16th May, 2017

The imminent arrival of Amazon in Australia has frightened many investors away from Australian retailers. We think that shareholders in traditional retailers should be very nervous indeed – much like the Australian media sector, the transformation of Australian retailing has barely begun.

The US retailing sector is much further down the painful path to re-invention, simply because the US is where most of the successful online retailers originated. US e-commerce sales rose from 10.5% of all sales in 2012 to 15.5% in 2016. As the chart below shows, more stores have closed in the first four months of this year than in the whole of 2016. Retail companies are going bankrupt at unprecedented rates: the ratings agency Fitch estimated in April of this year that the bond default rate by retailers would leap from 1% in the last twelve months to 9% by the end of 2017.

Traditional retailers are inclined to blame their misfortunes on online competitors, higher minimum wages, excessive regulation, bad weather, etc. And it is true that very few traditional retailers have managed to create a successful online offer. But the flaw in this argument is that some physical retailers are doing very well indeed. At the same time as the likes of Macy’s, Penney, Sears, Guess, Staples, Payless, and The Limited are closing stores, US retailers such as Home Depot and TJ Maxx keep on opening stores.

Many of the US success stories are global retailers who have only recently arrived in the US – for example, H&M from Sweden, Zara from Spain, Uniqlo from Japan, Primark from Ireland, Scotch & Soda from the Netherlands, Reiss and Superdry from the UK. These are serious competitors: each of the parent companies of H&M and Zara have about 150,000 employees and global sales of more than USD 20 billion.

It is clear that the problems in the retail sector are due to the business models of the traditional retailers, rather than to cheap online competition. The per-sale cost of online retailers is on average higher than physical retailers because, although online retailers escape the fixed costs of physical stores, they have to spend more on shipping, customer acquisition, and technology. Physical retailers often enjoy higher margins than their online competitors – what they lack is sales growth.

What are the implications for Australian retailing? It is obvious to any comparison shopper that the poor performance of traditional retailers is not caused by online retailers who don’t own stores or pay GST. Most traditional retailers compete reasonably well on price points, but the areas where they fall down are product range, time to market, and level of service. Zara, for instance, can get a new coat from the design workshop to its stores in 25 days.

In the last three years, Australian fashion retailers have already been through a baptism of fire with the arrival of Zara, Topshop, H&M and Uniqlo. Even though they had only opened a handful of flagship stores in three capital city CBDs, the global retailers generated unprecedented levels of competition, sending several local retailers into bankruptcy.

While Amazon will have some impact on Australian fashion retailers, the sectors which it will affect the worst are electronics and appliances, sports and leisure, books, and department stores. Unless Amazon Fresh can perform here far better than it has done in the US, supermarkets will not be much affected – Aldi is a bigger threat. As with Australian media, Arminius is unlikely to invest in any Australian retailers until they can demonstrate viable new business models.

Will a run of retailer insolvencies damage their landlords the mall owners? US comparisons are less useful here, because US department stores usually own rather than lease their sites in a mall. Therefore the mall owner must acquire the vacated space before it can re-design, re-fit, and re-let it. In Australia, the departure of a department store (or any other very large tenant) causes short term pain but long term gain. Anchor tenants such as department stores typically pay less than a quarter of the rent per square metre that specialty stores pay, so re-letting is a major boost to profitability. Furthermore, any store which is trading poorly is a drag on mall performance, because it is not attracting enough shoppers. The whole mall benefits if a poorly-trading tenant is replaced with a strong tenant.

That said, the short term pain of store closures has a negative impact on mall profitability, as well as on sentiment toward retail REITs. The chart above shows how US retail REITs have underperformed the REIT sector by 20% over the last twelve months. We are confident that Westfield, like its rivals Simon and General Growth, will survive the coming crisis in retail and emerge stronger. But a couple of years of underperformance is likely first.