I have been thinking at the off-price retail market recently, both offline and online. Businesses playing into this market rely on accessing surplus stock from brands, and then selling it down to the end customers at a markup (but still at heavy discounts to RRP). Surplus stock fundamentally exists because of structural inefficiencies in the retail industry which make it difficult for brands to accurately forecast demand (and therefore production): production cycles are long, so brands don’t know if it will be a good season until it’s too late to react. In categories like fashion, where trends are volatile and their lifespan difficult to predict, this factor is even more important: fear of missing out forces brands to deliberately over-produce.
One key question from the investor’s perspective is whether these structural imperfections will at some point go away, as brands become increasingly good at forecasting demand. That would obviously reduce the economic need for off-price retailers, as in a perfect retail marketplace brands should be able to sell 100% of their inventory at full price.
So I looked at the US market, where more data is available on listed off-price retailers. I specifically looked for evidence of low / decreasing importance of off-price retailers in the retail value chain (in my mind low was <5% of the entire market, a completely arbitrary low number). I was therefore surprised to find that the basket of six off-price retailers I used in my analysis contributed to 16.3% of the US Clothing & Clothing Accessories market in 2012, up from 12.9% in 2005. I looked at the clothing and accessories market as off-price retailers tend to mainly sell that.
Note: off-price include TJX, Ross Stores, Big Lots, Stein Mart, Overstock, Bluefly.
Source: companies accounts, US Census
This is even more impressive if one thinks that those off-price sales occurred at c. 50% discount to full retail price, so in terms of volumes the importance of off-price retailers in this category is enormous.
My analysis is deliberately conservative as it is excluding all privately-owned off-price retailers which I could not easily get revenue data for. These include large online off-price retailers such as Gilt, RueLaLa, HauteLook etc which experienced very high growth over the period I looked at and certainly would add % points to the 16.3% number I got to and steepness to the red curve.
What this is suggesting is that surplus stock is unlikely to go away from the industry any time soon and, if anything, brands should be feeling more comfortable in their over-production decision because of the efficiency of these channels in clearing up their unsold stock.
What this is not showing though is the impact on margins that this channel has for the brands…
As I think it is a good practice for investors to make investment thesis publicly available, this post will be about the investment thesis that led Forward Investment Partners to invest in Appear Here back in November 2012.
As a backgrounder on the company, Appear Here aims to be THE online marketplace where commercial property is rented out, irrespective of lease length. The investment thesis can be summarised as backing a compelling entrepreneur to disrupt a large, ripe market via a proven and attractive business model.
Commercial property is a large sector (between retail and office rentals, the UK market is worth well in excess of £30B a year), currently undergoing rapid and significant structural changes:
1) Landlords are under pressure as an ever larger portion of their portfolio becomes vacant and occupied lease lengths keep falling year after year.
- Vacancy rates up. This is driven by the weak economy, and online sales growing as a portion of total retail sales. This has meant UK retail vacancy rate (i.e. readily available retail units as a % of total available retail units) has surpassed 16% towards the end of 2012. This is likely to grow even further, possibly double, driven by ongoing growth of e-commerce and the large number of long-term leases coming up for renewal in the next 2-3 years which are unlikely to be renewed. It is also worth noting that vacancies have a double-whammy impact on landlords: not only do they generate no rental income (opportunity cost), they still incur in business rates which the landlords have to front (actual cost). This cost UK landlords £1.1B in 2011/12;
- Lease lengths down: the average length of new signed leases continues to shorten, from over 20 years in 1991 to c. 9 years in 1999 to below 5 years now, with terms now often including long rent-free periods and short break clauses. There is no sign of this trend inverting any time soon;
- Conclusion: landlords know they need to adapt to a new environment where their inventory gets rented out on extremely flexible and standardized terms (e.g. rolling weekly/monthly leases). What they are looking for is a platform that will help them to optimize this inventory so the total net value of the yield is the same.
2) Secondly, on the demand side, brands are increasingly trying to build direct relationships with their customers, cutting the intermediaries out of the equation as Paul Fisher has elegantly illustrated in one of his recent blog post.
- In the long-term the dis-intermediation of the retail world is inevitable and brands will establish more direct relationships with their customers;
- Retailers, particularly online ones, are starting to value bricks & mortar as an extension of their brand: much more about the touchy-feely customer experience rather than product revenue. What companies like Rapha, Warby Parker, Moo, Etsy etc. have done offline are good examples;
- As online cost of customer acquisition keeps increasing month on month and return from online marketing dollars is maxed out, offline becomes an attractive complement as another touch point in the customer purchase cycle. This requires a shift to viewing a square foot of space as media rather than as potential revenue generator;
- Conclusion: brands need flexible and easily accessible physical retail.
3) Last, dis-intermediation in the property marketplace is inevitable: timing is not clear, but the web WILL disrupt as it has done already in other sectors:
- the transparency brought by the internet makes it increasingly difficult for middle-men to justify their share of the value created along the entire value chain, leaving buyers and sellers to retain the margin that would otherwise go to the market intermediaries;
- the compensation model under which commercial property agents are remunerated is still the same as it was when lease length averaged > 10 years, with short-term leases not generating enough commission to be worth their while;
- Conclusion: the web will enable dis-intermediation in the commercial property market.
An online transactional marketplace is a proven business model that is very attractive because of its economics and its defensibility, at scale.
- Attractive economics: marketplaces generates a fee without taking the cost of inventory and incurring in the risk of not being able to shift it; in the case of Appear Here, the inventory is owned and held by the landlords, and Appear Here valuably facilitates the transaction via its website;
- Defensibility: marketplaces also tend to be highly defensible, once they reach a certain level of liquidity; this is because buyers/sellers tend to naturally gravitate (and stick) to highly liquid marketplaces where they have the highest chance of being able to find a large number of seller/buyers.
Ross Bailey is a charismatic and energetic entrepreneur with a grand vision and the courage to go after it. We, at Forward Investment Partners, love backing entrepreneurs like Ross.
Since Q3 2010 Amazon has been consistently growing headcount at a faster rate than net sales: while TTM net sales went from $30.8B in Q3 2010 to $66.8B in Q2 2013 (2.2x), headcount grew from 28k to almost 100k (3.1x) over the same period. What’s interesting is that this is a clear inversion of trend compared to the quarters leading up to Q3 2010: from 2001 to 2010 net sales grew by a factor of 10x while headcount ‘only’ trebled.
If one then looks at sales growth by segment (Amazon reports net sales by Media, Electronics & General Merchandise and Other), it all starts making sense: the bulk of the growth in absolute terms has come from the EGM segment, which grew from $15.6B TTM net sales in Q3 2010 to $43.1B TTM net sales in Q2 2013 and now accounts for close to two thirds of Amazon total net sales. EGM includes stuff like books, consumer electronics, DVDs, software, home & garden furniture, toys etc. which, unlike books, movies and video games (included in the Media segment) is heavy and bulky and requires both more warehouse employees AND more warehouse space. Also, as Amazon pushes aggressively towards same day delivery, more fulfillment centres are required to get closer and closer to the end customer, which is likely to further diminish Amazon efficiency at generating revenues.
Q3 2010 looks like an inflection point when the Media segment started being shadowed by the EGM segment in terms of net sales.
Benedict Evans, in a brilliant post on Amazon’s (lack of) profits, has recently speculated that the company could well be a cleverly orchestrated ‘Ponzi’ scheme where top line growth can only be sustained by suppressing profitability and constantly re-investing every cent of free cashflow back into the business (and particularly, in fulfillment centre staff).
“The other view is that this isn’t actually possible – that Amazon is a sort of Ponzi scheme. It can only grow by running at zero profit – as soon as it puts up prices or cuts capex the business will collapse, and as soon as the share price stops going up all the staff will leave. “
While the market does not seem yet to buy into this thesis (Amazon stock price trebled since Q3 2010, despite razor thin profits), I think it is interesting to draw a comparison between Amazon and other brick and mortar retailers that have historically suffered from Amazon stellar growth.
While Amazon pulls in c. $700k in annual sales per employee, the bricks & mortar retailers average just over $200k per employee. Again, that all still makes sense: the volume of online customers that can be serviced for every warehouse employee exceeds that of a physical retail store; and while Amazon’s servers don’t need that many dev ops to keep them up at night, other retailers need cleaners to mop the floors at each store location every night. That’s why on paper ecommerce beats brick & mortar retail on a unit economics basis. What’s interesting though is the trend in Amazon revenue per employee: while Amazon is still significantly more efficient than its offline competitors at generating revenues, the trend is now clearly showing a steady decline.
The acquisition of Kiva Systems, a warehouse automation company, in March 2012 (Amazon’s second largest ever after Zappos) was timely, although it is yet to make an impact on revenue / employee efficiency.
I will be monitoring this metric over the next few quarters.
[UPDATE TO Q3 2013: numbers are out. As expected Amazon continues to grow more inefficient. With total employees now at 110k, it's average LTM revenue per employee is at a 10 year low of $730k]
I just read about Walgreens acquisition of Drugstore.com for over $400mm. Wow.Traditional retailers are really feeling left behind in the race to online…this is happening more and more often. Not too long ago Morrisons, the UK supermarket group, acquired Kiddicare and snapped up a minority stake in FreshDirect, the US online groceries retailer. While this is a natural move for companies that have traditionally operated in the offline world (and do not have a clue about online), it is also driving valuations of eCommerce businesses through the roof, literally.
These are some multiples I have calculated based on public info:
- Drugstore.com, at $409mm enterprise value, is being valued by Walgreens at 25x 2010 EBITDA and 22x 2011 projected EBITDA
- Kiddicare, at £70mm, was valued by Morrisons at well over 20x 2010 EBITDA
- ASOS trades at over 30x 2011 forecast EBITDA!
- Ocado trades at 30x 2011 forecast EBITDA
I would love to see a chart of eCommerce multiples pre dotcom crash..I bet they were not that far away from what we are seeing in the market these days (if you have a source, please send me the link!).
UPDATE: some useful data on Ben Horowitz‘s blog, which compares multiples now vs. the dotcom bubble. The answer is: we are not in a bubble! yet.