Summary
- To more effectively compete with Amazon, Wal-Mart has cut its online prices below not only Amazon, but in some cases, below the prices offered in its stores.
- Wal-Mart's aggressive price actions, which are likely to reduce its gross margins, could draw a competitive response from players like Amazon and Target, leading to a price war.
- Similarly, the transition to more online sales at Wal-Mart is likely to increase SG&A. Coupled with lower gross margins, I expect significantly lower operating margins.
- I do not believe this phenomenon is limited to Wal-Mart. Ultimately, I expect margins for most general merchandise retailers to decline significantly over the next 3-5 years.
Though retail has always been a fiercely competitive business, it is seemingly becoming even more intense among the country's largest retailers. On Monday, I wrote about how Wal-Mart's (NYSE:WMT) fulfillment capabilities have improved dramatically, making it a viable competitor to Amazon (NASDAQ:AMZN) not only in terms of price, but also in being able to get merchandise to consumers' homes within 1-2 days. Jeff Bezos surely expected this - perhaps this is why Amazon is so eager to be able to provide same-day delivery as it seeks to maintain its competitive edge. While Amazon will likely be able to be the first to provide same-day delivery, it is only a matter of time before Wal-Mart is able to replicate this offering. As the battle continues, investors are wondering who will ultimately win this battle. The more I ponder this question, the more I'm convinced that the answer is the consumer - I expect the profitability of both retailers to erode over the coming years.
In the second half of 2014, Wal-Mart lowered its online prices below not only Amazon, but also below its own Superstores. Given that the cost of goods sold is the same irrespective of whether or not Wal-Mart sells the product through a store or the internet, this is necessarily bad for gross margins. Given the price differential, Wal-Mart is likely to see its lower online prices cannibalize a portion of its store sales. Offering lower prices and relatively comparable fulfillment capabilities means that Wal-Mart is a much more credible competitor to Amazon in the online arena. History has shown us that Amazon is unwilling to be undersold - I assume that the company will initiate a round of price cuts, as it seeks to improve its competitive positioning vis-à-vis Wal-Mart. It is likely that Wal-Mart could initiate a further round of price cuts, potentially deepening the price war between Wal-Mart and Amazon (and, of course, involving other large retailers like Target (NYSE:TGT), Macy's (NYSE:M), Sears (NASDAQ:SHLD), etc). I see gross margins in long-term secular decline.
Will the online business model allow brick-and-mortar retailers like Wal-Mart and Target to reduce expenses and hold (or maybe even increase) operating margins? I think this is unlikely. First, Wal-Mart has become more competitive in the online arena by using its 4,000-plus store network as mini-distribution centers. And given that it has $300 billion-plus worth of sales going through the offline channel, it is unlikely that the company is going to be able to significantly reduce its store base. Instead of the customer walking through the store and selecting merchandise, Wal-Mart must now pay its employees to collect the goods. Similarly, Wal-Mart now must pay to have merchandise shipped to a customer's home. It is easy to see that Wal-Mart's operating expenses are likely to increase for online sales while gross margins decline. This double whammy is likely to have a material negative impact on operating margins looking out 3-5 years. Today, Wal-Mart does 8%-9% operating margins in its Wal-Mart stores business (consolidated margins are lower due to Wal-Mart's lower-margin international sales, its distribution business and its lower-margin grocery business). Over time, I expect these margins to fall into the 5%-6% range. While sales may be higher, I think this is unlikely to offset this severe margin erosion. I expect a similar fate for Target.
As for Amazon, while the company has achieved reliable same-day delivery ahead of Wal-Mart in some regions, I don't view this competitive advantage as sustainable. Anyone who has studied Uber is aware that the company is expanding beyond just disrupting the taxi industry. Looking into the future, Uber (and competitors Sidecar and Lyft) drivers are likely to be delivering parcels. This flexible, on-demand workforce will make it relatively easy for any merchant with a dense store network to offer same-day delivery. As we have seen with standard item delivery, I expect that same-day delivery will eventually be free, and the additional costs will be borne by retailers, further lowering profit margins.
While the above may be unsettling to shareholders of the aforementioned companies, it should not come as a surprise. The advances made in communications, which have proliferated throughout the retail and transportation sectors, have lowered the barriers to entry, increased price transparency and given the consumer greater choice. However, disruptive technologies frequently redistribute earnings power. In this case, consumers (and Uber) appear to be the winners, whereas retailers are likely to suffer. An enterprising investor may wish to speculate on margin contraction by short-selling the SPDR S&P Retail Index ETF (NYSEARCA:XRT).
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