willing to get out of their pajamas to go to the stores if they enjoy the shopping experience. A lot of people prefer to buy items such as shoes or jackets by physically trying them out in the stores. However, in order to attract consumers in the first place, stores need to have a vast variety of different products. The sales associates should be polite and willing to help you out in order to make sure that you are able to find the right product.

Take the example of Starbucks (NASDAQ: SBUX). The coffee shop is well known for its reputation management. The little things that it does better has helped it immensely. Starbucks is selling a product for which there are nonexistent switching costs, intense industry competition and low barrier of entry. The company, with its strong moat, has been able to maintain a leadership position. Starbucks was quick enough to introduce its mobile offering (including the My Starbucks Rewards and Mobile Order and Pay platforms), geographical market expansion strategies and acquisition of complementary brands like Teavana, La Boulange and Evolution Fresh. So even for a generic product like coffee, people end up driving that extra mile to a nearby Starbucks outlet rather than any other coffee shop.

Here is an analysis of the company's revenue growth and profitability for the last five years:

To quote Howard Schultz from his annual letter to shareholders:

Our social, digital, and mobile applications are a strategic advantage as they extend our reach, strengthen our connection with customers, and drive profitability"

Year

2011

2012

2013

2014

2015

Revenue

11,700

13,300

14,892

16,448

19,163

% increase

14%

12%

10%

17%

Net income

1,246

1,384

8

2,068

2,757

Net Income as a % of revenue

11%

10%

0%

13%

14%

Click to enlarge

Source: Morningstar.com

As seen from the table above, the sustained increase in revenue and profitability growth makes it well positioned for future growth, (the negligible 2013 profit margin was due to internal restructuring operations and was only a one-time expense). SBUX has given an annualized return in excess of 28% over the past 5 years.

b. Brick and Mortar needs to embrace the digital channel

Digital innovation is not just opening up a website, it also needs to be a part of the in-store strategy. For a lot of products like sportswear, music etc., the primary consumer base is the younger generation between the ages of 15 to 40 who are more comfortable with the digital way of life. Retail stores can always add this experience to the in-store shopping. For example, the electronics store Best Buy (NYSE: BBY) price match guarantee uses an excellent strategy of matching internet prices in the stores to encourage its customers to gain the advantages of the in-store shopping experience plus the low cost advantage. Several retailers like Target offer "curb side pick-up" which enables customers to buy online and pick up from the location at a designated time. Shoppers in Macy's (NYSE: M) can buy the right sized blue jeans online and then pickup from the nearby store at their convenience. All these strategies help to bring the digital technology closer to the stores.

c. Product differentiation

For any retail business it is always easy to blame the falling revenue on underperforming stores, increasing competition and other external factors. But the fact remains that the stores are underperforming since they fail to meet the increasing demands of the consumers. The only way to remain competitive is to be able to differentiate. It is argued that there are two major long-term competitively defensible strategies, which retailers can pursue. They are low cost and product differentiation. Low-cost retailers such as Costco (NASDAQ: COST) have succeeded by reducing product choice, use of a self-service shopping environment, and an absence of services that their consumers view as secondary in importance (such as home delivery, no try-on rooms, and an absence of in-store displays).

At the other end of the positioning spectrum are retailers such as Trader Joe's, and Whole Foods (NASDAQ: WFM). These retailers have succeeded through a differentiation strategy that combines high levels of sales assistance by a dedicated and trained staff, specialized merchandise and a shopping environment that is viewed by many consumers as exciting, entertaining, and fun.

d. Constant innovation

Innovation need not be radical every time. Small changes to the existing way of conducting business can bring about a major change. When Nordstrom (NYSE: JWN) introduced the Nordstrom rack concept (Nordstrom rack is basically a baby Nordstrom which only carries the most frequently demanded items at reasonable prices), it suddenly gave a boost to the company's revenue. Manageable real estate, limited stock with moderate prices helped the company to contribute significantly to its top line. Nordstrom Rack currently contributes around one-fifth of the company's total revenue.

The company has also invested in advanced Digital Omni-Channel capabilities catering to the younger generation. Its rewards program generated 40% of its total sales last year. Introduction of technology inside the store has further given a huge boost to increase its sales. The company has overall maintained a rate of return on capital investment of 15%, which is fairly decent.

e. Meeting the ever increasing demands of the customers

Customer's demands and preferences keep changing constantly with the changing technology and introduction of new products. Companies, which are quick enough to adapt, can survive. An excellent example is that of Kroger (NYSE: KR). Kroger is the No. 2 retailer in the United States in the grocery business. With the increasing demand for organic products in the recent years, it not only introduced its own organic brand three years back, but also was able to make organic sales a significant part of its revenue thereby maintaining its top position (Organic sales account to around 10% of the total company sales).

The following table shows the revenue growth and net income of Kroger

Year

2012

2013

2014

2015

2016

Revenue

90,374

96,751

98,375

108,465

109,830

% increase

7%

2%

10%

1%

Net income

602

1,497

1,519

1,728

2,039

Net income as a % of revenue

1%

2%

2%

2%

2%

Click to enlarge

Source: Morningstar.com

Here is the EPS growth rate:

Year over year

19.77

3 years' average

14.15

5 years' average

18.81

Click to enlarge

Source: Morningstar.com

A proven track record of increasing revenue, growing market share and quick adaptability to changing consumer needs has put the company in a very strong position.

Also, new payment methods have been introduced in the recent years. A mere credit card payment is not enough to keep the customers happy. Stores which have been quick enough to adapt to the new forms of payment such as Apple Pay (NASDAQ:AAPL), bitcoin, Square (NYSE:SQ) have been able to keep their customers coming back.

e. Supply chain management

Supply chain and inventory management is a critical part of the retail business. The growth of Amazon (NASDAQ: AMZN) is not just about the online website, but the optimum supply chain system which the company has built over the years. This is what is making the company indispensable. Investors should research if the retailer is embracing digital innovation in aspects such as warehouse, and shipment optimization and other aspects of Supply Chain to ensure pressures on margins due to online competition are met with by improved efficiencies.

f. Company debt should be under control and the balance sheet healthy

Often times, as investors, we fail to notice the company's financial position for an increase in its top line. Companies generally adopt this strategy in the initial growth phase in order to gain more market share. However, if this trend continues for a prolonged period of time, the heavy debt burden can weigh down the company itself. Also, undertaking all of the new strategies such as free delivery, running promotional offers, tie-ups with vendors for home delivery etc will require the company to be financially strong in order to keep up with the ever-changing customer needs.

If the financial position of the company is not strong, the focus of the business shifts from "running a smart business" to "struggling to survive," which then poses a severe problem.

Bottom Line:

There are definitely going to be a lot of brick and mortar store closures in the coming years. The retail industry has the advantage of an ever-increasing demand from different sectors of the population. At the same time, it also faces severe competition due to factors such as lack of product differentiation making it very vulnerable. Make sure you identify the trends in your retail investment companies sooner and take corrective actions at the right time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment advisor. This is not an investment advice.