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  • January 6, 2013MORGAN STANLEY BLUE PAPER MORGAN ST ANLEY RESEARCH Global 1 Scott Devitt 1 Andrew Ruud 1 David Gober 1 Joseph Parkhill 1 Kimberly Greenberger 1 Mark Wiltamuth 2 Richard Ji 2 Philip Wan 2 Timothy Chan 2 Robert Lin 2 Angela Moh 3 Geoff Ruddell 3 Edouard Aubin 3 Anisha Singhal 3 Louise SinglehursteCommerce Disruption: A Global Theme 3 Edward Hill-Wood 3 Nicholas AshworthTransforming Traditional Retail Maryia Berasneva Loredana Serra 1 3 5 Tom KierathFulfillment execution is key to realizing eCommerce’s disruptive potential. By 2016, 5 Crystal Wangour AlphaWise survey and global eCommerce model suggest a nearly 50% increase in 6 Tetsuro Tsusakapenetration of retail sales, to 9.3% (from 6.5% today), surpassing $1 trillion. As the key 1 Zachary Arrickdisruptors of the past 10 years become incumbents, their continued success hinges on 1 Nishant Vermabuilding scale and brand equity. *See page 2 for all contributors to this reportWhich companies will benefit? Amazon, eBay, MercadoLibre, and Rakuten should 1 Morgan Stanley & Co. LLCbenefit as the scale-based eCommerce platform companies. Traditional retail 2 Morgan Stanley Asia Limited+beneficiaries include Nordstrom, Sun Art, Williams-Sonoma, and eventually Walmart. 3 Morgan Stanley & Co. International plc+Niche online players like ASOS and Blue Nile could also prosper from the global, 4 Morgan Stanley C.T.V.M. S.A+ 5 Morgan Stanley Australia Limited +disruptive, long runway trend of eCommerce. For some, eCommerce is a relatively minor 6 Morgan Stanley MUFG Securities Co., Ltd.+issue. High-end apparel and footwear, price clubs, and specialty food retailers havebusiness models that seem less vulnerable to market share erosion from eCommerce.We put Costco in this category.This Blue Paper leverages insights from Morgan Stanley retail and internet analystsfrom all over the world to arrive at five key conclusions: 1) fulfillment infrastructure iscritical, 2) some categories remain resistant to change, 3) third-party marketplaces canprosper, 4) the mobile opportunity is promising, and 5) scale / brand favors incumbents. Morgan Stanley Blue Papers focus on critical investment themes that require coordinatedDriving those conclusions are the competitive advantages successful eCommerce players perspectives across industry sectors, regions,enjoy: price, selection, convenience, distribution, and cost structure. or asset classes.Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm mayhave a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factorin making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.* = This Research Report has been partially prepared by analysts employed by non-U.S. affiliates of the member. Please see page 2 for the name of each non-U.S.affiliate contributing to this Research Report and the names of the analysts employed by each contributing affiliate.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSErestrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailGlobal Internet and Retail TeamsContributors to This ReportUS InternetScott Devitt1 +1 (212) 761-3365 Scott.Devitt@morganstanley.comAndrew Ruud1 +1 (212) 761-5978 Andrew.Ruud@morganstanley.comZachary Arrick1 +1 (212) 761-4226 Zachary.Arrick@morganstanley.comNishant Verma1 +1 (212) 761-6320 Nishant.Verma@morganstanley.comUS RetailHardlinesDavid Gober1 +1 (212) 761-6616 David.Gober@morganstanley.comBranded Apparel & FootwearJoseph Parkhill1 +1 (212) 761-0766 Joseph.Parkhill@morganstanley.comSoftlinesKimberly Greenberger1 +1 (212) 761-6284 Kimberly.Greenberger@morganstanley.comFood, Drug and DiscountersMark Wiltamuth1 +1 (212) 761-8589 Mark.Wiltamuth@morganstanley.comChina InternetRichard Ji2 +852 2848-6926 Richard.Ji@morganstanley.comPhilip Wan2 +852 2848-8227 Philip.Wan@morganstanley.comTimothy Chan2 +852 2239-7107 Timothy.Yh.Chan@morganstanley.comChina RetailRobert Lin2 +852 2848-5835 Rob.Lin@morganstanley.comAngela Moh2 +852 2848-5405 Angela.Moh@morganstanley.comWestern Europe RetailGeoff Ruddell3 +44 20 7425-8954 Geoff.Ruddell@morganstanley.comEdouard Aubin3 +44 20 7425-3160 Edouard.Aubin@morganstanley.comAnisha Singhal3 +44 20 7425-7526 Anisha.Singhal@morganstanley.comLouise Singlehurst3 +44 20 7425-7239 Louise.Singlehurst@morganstanley.comEurope InternetEdward Hill-Wood3 +44 20 7425-9224 Edward.Hill-Wood@morganstanley.comNicholas Ashworth3 +44 20 7425-7770 Nicholas.Ashworth@morganstanley.comMaryia Berasneva3 +44 20 7425-7502 Maryia.Berasneva@morganstanley.comLiz A. Rich3 +44 20 7425-7082 Liz.Rich@morganstanley.comBrazil RetailLoredana Serra1 +1 (212) 761-7954 Lore.Serra@morganstanley.comJeronimo De Guzman1 +1 (212) 761-7084 Jeronimo.De.Guzman@morganstanley.comFranco Abelardo4 +55 11 3048-9609 Franco.Abelardo@morganstanley.comAustralia RetailTom Kierath5 +61 2 9770-1578 Thomas.Kierath@morganstanley.comCrystal Wang5 +61 2 9770-1195 Crystal.Wang@morganstanley.comJapan InternetTetsuro Tsusaka6 +81 3 5424-5901 Tetsuro.Tsusaka@morganstanleymufg.com 1 Morgan Stanley & Co. LLC 3 Morgan Stanley & Co. International plc+ 5 Morgan Stanley Australia Limited + 2 Morgan Stanley Asia Limited+ 4 Morgan Stanley C.T.V.M. S.A+ 6 Morgan Stanley MUFG Securities Co., Ltd.+See page 145 for recent Blue Paper reports. 2
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailTable of ContentsExecutive Summary: Retail Transformed .......................................................................................................................... 4Five Key Conclusions: Where Does eCommerce Go from Here?.................................................................................... 5Disruptive Forces and Key Stock Calls............................................................................................................................... 7Takeaways by Region ........................................................................................................................................................... 8Key AlphaWise Conclusions................................................................................................................................................ 12Segment Analysis by Region United States Internet ........................................................................................................................................................................ 14 Retail............................................................................................................................................................................ 23 Food, Drug and Discounters ................................................................................................................................. 27 Branded Apparel & Footwear ................................................................................................................................ 28 Hardlines ................................................................................................................................................................. 31 Softlines .................................................................................................................................................................. 33 Western Europe Retail............................................................................................................................................................................ 43 Retail – Luxury............................................................................................................................................................ 53 Brazil: Internet and Retail ................................................................................................................................ 54 China Internet..................................................................................................................................................................... 61 Retail ........................................................................................................................................................................ 68 Russia Internet..................................................................................................................................................................... 78 Australia Retail ........................................................................................................................................................................ 84 Japan Internet..................................................................................................................................................................... 89Key Stock Calls by Region ................................................................................................................................................... 95Morgan Stanley Global eCommerce Model......................................................................................................................... 143 3
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExecutive Summary: Retail TransformedOver the past 15 years, eCommerce has evolved understand why Amazon Founder and CEO Jeff Bezosfrom what many people believed to be a convenient suggests “it’s still Day One” for eCommerce.novelty to the single largest contributor to retailsales growth. Exhibit 1 Morgan Stanley Global eCommerce Model:During the 1990s, eCommerce was dismissed as eCommerce still has a long runway for growth, evenperipheral, yet the category grew on a foundation of low in developed marketsprices. During the early 2000s, eCommerce was tolerated and eCommerce penetration of retail saleslargely ignored even as selection increased, with an ever-broadening set of product categories moving online. By the 0% 5% 10% 15% 20%mid-2000s, the disruptive effects were readily apparent, andboth retailers and consumers alike accepted eCommerce as a South Korealegitimate alternative to traditional retail.Today, we expect traditional retail sales disruption to be a USglobal trend that may actually accelerate over the nextfour years. UK 2016eThe conclusions in this Blue Paper are supported by an JapanAlphaWise survey, a global eCommerce model, and the 2012einsights of Morgan Stanley Internet and Retail analysts from Australiaaround the world. We have examined the structural drivers of 2008 9.3%eCommerce in the largest, most relevant markets and Global 6.5% 4.0%articulate actionable stock calls on best-positioned andpotentially challenged companies. We support our stock calls Chinathrough bottom-up analysis of local competitive dynamicsamong both online and offline participants, by region. Germany 1Global eCommerce sales, as defined by Morgan Stanley , Francewill surpass $1T in 2016. From 2008 to 2012, we estimateglobal eCommerce gained 250 bps of retail sales penetration, Russiaincreasing from 4.0% to 6.5%. Looking forward over the nextfour years, we forecast that eCommerce penetration will Brazilaccelerate with an increase of 285 bps to 9.3%, by 2016. Thisinflection will be driven by high-growth emerging markets such Argentinaas Russia and Latin America as well as the destabilization ofspecialty retail in developed markets, particularly within the ChileUS and Australia.For traditional retailers, there is both good news and bad Italynews. We expect eCommerce to continue to grow at aboutfour times the rate of traditional retail sales. Importantly, some Mexicotraditional retail categories, such as food, drug, club stores,softlines and branded apparel may be relatively protected Spainfrom the more damaging impacts of online distribution.However, we expect continued deterioration in areas such as Source: Morgan Stanley Research estimates, ComScore, Euromonitor, iResearch, NAB,media and electronics. At just 6.5% of global retail, we Quantium, US Census Bureau, and national statistics from the governments and various industrial bodies of the countries listed1 Morgan Stanley defines “Global eCommerce” as the sum of eCommerce sales in SouthKorea, UK, US, Japan, China, Australia, France, Germany, Russia, Brazil, Argentina, Chile,Mexico and Spain. 4
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailFive Key Conclusions: Where Does eCommerce Go from Here?1. Fulfillment infrastructure is critical Food retailers also have been relatively insulated from new eCommerce entrants, at least thus far. Amazon Fresh (inIn the long-term, scale wins, and the right fulfillment Seattle) and Fresh Direct (in New York City and Philadelphia)infrastructure is the means to achieve scale. Whether the are the only two eCommerce companies operating at any sortcustomer is driving to the store to pickup a web-based / shop of scale in the US. Amazon may be running Amazon Fresh atin-store order or the United Parcel Service (UPS) is providing a breakeven or low operating margin and Fresh Directnext-day delivery from a nearby fulfillment center, appears to work best where the company can achievemerchandise fulfillment is quickly becoming a key focus for sufficient route density to justify the fixed distribution costsboth traditional retailers and eCommerce players. against the contribution profit of orders. In the UK, Ocado has developed meaningful scale (it is now generating sales of $1BGlobal fulfillment networks are highly capital intensive. With a per annum) and is available nationwide, however, it still hasprojected total of 87 fulfillment centers around the world, yet to prove that it can generate attractive economic returns.Amazon operates the largest multi-node, one-to-one retail Consumers in Europe (particularly the UK and France) havefulfillment network currently in existence. We estimate clearly shown that they are interested in shopping online forAmazon has invested $8-10B in its fulfillment network, not groceries and our AlphaWise survey suggests a growingcounting planned upgrades and repairs. This represents a interest from US consumers in doing so in the future, but wematerial barrier to entry for would-be competitors. That said, believe that the existing, store-based, operators are best360buy in China, Rakuten in Japan and eBay (through its GSI placed to meet this demand.Commerce asset) in the US are all investing to offerindependent fulfillment services for their third-party Exhibit 2marketplaces. The question is whether or not these Books and consumer electronics have the highestcompetitors actually have the sustainable, core-competency online penetration, while groceries and homein fulfillment logistics necessary to fulfill global ambitions. improvement are among the lowest % bought online by global respondentsTraditional retailers are not standing idly by. Select traditionalretailers, such as Nordstrom and Marks & Spencer, are Books 53%building independent fulfillment centers to support their Consumer electronics 46%eCommerce initiatives. Others are utilizing their retail storeportfolios to fulfill customer orders, either through in-store Athletic apparel 42%pick-ups of items ordered online, or “true fulfillment” from Sporting goods 40%existing store inventory. Shoes 39%2. Some categories remain resistant to change Pet supplies 38%Branded apparel, food, drug, club stores, softlines, and homeimprovement retailers appear relatively impervious to Clothing 37%eCommerce disruption. Vertically integrated branded apparel Jewelry 36%companies, such as Coach, control both manufacturing anddistribution of their products. By operating a portfolio of full- Office supplies 36%price retail stores, outlet stores, and an eCommerce site,Coach can afford to be selective with its offline and online Auto parts 35%retail partners. Club stores, such as Costco, are relatively Home furnishings 31%immune due to their high-volume, low-SKU business model.By focusing on perishable consumables and low markups on Home improvement 29%bulk items, Costco is able to drive earnings growth throughincreased member growth and member fee increases while Personal care 28%maintaining high inventory turnover. Groceries 22% Source: AlphaWise, Morgan Stanley Research 5
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail3. Third-party marketplaces can prosper Smartphone penetration is highest in the US and UK. Not-The success of owned-inventory eCommerce sites (“first surprisingly, eCommerce sales through mobile devicesparty,” or 1P) versus third-party marketplaces (3P) varies by represent 10-12% of all eCommerce purchases in thoseregion. The US and Western Europe have seen success in countries, which is at least 2-3x the rate for emergingintegrated eCommerce platforms, 1P+3P, dominated by markets. According to comScore, US mobile eCommerceAmazon, although eBay has re-emerged as a capable 3P- penetration has grown from 2% in 2Q10 to 10% in 3Q12.only competitor. While one could argue that selling owned eCommerce companies are beginning to disclose their owninventory alongside third-party sellers creates a conflict of smartphone eCommerce penetration. eBay, for example,interest, there are benefits to being a market maker. estimates about 13% of GMV will be purchased via aAmazon’s owned inventory business helps it set market smartphone in 2012, of which the company estimates 1/3 ispricing for third-party sellers. While this could mean lower incremental to desktop GMV. The company has alsoprofits on a unit basis for third-party sellers, it drives lower developed an app that simplifies the listing process, whichprices in the marketplace, which drives greater customer enables the company to gain traction with sellers, as well.adoption, leading to increased third-party sell-through. Exhibit 4In markets like South Korea, China and Japan, 3P continues comScore estimates 10% of eCommerce sales into lead. However, third-party marketplaces in these markets the US were made on a mobile devicetend to have an inability to bundle orders (meaning products US eCommerce ($B) Percentage Spent via Mobile Devicesare delivered from a variety of sellers) making it tough to $60 12%compete with owned inventory players on delivery speed and $50 10%consistency of experience. Therefore 3P marketplaces,particularly Rakuten, are aggressively investing in building a $40 8%fulfillment network. While MercadoLibre management $30 6%recognizes the value of offering fulfillment, the company doesnot have plans to do so in the near-term. $20 4% $10 2%4. Mobile eCommerce: A promising opportunity –for both online and traditional retailers $0 0% 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12While mobile can represent an extra layer of convenience, via Source: comScore, Morgan Stanley Researchthe ability to purchase anytime / anywhere, it can also havethe opposite effect, as 1) entering billing and shipping Mobile can also benefit traditional retailers. By equippinginformation can be cumbersome and 2) given smaller screen clerks with mobile devices, shoppers can speed upsize, the app must be highly intuitive. We believe larger purchasing by skipping the checkout line. It can also helpcompanies, with the resources to develop well-designed apps provide better inventory management when combined withthat integrate customers’ existing account information can technologies like radio frequency identification.generate incremental sales. 5. Scale / Brand: The big should get biggerExhibit 3Smartphone penetration by geography Traditional retailers benefit from legacy brand and storeSmartphone installed base as a % of mobile subscriber base footprint. Online retailers that can achieve scale (which is Smartphone penetration by region North America rare) benefit from brand awareness, effective online customer 74% service, and a more variable cost structure. The admittedly small number of instances of scale success, albeit with Western Europe 66% significant economic value creation, include Alibaba, Amazon, eBay, MercadoLibre, and Rakuten. Our scale / brand China conclusion is that online retail may ultimately have more 55% consolidated market share than offline retail favoring large Latin America 47% players. In this context, traditional discount retailers may be Eastern Europe best positioned to participate in the consolidation of specialty 37% retailers. Companies such as Costco and Walmart represent material distribution points for many global brands, and it may 05 06 07 08 09 10 11 12e 13e 14e 15e be difficult for eCommerce to disrupt the scale advantages ofSource: Company data, Gartner, IDC, Nielsen, Morgan Stanley Research larger, established traditional retailers. 6
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailFive Disruptive Forces Summary of Top Stock Calls Exhibit 5Consistent across our AlphaWise survey and geography-specific The companies listed below either exemplify – orresearch, we have identified five forces that have driven eCommerce lack – execution of the five disruptive forcespenetration. Best-Positioned US Internet1. Price Amazon Most disruptive force in eCommerce; continued share gainMany retail items are pure commodity products – consumers like to buy Blue Nile Leader in engagement; opportunity in non-engagement eBay Largest global marketplace; accelerating GMV growthsuch items at the lowest possible price. The Internet and smartphones US Retailhave taken price comparison to an entirely new level. Companies like Costco Highly defensible merchandising strategyAmazon have capitalized on the preference for low prices by working to Macys Industry-leading multi-channel sales strategybe able to afford to offer low prices over time on an ever-broadening Nordstrom Best in class operator with long-term growth initiativesvariety of products. Walmart Low price leader; build or buy stronger online positioning Williams-Sonoma Strong furnishing brands benefit from "showrooming"2. Selection Urban Outfitters Leading mobile / online initiatives; expect margin rebound Under Armour Expect 20%+ revenue growth from new sales initiativesOnline offers the opportunity for vast selection given there is no constraint Western Europe Retailof shelf space. The selection preference favors online, although offline ASOS Most visited apparel website in the worldretailers are now expanding their own virtual shelf space using their own Latin Americawebsites. MercadoLibre* Largest pure play eCommerce marketplace in LatAm3. Convenience Japan Internet Rakuten Largest eCommerce player in Japan; strong track recordOnline offers a level of convenience not available in offline retail, China Retailparticularly in the current environment of accelerated delivery programs. Belle Best-positioned to be leading specialty retailer in ChinaOffline retail has pushed back with initiatives such as ship-to-store to Intime Leading dept store chain with dominant market shareleverage store footprint. Sun Art Consolidating food industry; defensible from competition4. Distribution Potentially ChallengedOnline offers the ability for a merchant to gain global distribution in an US Retailinstant – it is not limited by the constraint of a store footprint. To be sure, Bed, Bath & Beyond Decentralized distribution; lacking eCommerce initiatives RadioShack Pressure from carriers / handset makers; strong competitiona store base heightens brand awareness, which has led to online Australia Retailaggregation points online. David Jones Highly exposed to online sales leakage due to high prices5. Cost structure JB Hi-Fi High exposure to consumer electronics Harvey Norman Minimal online presence; expected share lossTraditional retailers require stores, while online retailers require China Retailmarketing spend to become a destination. At scale, there are benefits Li Ning Focus on sportswear brand; lacks omni-channel strategyto online in that sales marketing efficiency leads to an overall lower *MercadoLibre is covered by Scott Devitt.cost structure than offline peers. Achieving scale is the difficult part. Source: AlphaWise, Morgan Stanley Research 7
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailSummary of Key Takeaways:United StatesInternet Key stock calls: Amazon, Blue Nile, eBay (best-positioned) 1. Over the next five years, logistics and fulfillment innovation should determine the level of disruption of traditional retail. 2. Structural and socioeconomic demographics determine the company-specific strategy an eCommerce retailer will have to lead with in a specific market; in the US, fulfillment is crucial. 3. Investments that improve an eCommerce retailer’s ability to offer low prices, broad selection and increased convenience will likely lead to higher sales growth, albeit at a potentially lower margin.Retail – Hardlines Key stock calls: Williams-Sonoma (best-positioned), and Bed Bath & Beyond and RadioShack (potentially challenged) 1. eCommerce penetration for the consumer electronics category is high (47%), and likely to keep increasing. 2. About 30% of home furnishings buyers shop online. Williams-Sonoma is well-positioned (33% of total sales online) while Bed Bath & Beyond is not, given 1% of revenue online, decentralized distribution, and high skew of branded, easily price-comparable products.Retail – Branded Key stock calls: Under Armour (best-positioned)Apparel 1. As brands control their own distribution, they remain largely insulated from typical pressures from pure online competition. 2. eCommerce provides a key means to enter markets internationally and elevate brand awareness with new users.Retail – Softlines Key stock calls: Macy’s, Nordstrom, and Urban Outfitters (best-positioned) 1. A secular shift towards eCommerce has compelled apparel retailers to develop, expand, and enhance their online platforms. 2. Softlines retail is one of the most defensible retail categories against online-only competition.Retail – Food, Drug Key stock calls: Costco and Walmart (well-positioned)and Discounters 1. Costco and the club stores can still thrive due to low prices and focus on perishables that are not easy to ship. 2. We believe Walmart has the potential to become a global leader in eCommerce sales, due to its buying power and ability to buy or build its way to a stronger competitive position. 8
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWestern EuropeRetail Key stock calls: ASOS (best-positioned) 1. Online penetration varies significantly across Western Europe. About 15% of non-food sales and 5% of food sales now occur online in the UK (one of the highest rates in the world), but in Southern Europe, online spending remains minimal. 2. "Click and Collect" services are proving very popular in both the UK and France, though it is not yet clear whether this is merely because these services are offered for free by most retailers. 3. The impact of the online shopping revolution in the UK goes well beyond the retail industry. It is beginning to have a profound impact on the property industry and, increasingly, on the very fabric of society.Latin AmericaInternet and Retail Key stock calls: MercadoLibre (best-positioned) 1. Growing middle class penetration should drive future eCommerce growth. 2. Price and convenience have been the main drivers of adoption so far; shipping, payment terms, and security can drive further growth. 3. High penetration of high-ticket electronics/appliances currently but significant room for growth in new lower-ticket categories. 4. Traditional linked retailers dominate eCommerce space in Brazil; core customers vary significantly by site. 9
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailChinaInternet Key stock calls: None 1. We believe eCommerce in China will continue to benefit from increasing domestic consumption and higher online shopping penetration. 2. eCommerce currently represents about 5% of China’s total retail sales. Compared to the developed countries (10-12% for US and UK), China is relatively underpenetrated and has significant room for upside. 3. As B2C marketplaces enjoy higher scalability, broader product selection, and wider customer bases, they should continue to gain traction and share in China’s eCommerce market. 4. Chinese eCommerce leaders are enjoying robust market expansion but suffer from weak margins because of intense competition, lack of scale, and large investments in customer acquisition and fulfillment capacity.Retail Key stock calls: Belle, Intime, Sun Art (best-positioned); Li Ning (potentially challenged) 1. A higher level of offline market concentration translates into a higher risk of disruption from online players. The sub-segments from highest to lowest risk in China are consumer electronics (highest), department stores (medium), and hypermarkets (lowest). 2. The key challenges for a majority of eCommerce players in China are lack of scale, lack of differentiation, and a fast pace of cash burn, potentially leading to multiple years of losses and multiple rounds of fundraising. Therefore, offline players that are well-capitalized with strong cash flow generation have ample means to invest in their online operations to take part in the eCommerce growth. 3. Brands that control their retail channel by operating their own stores and efficiently managing inventory appear well-positioned to capture share in the eCommerce channel. 4. Marketplace focus: Unlike the US, about 80% of eCommerce market share in China is dominated by a marketplace-driven ecosystem. This creates retailing complexity and conflicts for brands that adopt a multi-layer wholesale business model to distribute their products. 5. “Smarter” shoppers: We believe retailers and brands in China will focus more on mobile than pure online. 10
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailRussiaInternet Key stock calls: None 1. Russia’s nascent eCommerce sector is approaching a tipping point, with penetration increasing from 2% to 5% of retail sales by 2016. 2. Key drivers are increasing broadband penetration and credit card usage. Distribution remains the major barrier to growth. 3. A vibrant local eCommerce ecosystem is emerging, with search, classifieds, payments, and key eCommerce verticals such as Fashion and Travel. 4. Market leader Ozon is among the fastest-growing and dynamic private eCommerce companies globally.AustraliaInternet Key stock calls: David Jones, JB Hi-Fi, Harvey Norman (potentially challenged) 1. eCommerce has permanently reshaped the retail landscape in Australia through greater price transparency and access to global retailers. A trend unique to Australia is the large amount of offshore buying, given lower pricing relative to local retailers. 2. We expect continued solid growth for eCommerce, given the relatively low starting point and high retail cost base (labor and rent), leading to ongoing price differentials. 3. Non-food retailers are potentially challenged (JBH, HVN, DJS, and MYR). Conversely, supermarkets (WOW, MTS, and WES) appear least vulnerable to market share loss to eCommerce competition.JapanInternet Key stock calls: Rakuten (best-positioned) 1. Robust eCommerce growth amidst stagnating retail sales highlights the attractive dynamics of the eCommerce market in Japan. 2. Rakuten and Amazon are the dominant eCommerce players and are poised to continue taking market share from offline retail players. 3. Marketplace business models, such as Rakuten and Yahoo! Japan, are aggressively investing in logistics and fulfillment to compete with hybrid market-maker / marketplace models, such as Amazon. 11
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailKey AlphaWise Conclusions1. Pursuit of “value” and “convenience” is universal Currently about 90% of online orders are fulfilled via deliverymotivation that continues to drive eCommerce to a home or work address. Although in some markets manyOf the 6,000+ online shoppers we surveyed across eight online shoppers have had the experience of ordering onlinemarkets, 49% think the top reason to shop online is “it’s and picking up in stores (UK 39%, US 33%), only one in fivecheaper,” while 34% think it’s “to save time” or the ability to globally would prefer in-store pickup to delivery.“shop from anywhere at any time.” Return/exchange is an area where stores leverage theirSimilarly, the formula for success as an online retailer is physical presence. One of the biggest obstacles tolargely the same across markets – “low prices,” “broad eCommerce everywhere is the notion that it is easier to returnselection,” “easy to use website,” and “free shipping” are the products if bought in stores. Consumers overwhelminglytop reasons consumer pick their “favorite” online retailers. (75%) prefer not having to pay shipping for return/exchange. Sixty-two percent would buy online more often if they couldConsumers’ quest for cost-/time-saving will continue to propel return or exchange products at a store.eCommerce – 65% of online shoppers feel it is increasinglymore advantageous to buy most products online. 5. Category vulnerability varies by market2. In emerging markets, eCommerce needs to close the Books have the highest online penetration among over a“trust” gap dozen product categories in all but three emerging markets: ,Consumers in emerging markets are much more likely than Brazil, China, and Russia.their counterparts in developed markets to mention lack of Consumer electronics (CE) is also highly penetrated acrosstrust as an obstacle to buying on line, such as in the security all markets. Interestingly, a higher percentage of emergingof online payments (32% in EM vs. 27% in DM), online market CE buyers bought online than those in developedmerchants (23% vs. 14%), quality of online merchandise markets (66% EM vs. 55% DM).(21% vs. 12%), or worry-free shipping (24% vs. 9%). Inemerging markets this “trust gap” outweighs lack of credit Buying apparel is immensely popular in China. In the last 12cards (15%) or “delivery takes too long” (17%). months, 91% of urban mass-affluent Chinese consumers bought clothing online. And among shoe buyers, 82% bought3. Consumers want “free” shipping more than “fast” online; for athletic apparel, the figure was 73%.shipping While groceries remains one of the most insulated categories,Globally, 80% of online shoppers would choose the cheapest many consumers in densely populated markets have begunshipping options, while just 22% are willing to pay more for experimenting with online buying (44% in Japan, 29% in UK).faster shipping. Free shipping is already ubiquitous indeveloped eCommerce market such as the US and UK, andwe expect it to become standard elsewhere, as theoverwhelming majority in all markets surveyed (86%) think Core Questions for Evidence Researchthey would buy more online if retailers offer free shipping.  How are consumers shopping online today?“Same day shipping” seems to have limited appeal in  How do consumer attitudes toward online shopping differ?developed markets, but interestingly could be a strong  Which categories are more vulnerable to online threat?stimulant for eCommerce in emerging markets, which stillbattle the “trust” issue. What Gives Us Confidence  In Oct-Nov 2012, we conducted an online survey of 8,000+4. Physical stores can be a strategic asset in an omni- consumers in 8 countries. The survey sample is representativechannel retail world of the 18+ population by gender, age, geography and income inThe success of the Amazons of the world proved that the Australia, Germany, Japan, Russia, UK and US. Respondents in Brazil are a national sample of online consumers from the A,absence of physical locations is not a handicap and B & C socio-economic classes, and in China, online consumersconsumers can be “channel-neutral” so long as their need for from 14 Tier 1&2 cities with above-average education andvalue, convenience, and selection is met. Not surprisingly, income. At about1,000 sample size, conclusions based on the total sample of each country have a maximum margin of erroropinions are divided on the importance of physical stores – of +/- 3% at 95% confidence level.35% prefer buying online from retailers with brick-and-mortarpresence, while 23% prefer online-only stores. 12
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMORGAN STANLEY BLUE PAPEReCommerce Disruption: A Global ThemeSegment Analysis by Region 13
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailUS InternetScott Devitt – while comparable traditional retail sales haveAndrew Ruud grown at just 4% over the same period. eCommerceZachary Arrick outperformance has led to significant market shareNishant Verma growth from 2% to 11%, over the same 12 year period. eCommerce market share gains are a result of both structuralExecutive Summary / Key Takeaways and traditional retail industry-specific factors that have allowedBest Positioned: Amazon, eBay, and Blue Nile eCommerce companies to evolve their business models around driving efficiencies and customer service.1. Over the next five years, logistics and fulfillment innovation will determine the level of disruption of traditional retail; Amazon is best- The US has specific structural characteristics that have positioned to breakaway from competing traditional retailers and allowed traditional retail to thrive eCommerce players that do not have a vertically integrated The US consumer may be the single most influential customer fulfillment network. demographic in the world. She has disposable income, access to consumer credit, is relatively well educated and has2. Structural and socio-economic demographics predetermine the the luxury of optionality and choice. Most importantly, the US company-specific strategy an eCommerce retailer will have to lead consumer is ubiquitous, living not only on the East and West with in a specific market; in the US, fulfillment is crucial. coasts but also in Middle America. This has had a significant3. Investments that improve an eCommerce retailer’s ability to offer low impact on the evolution of the contemporary traditional retail prices, broad selection and increased convenience will likely lead to strategy. higher sales growth; albeit at a potentially lower margin. Amazon has traditionally led the way – so far there has been no proof of any Exhibit 7 competing eCommerce or traditional retailer that is willing to do so at The US economy is the largest in the world at 22% that level. of global GDP… US 22%Exhibit 6 China 10%eCommerce penetration continues to grow steadilyand appears to have a long runway to go Japan 8% eCommerce penetration: (US$ tn) 2.0 12% Germany 5% 10% France 4% 1.5 8% Rest of World 51% 1.0 6% Source: World Bank 4% A large economic GDP in and of itself does not signify a 0.5 large potential traditional retail opportunity 2% Large GDP economies certainly have the greatest potential 0.0 0% also to be large markets for consumer consumption. Global Sep-00 Mar-02 Sep-03 Mar-05 Sep-06 Mar-08 Sep-09 Mar-11 Sep-12 GDP is highly concentrated among the top five GDP Adj. Retail Sales eCommerce Sales eCommerce Penetration economies. Unsurprisingly, these top five economies are alsoSource: US Census Bureau, Morgan Stanley Research often cited as key retail markets for global brands and retailers.Over the past 12 years, eCommerce salespenetration of traditional retail sales hasexperienced a compound annual growth rate of 20% 14
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 8 Exhibit 10…and the US also derives the greatest proportion US household wealth is higher in smaller cities /from household consumption, relative to peers towns, where population density is lower 2010 Household expenditures / GDP Average median household income by city population 80% 56,000 54,000 60% 52,000 40% 50,000 48,000 20% 46,000 0% 44,000 US Japan France Germany China Straight WeightedSource: US Census Bureau, OECD and World Bank Below 500K Above 500K Source: US Census BureauHousehold consumption expenditures drive traditionaland eCommerce sales The retail opportunity is “Middle America,” whereThe US leads all major global economies in terms of gross populations are lower and so is population densityhousehold consumption as a percentage of GDP. This Most developed economies, outside of the US, havecoupled with the fact that the US is the largest global GDP demographics that are higher in both population density aseconomy in the world, is precisely why the traditional retail well as urban household expenditures vs. non-urbansales opportunity is so large. We believe that emerging household expenditures. Therefore, the obvious internationalmarket economies have substantial upside to grow household eCommerce opportunities are typically in developed countriesconsumption as middle-class demographics evolve. where population density is high, total household / personal consumption expenditures is large and household / personalExhibit 9 consumption expenditures per capita is high. The US isThe vast majority of the US population does not live unique in that its middle-class demographic residesin areas of high population density throughout the country. This results in “Middle America” being Density per sq. mi. as % of total population a crucial component to the growth strategy for any retailer. As 12,000 the preceding exhibit indicates, household income in population centers below 500,000 people is actually higher 10,000 than those above 500,000 people. 8,000 Exhibit 11 6,000 Building a mass-market retail presence requires a 4,000 large store portfolio Average US store count 2,000 4,784 4,515 0 5% 10% 15% 20% 100%Source: US Census Bureau, World BankThe US is unique in that it is the largest economy in the 2,334 2,004world but has low population density 1,611Most large, global economies leverage population density into 1,166 1,111 993high levels of worker productivity and therefore cost-adjustedoutput. The US is unique in that its consumers reside all 84across the country, which weighs negatively on population Drug/ Auto Broadlines Home Hardlines Grocery Softlines Dept. stores Luxurydensity. Vitamin parts improvement Source: Company Data, Morgan Stanley Research 15
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailTraditional retailers must invest significant resources in expansion of the middle-class’ broadband connectivity hasorder to address the fragmented US population accelerated the secular transition of traditional retail toIn order to reach critical mass and address the entire US eCommerce.population, traditional retailers must either invest massiveamounts of capital to build out a store base or finance off- Fulfillment assets, while not cheap, are relatively lessbalance sheet operating leases. With very few retailers expensive as compared with retail storefrontsowning a substantial portion of their stores, rent and We estimate that a fulfillment center may cost about $30 peroccupancy costs represent sizable expenses for most square foot to buy / build the housing. We estimate that anretailers. Physical store footprints create a unique opportunity Amazon fulfillment center of 1MM square feet would requirefor eCommerce businesses since they can leverage $75-100MM for automation equipment. Despite $100-130MMcentralized inventory management in fulfillment centers to build out a fulfillment center, we believe companies such asinstead of incurring the large fixed costs associated with the Amazon are able to optimize the fulfillment asset andrent and occupancy expenses. For US department stores that generate higher inventory velocity as well as manage itspay very little rent expense, we believe eCommerce payable terms better to generate a higher cash return on thecompanies have inventory management advantages. cash investment.Structurally, the domestic eCommerce retail channel also Freight forwarding / logistics are at least partiallyenjoys favorable characteristics subsidized by the Federal and state governments.eCommerce consumers tend to be of a higher income The US is fortunate to have a strong infrastructure of roads asdemographic. On the back-end, the US still offers relatively well as commerce-friendly regulatory bodies that oversee bothlow-cost land and buildings to develop a fulfillment network. the rails and aviation space. These strengths allow freightFinally, states bear the burden for public infrastructure; the forwarders such as FedEx and UPS to operate at peakFederal Government subsidizes the US Postal Service and efficiency. Additionally, the Federal government oversees thethere are two very reliable, global freight forwarding / logistics US Postal Service, which is also leveraged by eCommercecompanies in FedEx and UPS to deliver eCommerce companies.packages. eCommerce was born out of inefficiencies in theExhibit 12 traditional retail channelBroadband penetration and household income By exploiting these inefficiencies and developing customer-distributions are at parity centric innovation by providing low prices, broad selection and Distribution of broadband users and households by income increased convenience, eCommerce was able to disrupt the 100% status quo. 80% Centralized, fulfillment-based inventory allows for an almost infinite selection of merchandise 60% $100K+ Wide product selection allows mass-market adoption by $75-100K $25-75K providing “something for everyone”. This, in turn, usually 40% $15-25K drives incremental sales volume as customers visit first to buy 20% $0-15K a specific product but then stay and shop for other items due to the breadth of selection. Discount retailers such as Walmart 0% and Target leveraged this selection-based business model Broadband users US households and incrementally built upon it when they expanded intoSource: US Census Bureau, Morgan Stanley Research grocery. Wide selection, however, usually implies high levels of inventory holdings. The leaner a company can run itsThe primary demographic responsible for the majority of inventory, the lower risk it takes on any given stock keepinghousehold expenditures now also has broadband unit (SKU) and the broader the selection of SKUs theconnectivity company can offer. The biggest problem a traditional retailerFrom 2004 to 2011, broadband penetration of households faces is that each store must carry the full line of merchandisewith income of $75K+ has more than doubled. During that or it risks losing the sale to a competitor. An eCommercesame time-period, broadband penetration of households with company, however, effectively has only its fulfillment centersless than $75K grew less than 50%. We believe the to stock (assuming each carries the same merchandise, 16
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailwhich is often not the case). Amazon operates the largest Exhibit 14domestic fulfillment network, by far, totaling 30-35 fulfillment Amazon’s working capital spread, measured incenters. By comparison, the average discount retailer has days, has been extremely stable for over 15 years Inventory vs. payable days (through Sep-12)about 2,000 stores. 80Exhibit 13 70Amazon’s centralized inventory appears to drivemore efficiencies vs. Target’s decentralized model 60 Payable Inventory turnover (through FQ3:2012) 50 days 45x 40 40x 30 35x Inventory 20 days 30x 25x 10 20x -- 15x Dec-97 Jul-99 Feb-01 Sep-02 Apr-04 Nov-05 Jun-07 Jan-09 Aug-10 Mar-12 10x Source: Company Data 5x Amazon has negotiated favorable payment terms, --x 1997 1999 2000 2002 2003 2005 2006 2008 2009 2011 offsetting the inventory-related “growing pains” Amazon Target Despite inventory turns declining over time, it is apparent thatSource: Company Data, Morgan Stanley Research the company does not necessarily manage to working capital metrics, but rather to a level of operating risk management.Amazon has enjoyed high inventory velocity over time, For over 15 years, Amazon has consistently managed itsbut “growing pains” are evident cash conversion cycle to a negative 30 days. We believeIt is difficult to argue against Amazon’s ability to drive investors and business operators alike would be hard-pressedinventory management efficiencies through its fulfillment to find another example of such a stable cash conversionnetwork. The chart above compares Amazon to one of the cycle for over 15 years, given the level of growth the companymore efficient discount retailers in the US, Target. One cannot experienced in that timeframe.help but notice the degradation in inventory turnover throughthe course of Amazon’s reported history. We do not believe eCommerce is not limited to owned-inventory models;this is in and of itself a bad thing; in fact, we see this as a third-party marketplaces also succeednatural side effect of the company growing into a broader set It is economically impractical for an eCommerce retailer toof product verticals. Going forward, we expect Amazon’s always have every SKU in stock. A third-party marketplaceinventory turnover to stabilize or even inflect upward as the allows an eCommerce company to “carry” an infinitelycompany continues to build fulfillment centers closer to the scalable selection of merchandise and may operate as aend-customer. standalone business in the case of eBay or a complementary business in the case of Amazon.Best-in-class eCommerce retailers tend to generate cashthrough negative cash conversion cyclesBecause of their relatively fewer fulfillment centers (vs. retailstores) and the benefits of centralized inventory, eCommerceretailers have the opportunity to generate very high levels ofinventory velocity while maintaining comparable paymentterms to those of a traditional retailer. If managed correctly,this can generate a positive cash float that increases so longas sales growth continues and the spread between inventoryand payable days stays negative (days inventory, minus dayspayable). 17
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 15 Exhibit 16Amazon’s growth in third-party units allows more Amazon has lower owned-inventory merchandiseprofit dollars to be invested into first-party growth gross margins than Target and Walmart TTM first-party / third-party paid unit mix (bn) Comparable merchandise gross margins 3.5 35% 3.0 3P Units 30% 1P Units 2.5 25% 2.0 20% 1.5 15% 1.0 10% 0.5 5% -- --% Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- 02 03 04 05 06 07 08 09 10 11 12 TGT WMT AMZN 2009 2010 2011Source: Company Data, Morgan Stanley Research Source: Company Data, Morgan Stanley ResearchCombined with its owned-inventory, Amazon’s third-party Amazon’s primary strategy for taking market share frommarketplace significantly extends selection traditional retailers is leading with low pricesAmazon’s third-party marketplace plays two important roles We find the preceding exhibit particularly telling as groceryfor the company. 1) The marketplace backfills SKUs that are constitutes 19% and 55% of Target and Walmart’s sales mix,inefficient to sell through the company’s owned-inventory while Amazon provides grocery only in Seattle, Washington.business, as well as SKUs that are temporarily out of stock. 2) Amazon does not employ an everyday-low-pricing strategy,Amazon realizes marketplace revenue on a net fee basis and however. The company is very mathematical in pricing itstherefore has very few direct costs associated with generating merchandise and scrapes other websites as well as monitorsa marketplace sale. This allows the company to generate unit sell-through at the SKU level. Amazon sets pricing withprofit dollars that enable it to subsidize lower prices and more such precision that other retailers, both eCommerce andconvenience (better shipping terms) for Amazon’s first-party traditional retail, actually calibrate their pricing to be in linecustomers. with Amazon pricing in order to stay competitive. For this reason, we often think of Amazon as the market maker forLow prices usually win retail sales retail pricing.Any consumer will tell you that paying less for a product is toppriority. eCommerce businesses do not have physical product eCommerce only works if the overall level of conveniencedisplays nor do they have a friendly sales associate who can is higher than shopping in-storedemo a product in real-time with a prospective buyer. For this Shopping in-store has its benefits, including being able toreason, they must win the customer over by leading with low physically see and touch as well as ask questions about theprices. In our AlphaWise survey, lower online pricing was the product and the instant gratification of being able to walk outmost frequently cited reason for shopping online (41% of of the store with the product immediately. The bar for qualityrespondents placed it in their top three). of experience is set rather high for an eCommerce company to win the sale, especially if the company does not have a price or selection edge. To meet and exceed consumer expectations, eCommerce retailers have invented numerous ways of reducing transaction friction. Some key examples include Amazon’s well-known “Buy now with 1-Click” button, Amazon Prime, the company’s two-day shipping subscription, eBay’s integration of PayPal, real-time shipment tracking, free return shipping (case-by-case basis), and product recommendations. 18
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 17 (GMV) growth. eBay launched its TRS program in 2008, withAmazon Prime continues to be a catalyst for driving the goal being to improve customer service by offeringsales growth 9/14/11 incentives to merchants to undertake initiatives that would Amazon Primes effect on net sales per account -Spain enhance the customer experience. Some examples are free $350 11/23/10 -Italy shipping, allowing 14-day returns and requiring merchants to 10/1/08 $300 -France achieve a high feedback approval rating. If merchants meet 11/5/07 6/8/07 -UK these criteria, they would be given a discount on their seller $250 2/2/05 -Japan -US -Germany fees, and a higher ranking in customer search results. $200 Net Sales / Account TRS SSS grew, on average, 24% faster than GMV $150 Prime Launch growth in the first year eBay reported the data $100 This encouraged more merchants to obtain the “TRS Badge,” Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- Sep- and reap the benefits of faster growth. Over the next two 00 01 02 03 04 05 06 07 08 09 10 11 12 years, as the TRS program became more widespread, the difference between TRS SSS and GMV growth decreased toSource: Company Data, Morgan Stanley Research 8%. Since beginning to disclose TRS data, TRS sellers have outperformed US GMV by about 12%, and comScoreAmazon Prime changed the game for eCommerce eCommerce by 8 percentage points.When commerce over the Internet began, there were manyparallels to the prior norm of catalog shopping, including the In the chart below, we compare eBay’s TRS same-store-salestypical 7-10 business day delivery time. Amazon changed all (SSS) growth to overall US GMV growth and comScore’s USof that with the advent of Amazon Prime in February 2005. eCommerce estimate.The concept was simple: Introduce a fixed hurdle by chargingAmazon customers $79 per year in exchange for unlimited 2- Exhibit 18day shipping with no order minimums on goods sold by eBay’s US GMV growth has historically performedAmazon or qualifying third-party merchants. Customer order below comScore US eCommerce estimates, whilefrequency increased dramatically, effectively “amortizing” the top rated sellers have outperformedpsychologically meaningful $79 fee over the course of the Quarterly y/y growthyear. The need to “find things” in order to buy more and 30%thereby justify the $79 encouraged consumers to look toward 25% TRSAmazon as a search domain for merchandise, a phenomenon 20%that continues to this day. The company has since introduced 15% comScoreAmazon Prime in Japan, the UK and Germany in 2007, 10% eCommfollowed by France in 2008, Italy in 2010 and Spain in 2011. 5% US GMV 0% (ex-auto)In 2008, eBay’s Detailed Seller Ratings (DSRs) and -5%Top Rated Seller (TRS) programs were developed to -10%improve consistency of service -15% Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11 Mar-12DSRs allow a buyer to leave more specific feedbackabout the seller after a transaction has been completed Source: Company Data, comScore, Morgan Stanley ResearchIn eBay’s transaction rating system, buyers appoint 1-5 starsto four aspects of the transaction: item description accuracy, Next, we show the proliferation of TRS growth. TRS’satisfaction with the seller’s level of communication, shipping contribution to US GMV has increased from 25% to almostspeeds and shipping charges. High DSRs are one 50% over the past three years. The dip in 3Q12 was a resultrequirement of a merchant becoming a TRS. Other conditions of the implementation of stricter TRS standards, whichinclude uploading package tracking information and rarely reduced the number of merchants that qualified for the TRSbeing the subject to buyer complaints, or “Buyer Protection” designation.cases.The most easily measurable improvement from eBay’s firstphase of change is the TRS’ same store sales (SSS) growth,which we can compare to US Gross Merchandise Value 19
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 19 eBay’s renewed focus on improving customer serviceeBay’s TRS’ GMV has increased share of total eBay and user trust also drove inflections in active user andUS GMV paid unit growth TRS GMV as % of US GMV From 2001-09, as shown in Exhibit 20, eBay experienced 60% consistent deceleration in items sold and active user growth. 50% The causes were primarily due to decreasing product supply (fewer merchants as a result of eBay raising seller fees), 40% prevalence of illegal merchandise (and less high-quality 30% goods) and system gaming (e.g., pricing an item for $1 with 20% artificially high shipping cost). All of these issues were 10% compounding, with the backdrop of Amazon ramping its third- party / Fulfillment by Amazon (FBA) marketplace. eBay 0% Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 attempted to fix these issues with the TRS program but also added a key feature to increase trust: Buyer protection (BP).Source: Company Data, Morgan Stanley Research BP offers no-questions-asked reimbursements to customersHowever, neither fast shipping, nor TRS, was solely for purchases that are not received or are not as described inresponsible for the eCommerce disruption of the listing.traditional retailDespite Amazon resetting consumer expectations with Accelerating “sold items” and “active users” could implyAmazon Prime, it was the combined effect of broad selection, future GMV accelerationtrust, and convenience that drove Amazon and eBay’s growth Sold items, which have grown at rates faster than users andover the past 7-8 years. GMV, implies current users are purchasing more frequently, albeit at a lower average selling prices (ASP). Active userAmazon’s unit sales began accelerating as the company growth has accelerated for five consecutive quarters,increased selection and convenience highlighting that these changes have both reduced churn andAs Amazon continues to increase the breadth of product helped eBay increase network effects.categories, consumer convenience also benefits. With amerchandise assortment that rivals discount retailers, Exhibit 21Amazon is now a one-stop destination for shoppers. We can … and as a result of its customer service initiatives,see that as assortment and Amazon Prime adoption eBay’s sold items began to inflect in 2008 TTM worldwide paid units vs. average active customer accountsincreased, the number of units purchased vs. the number of 800customer accounts drastically decoupled from one another. 700Exhibit 20 600Amazon’s inflection point for convenience was 500during 2005, the year Prime was introduced… TTM worldwide paid units vs. average active customer accounts 400 300 2,500 200 TTM indexed worldwide paid units TTM indexed worldwide paid units TTM indexed average active customer accounts 100 TTM indexed average active customer accounts 2,000 0 01 02 03 04 05 06 07 08 09 10 11 1,500 Source: eBay, Morgan Stanley Research 1,000 Just as Fulfillment-by-Amazon enables third-party 500 merchants to sell goods on Amazon more efficiently, PayPal enables merchants to better -- convert customers on their own sites. Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- 00 01 02 03 04 05 06 07 08 09 10 11 While PayPal’s US growth has been predominantly off-Source: Company Data, Morgan Stanley Research eBay, it helped eBay maintain its relevancy 20
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMerchant Services Transaction Processing Volume (TPV) is Exhibit 23defined as the total dollar volume of PayPal’s payments PayPal’s penetration of eBay GMV has steadilycompleted off ebay.com and GSI (a wholly owned eBay increased since 2006 PayPal On-eBay penetrationsubsidiary). In the chart below, we show PayPal Merchant 100%Services TPV has increased twelve-fold since 2005, while on-eBay TPV has roughly doubled. Merchant Services TPV 90%growth is a result of increasing the number of online stores on 80%which it is offered and gaining share within those stores. 70%Exhibit 22Merchant services TPV has grown approximately 4x 60%faster than On-eBay TPV 50%Indexed LTM worldwide TPV ($ bn)1,000 40% 800 30% Jun Dec Jun Dec Jun Dec Jun Dec Jun 600 -08 -08 -09 -09 -10 -10 -11 -11 -12 Source: Company Data, comScore, Morgan Stanley Research 400 Outbound shipping is not cheap, and Amazon is in the 200 process of trying to reduce it 0 While Amazon Prime has driven unit sales up, exponentially, Jun-06 Dec-07 Jun-09 Dec-10 Jun-12 it has also created a material economic burden for the Merchant Services On-eBay company. Over the last 12 months, Amazon spent nearly asSource: Company Data, Morgan Stanley Research much on shipping as it expensed on fulfillment.PayPal provides an attractive value proposition to both Exhibit 24merchants and customers, which is evident from an Amazon’s shipping costs represent a monetizableincrease in eBay GMV penetration opportunity to increase profitabilityFirst, for merchants, PayPal’s payment service costs about TTM fulfillment expense (US$ mn)the same, or slightly less, than credit cards. Further, PayPal 2 R = 0.9983 7,000reduces “checkout abandonment,” where customers leave thecheckout page because typing in billing or shipping 6,000information is too cumbersome or time-consuming. Finally, 5,000PayPal has built a worldwide customer base of 117MM active 4,000users, which is can leverage to generate other revenue 3,000streams. 2,000 1,000For customers, PayPal offers a secure way to pay for goodsor services online, because the merchant never receives the -- -- 1,000 2,000 3,000 4,000 5,000 6,000payment information, just a debit into the merchant’s PayPalaccount. PayPal also offers the consumer a more convenient TTM outbound shipping costs (US$ mn)way to purchase products online. Source: Company Data, Morgan Stanley Research Reducing shipping costs is a significant opportunity; increased convenience is a byproduct While Amazon enjoys economies of scale with respect to shipping costs, the company spent $4.8B on outbound shipping for the TTM period ending September 2012. We believe that it may be able to realize shipping cost savings by 21
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailbuilding fulfillment centers closer to its end customers. While pets, bar code scanning, etc), which have generated 100MM+the cost of doing so is not insignificant, the company will likely downloads. A well designed app that is additive to thebe able to run these “last-mile” fulfillment centers much more customer experience can be incremental.efficiently by curating the merchandise mix toward the fastestturning SKUs. The preceding chart implies that fulfillment eBay estimates it will generate over $10B of mobile GMV incosts are variable in nature. Due to Amazon’s growth curve 2012, up from $5B in 2011. This translates to about 13% ofinto new product categories and geographies, inventory total GMV (including autos). Company management hasturnover has come down steadily, which in turn has limited implied about 1/3 of this mobile GMV is incremental, whichAmazon’s ability to show consolidated efficiency in leveraging means eBay generated about 4% of incremental GMV fromits fulfillment network. If Amazon is able to reduce the per-unit mobile, or $3.3B.variable costs (shipping being one of them) and increase itsinventory turnover within new fulfillment centers, we should Exhibit 26see fulfillment expense leverage. In 2012, Mobile GMV would represent 13% of eBay’s total GMVExhibit 25 Source of eBay GMV (including auto) 2%comScore estimates 10% of eCommerce sales were 100% 4% 5%purchased on a mobile device in 3Q12, up from 3% 90% 9% Incremental Mobile GMVin 3Q10 80% Mobile GMV US eCommerce ($bn) Percentage spent via mobile devices 70% (Cannibalized $60 12% 60% from Desktop) Desktop GMV 50% 100% 99% 97% 93% $50 10% 87% 40% 30% $40 8% 20% $30 6% 10% --% $20 4% 2008 2009 2010 2011 2012e Source: eBay, Morgan Stanley Research $10 2% $0 0% Amazon and eBay have led the large-scale innovation 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 cycle for the eCommerce category, both in the UnitedSource: comScore, Morgan Stanley Research States and Internationally While eCommerce, as a category, certainly extends beyondMobile shopping is also an eCommerce growth driver – it the scope of just Amazon and eBay, these two eCommerceadds a layer of convenience – by offering the ability for a retailers have built sustainable business models on acustomer shop anywhere / anytime foundation of innovation. They continue to lead the disruptioncomScore estimates 10% of US eCommerce was purchased of traditional retailers by maintaining acute focus on low price,on a mobile device in 3Q12, and expects that to rise to 13% in broad selection and increased convenience. We believe boththe 2012 holiday season. This compares similarly to mobile Amazon and eBay will continue to lead the transition fromeCommerce penetration of the UK of 11.6%. traditional to eCommerce sales for years to come.eBay as a mobile case studyeBay has built at least eight unique mobile apps, focused ondifferent verticals (general interest, fashion, auto, classifieds, 22
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailUS RetailMark Wiltamuth (Food, Drug and Discounters) eCommerce Key Trends for Retailers:Joseph Parkhill (Branded Apparel & Footwear) Exhibit 27David Gober (Hardlines) Online penetration varies across the retail industryKimberly Greenberger (Softlines) 80% 70 % Bought online Categorys online share 60Executive Summary / Key Takeaways 60% 50Best-positioned: Williams-Sonoma, Under Armour, Macy’sNordstrom, Urban Outfitters, Costco, and Walmart 40Challenged: Bed Bath & Beyond, RadioShack 40% 30Food, Drug and Discounters 201. Costco and the club stores can still win in the Internet era due to 20% their low prices and focus on the food / perishables that are not 10 easy to ship. 0% 0 Cons.electronics Pet supplies Pers. Care & improvement Groceries Books Shoes Sporting goods Home furnishings Clothing Office supplies Athletic wear2. We believe Walmart has the potential to become a global leader in Auto parts Jewelry HHLD prod Home eCommerce sales. Walmart’s buying power ensures it will not be beaten on price, and we expect it to buy or build its way to a stronger competitive position in this channel. Source: AlphaWise, Morgan Stanley ResearchBranded Apparel The Multi-Channel Retailer: Shifting from Defense to1. As brands control their own distribution, they remain largely Offense insulated from typical pressures from pure online competition. For retailers, the key question for the next decade is whether2. eCommerce provides a key avenue to enter markets internationally they can rise to the challenge of becoming multi-channel and elevate brand awareness with new consumers. retailers, spanning traditional retail stores, online and mobile platforms. Retailers that allow consumers to choose how,Hardlines where and when to transact business will be the long-term1. Consumer Electronics – eCommerce penetration is high (47%), and winners. likely to keep growing. Best Buy and Radio Shack are negatively impacted, but Radio Shack least prepared with 1% of total revenue Traditional retailers increasingly have started developing generated online. multi-channel strategies that turn their traditional retail stores into eCommerce assets. Convenience is now even more2. Home Furnishings – about 30% of furnishings buyers shop online. important and retailers can exploit their physical locations and Williams-Sonoma is well positioned (33% of total sales online) while extend their offerings by opening up a variety of shopping and Bed Bath and Beyond is not, given 1% of revenue online, delivery options: decentralized distribution and high skew of branded, easily price comparable products. Creating the “endless aisle” eCommerce offers retailers a way to extend their inventorySoftlines beyond their store shelves. For example, vitamin retailer GNC1. A secular shift towards eCommerce has compelled apparel retailers has an average store size of just about 1,500 square feet to develop, expand and enhance their online platforms. displaying 1,800 SKUs but offers close to 3,000 items on its branded site and 30,000 on its discount website. Even large-2. Softlines retail is one of the most defensible retail categories box discounter Walmart, which offers over 100,000 SKUs at against online only competition. its supercenters, sees the Internet as an opportunity area where it can offer 1MM+ SKUs. Advanced inventory systems are helping retailers immediately locate an item of a specific color, style and size. These inventory systems coupled with employees armed with smartphones or tablets can help “save 23
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailthe sale” from the in-store customer who cannot find the right Consumers want their products delivered fast and they wantsize or color. For example, Urban Outfitters sales associates them delivered free. In our survey, 89% of consumersutilize iPad tablet technology to download product info, aid in indicated they would opt for the least expensive deliveryreturns/restocking and search other stores / online for method. Cheapest seemed to win out over fastest; only 36%merchandise. indicated same day shipping was appealing.Site-to-store Same day delivery is being tested by a number of operators:Retailers are starting to use their store locations as delivery Walmart is testing same-day delivery in four markets:points for their eCommerce transactions. Interestingly, Philadelphia, Minneapolis, Washington DC and SanWalmart’s site-to-store program delivery option now accounts Francisco/San Jose. Orders must be placed by noon, thefor 50% of the company’s online purchases. We believe service will cost $10 and orders will be fulfilled from existingconsumers are using this option to sidestep high delivery stores. If the test works, Walmart’s 4,000 stores could take oncosts for large and heavy items like patio sets, large sports a new role as hyper-local fulfillment centers. Also in 2012,equipment, and trampolines. Target, Finish Line and Best Buy eBay partnered with retailers Finish Line, Target, and Homeall offer site-to-store delivery as an option. Depot to test same-day delivery in San Francisco. Since late 2011, Nordstrom has been piloting same day delivery inSite-to-store-to-door (stores as virtual fulfillment centers) select markets, including Seattle and Bellevue, Washington,Retailers are starting to think of their stores as virtual and La Jolla, California. Amazon is also testing same-dayfulfillment centers. Taking the site-to-store concept one step shipping for Prime members in 10 markets: It costs $8.99 plusfurther, delivery to the customer’s home can occur from a $0.99 per item.nearby store rather than from an eCommerce fulfillmentfacility. We suspect that same day delivery could prove to be logistically difficult and the $10 fees may not fully cover costs.“Anytime, anywhere” returns However, the lessons learned from these tests may help theWe believe reducing hassles for customers is essential for industry shrink delivery times and improve efficiency.driving multi-channel retailing. In our AlphaWise survey, 60%of respondents indicated that they would buy online more Retail eCommerce Technology Trendsfrequently if they could return or exchange products at a store. In-Store Price Comparison and “show-rooming”: RetailersRetailers are starting to embrace this concept; Nordstrom and have long had to contend with customers who visit brick andJ.C. Penney have both introduced an “anywhere, anytime” mortar stores in order to compare different products and gleanreturn policy. information from salespeople before returning home to purchase products from an online retailer for a lower price.International sales made easier Savvy consumers are now taking this one step further, joiningOnline presence will also make it easier for companies to smartphone technology and price checking websites to doexpand their international operations. Companies will be able price comparisons while standing in the aisle of a store.to enter markets without having any physical retail locations.In this sense, retailers can benefit from some of the same Exhibit 28advantages that online retailers like Amazon benefit from in Price perception still strongly in favor of onlinethe US. Macy’s is a prime example of this: The company has retailstores only in the US but ships to more than 100 countries. Perceived online cost advantage vs. stores 0% 20% 40% 60% 80% 100%The Next Battleground: Speed of Fulfillment Large home appliances Auto parts & accessoriesAmazon is in the process of building fulfillment centers in Los Consumer electronicsAngeles and San Francisco with an eye towards reducing Sporting goodsdelivery times. As Amazon’s price advantage starts to fade Athletic apparel & athletic shoes Office & school supplies for home usedue to the collection of sales tax, it is improving convenience Home improvement items & toolsto maintain its value proposition to customers. Jewelry Shoes Personal care & household productsFree delivery within 3-5 days is approaching the norm for Home furnishings & accessorieseCommerce transactions. We believe this timeframe may Clothingstart to compress down to three days or less as operators A lot cheaper Somewhat cheapershorten the delivery times from fulfillment center to consumer. Source: AlphaWise, Morgan Stanley Research 24
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailAs the traditional retailers offer an immediate place reduce labor costs, and enable easier integration ofadvantage, the key to winning the sale is having a price that is eCommerce / DC channels.reasonably close to online retailers, or that meets a pricematch guarantee (ToysRUs, Target, and BestBuy are offering Price Comparison Still the Current Focus in the Onlinean online price match for the 2012 Holiday season). vs. Bricks-and-Mortar Battle We believe Internet retailing’s rise has been fueled largely byDynamic pricing a price advantage. In our AlphaWise survey, lower onlineIncreased price transparency and comparison capabilities pricing was the most frequently cited reason for shoppinghave led some retailers to begin employing dynamic pricing. online (41% of respondents placed it in their top three).Walmart announced at its 2012 analyst meeting that it has Depending on the category, online retailers offer pricing thatdeveloped a price monitoring system that checks online can be 5-20% below the all-in traditional retail price. Oftencompetitor pricing every 20 minutes and allows it to adjust its online retailers will offer a lower product price, but the bottomown online pricing accordingly. While this shows retailers line cost savings can also come from a combination of freetaking positive steps, we believe Amazon remains the leader shipping offers and a lack of state taxes.in this area: The company’s pricing algorithm allows foressentially real-time pricing based on internal supply / Lower product pricesdemand dynamics as well as many other factors such as Economies of scale in purchasing and a lack of physicalseason and how a certain price might drive traffic to other stores help online retailers keep their cost structure andproducts. product prices low. In some products, manufacturers have recommended prices that Internet retailers will adhere to, butAlternative means of payment in cases where suppliers exert little influence over pricing,A proliferation of payment methods may help make online retailers may set pricing below the prices of bricks andeCommerce more accessible to a greater number of mortar retailers.customers. Payments are moving beyond credit cards to newmobile / online payment systems such as PayPal and Google Tax advantage for eCommerceWallet and retailers have even found a way to make cash a While 45 of 50 US states have a state sales tax, most statespayment option. In order to accommodate PayPal’s 50MM do not charge sales tax for online transactions if the onlineactive customers in the US, retailers including Home Depot retailer has no physical presence in the state. This is aand Abercrombie & Fitch have begun accepting PayPal in significant disadvantage for traditional retailers. So even forstores. Other retailers such as Foot Locker, Guess and products where the Internet product price matches that of theMacy’s have begun accepting Google Wallet. On the other traditional retailer, a combination of zero state taxes and freeend of the spectrum, Walmart has a program that allows shipping can net a consumer 5-7% savings. It is important tocustomers to buy online and pay in store with cash. This note that consumers may not fully understand or isolate theprogram serves the un-banked and under-banked population, tax advantage and instead focus on overall price difference.as well as consumers leery of making payments over theInternet. Exhibit 29 Sales tax not so black and white for consumersRadio-frequency identification (RFID) 54%We believe RFID will be an important inventory management Yestool that may help retailers “save the sale” for customers who 19%cannot find a specific size, color, or style in the store. Whilestanding with a customer in a store, a sales clerk could find 10%the needle in the haystack of company-wide inventory (“We’ve Nogot your purple sweater, size 8. There are five in our 39%warehouse and four in our New Jersey store… We can ship itto your address.”) RFID inventory systems attach a small chip 37% Dont know/to each piece of merchandise in order to make tracking and not sure 42%identification of products easier. By providing accurateknowledge of current inventory, RFID allows retailers to more States with sales tax States without sales taxefficiently manage their products, reduce out-of-stocks, Source: AlphaWise, Morgan Stanley Research 25
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailThe survey responses lead us to believe that although sales Free shipping offers:tax is not well understood by Amazon shoppers, its impact is In our AlphaWise survey, 89% of respondents in the USpotentially meaningful. Among respondents in states with agreed that they would buy online more if retailers offer freesales tax, 11% would stop buying from Amazon altogether if shipping. Many online retailers already offer free shipping toAmazon were made to charge those taxes, while an additional help reduce the friction of the online purchase and lower costs60% would buy less. for consumers. Free shipping is rapidly becoming the standard for online transactions. A few have blanket freeExhibit 30 shipping, some require a minimum purchase, and some maySales tax a clear competitive advantage for Amazon offer free shipping for select customers (Amazon Prime Impact of sales tax on Amazon shopping Members who pay $79 / year, Target’s RedCard holders get 5% discounts plus free shipping, Abercrombie & Fitch No impact 29% provides free shipping to loyalty customers only). Retailers who control their own brands are less exposed Buy a little less 36% to Internet discounting We believe apparel retailers and many specialty retailers who control distribution of their own brands are less exposed to the Buy a lot less 25% discounting of online retailers. While branded apparel can be found at online marketplace sites it is typically limited to either Stop buying 11% third-party restricted inventory or isolated instances such as the Coach partnership with eBay for select product.Source: AlphaWise, Morgan Stanley Research Traditional branded apparel players are also likely to offer aWith states now clearly aware that they are losing out on tax better selection of merchandise while only making certainrevenue, the tax advantage for online retailers is starting to items available to online retailers in order to clear inventoryerode. For example, Amazon is currently collecting sales tax (limited sizes and colors). In addition to benefiting from thisin eight states, with California joining the list in September limited merchandising, retailers such as Foot Locker and2012. Amazon will start collecting state taxes in New Jersey Finish Line suffer from a slight price disadvantage and priceand Virginia in 2013. Indiana, Nevada, and Tennessee will lower than Zappos.follow in 2014 and South Carolina is slated for 2016.Exhibit 31Amazon currently collects sales tax in 8 statesSource: New York Times, Morgan Stanley Research 26
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailFood, Drug and Discounters Club stores can still win due to their low prices and focus on food / consumablesDiscounters, among the more heavily impacted, are We believe Costco and the club store industry will continue tostarting to react; Walmart is poised for prominence win in an Internet focused marketplace. Bottom line, lowLarge discounters Target and Walmart face the greatest near- prices will always resonate with consumers. Despite beingterm threat from eCommerce. Target is more exposed admittedly behind on its own eCommerce efforts, Costcobecause 78% of its sales come from non-grocery compared to continues to gain share and draw in consumers with its lowonly 45% for Walmart. However, well aware of the prices, high quality private label products, discount gasolineeCommerce threat, both retailers have been investing more in and treasure hunt atmosphere.this area, and as outlined below, we believe over the longer-term Walmart could emerge as a major player in eCommerce. The company’s narrow SKU base (about 4,000 items) enables it to concentrate its buying power and pass on theWalmart: We believe Walmart’s low price model will continue savings to its members. The company has a policy of limitingto thrive even as eCommerce trends continue to grow. its markup on branded products to 14% and 15% on privateFurther, we believe Walmart could be the one traditional label. Across all of its sales, the company only earns a 10-retailer with the potential to become a global leader in 11% gross margin and a retail operating margin of under 1%.eCommerce sales. As the world’s largest retailer, Walmart This in turn drives extreme loyalty from its memberscan use its buying power to ensure it will not be beaten on (membership renewal rates of about 90%). Its membershipprice, and we believe the company will either buy or build its fee base is perhaps the company’s greatest investmentway into a stronger competitive position in eCommerce. attribute; 80% of the company’s earnings come from membership fees and with fees increasing every 5 years andWalmart CEO Mike Duke has set a goal for Walmart to be a membership ranks growing with each new store.global leader in eCommerce. This seems like a tall order, butthe market should not underestimate the power of Walmart. At We believe Costco enjoys some protection from online threatsits analyst day in October 2012, Walmart outlined several because of the nature of its products. Its large package sizes,initiatives that show that it is investing in this area, and we food / perishables focus (55% of sales are consumer staples),sense that a strategy is starting to emerge. The company and lower dollar value per pound makes these products aguided to about $9B in eCommerce sales worldwide in 2013, shipping challenge for online operators. We believe the clubor about 2% of overall sales. Programs such as same-day store may still be the most efficient venue for consumers todelivery, order online / pay with cash, and its new search stock up on paper towels, toilet paper, bottled water, gallonsengine were highlighted. We expect the company to continue of cooking oil and 40 lb bags of rice.to invest in both technology and talent in the eCommercearena. The company has been investing in eCommerce- Grocery: perishables focus limits exposure to onlinefocused personnel at @Walmartlabs (including the 2011 Out of all of the retail-industries, grocery is the least exposedacquisition of social media company Kozmix). to risk from eCommerce. While some incursions have clearly occurred in the center of the store (Diapers.com’s share in theTarget: Target ended its partnership with Amazon and diaper category now exceeds that of some of the largestrelaunched its own website in mid-2011. So far, the website grocers), most of the grocery store has low value items orhas had latency problems and required three major version perishable items that are difficult to distribute through onlineupdates. However, it was expected to finally be additive to fulfillment. Amazon is testing grocery delivery in the Seattlecomps by 4Q2012. While we estimate that eCommerce market but has yet to roll it out broadly. From observing theaccounts for only 2% of sales as of late 2012 and has lower few online grocery models that are successful (FreshDirect inmargins, we expect Target to focus on increasing sales the NY metro area and Philadelphia, Tesco, Sainsbury in thethrough this channel. UK), we believe retailers need a concentrated population to make grocery delivery economics work. Some grocers have aTarget is working to thwart online price challenges through a delivery model in place that leverages local store labor and in-holiday online price match program, it is challenging its store inventory (Ahold’s Peapod and Safeway), but we do notmerchants to source more exclusive products, product launch believe these are very profitable. We view these as a serviceopportunities and unique limited time offers (Target / Neiman for customers, not a business model that management teamsMarcus Holiday Collection designer gifts, Missoni for Target, are expanding upon.Harajuku Mini for Target, etc). 27
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailVitamin Retailers: exposed, but private label helps limit acquisition of drugstore.com, which offers a deeper selectionimpact of cosmetics and OTC products.Vitamin retailers, GNC and Vitamin Shoppe, each facecompetition from lower priced online retailers. An online price Branded Apparel & Footwearsurvey we conducted in the US showed Amazon and Vitacostpriced about 13% lower than Vitamin Shoppe and about 30- For apparel and footwear, eCommerce is an40% lower than GNC. While the price differences are notable, opportunity, not a threatwe believe Vitamin Shoppe is more exposed as it focuses on Most established brands appear well-positioned within themarketing known third-party brands that can be easily context of increased eCommerce penetration. Our surveycompared on price. GNC’s heavy private label offering (57% data suggest that emerging markets, particularly China, areof retail sales) which cannot be bought at a discount online, more likely to make purchases online. The highest categoryhelps serve as a moat against market share loss. Vitamin within China for online purchases in the last year was clothingShoppe, in contrast, derives only 24% of its sales from its own (91%), followed by shoes (82%). Athletic apparel andbrands. footwear also had a high incidence of online purchasing behavior (73%) and showed the second-highest delta inBoth companies tout face-to-face customer service as an buying online over the next 12 months (+7%, sporting goodimportant factor in driving sales. As the myriad of showed the largest intention to increase +13%). As brandssupplements can be difficult to navigate, we do believe have control over their distribution, pure eCommerce retailerscustomers are likely to turn to traditional retailers for do not pose a threat as they either need to comply with aguidance. The challenge, however, comes in securing the brand’s pricing or cannot carry the product. Since consumersrepeat purchase once the customer has settled on a regular seek out specific brands, we believe there is less threat ofproduct that in many cases can be replenished at a lower substitution as well.price online. Exhibit 32 Higher levels of eCommerce penetration tend to beGNC has adopted a two pronged Internet strategy. Its more US-centricGNC.com site offers the same products customers find in-store, at the same pricing. This ensures that franchisees are Online salesnot undercut by the company’s Internet activities and it helps 12%protect GNC private label pricing. On its recently acquired 10%Lucky Vitamin website, GNC is fully participating in theInternet discounting, but with third-party brands. With this 8%approach, we believe GNC gets to participate in the 13-14%growth in the vitamin / supplements eCommerce channel 6%without dragging its own brands into the fray. 4%Vitamin Shoppe has been investing in improving its website 2%and search capabilities, and has started offering free shippingfor orders over $25. As a result, its sales growth in 0%eCommerce (also known as its “direct” business) has been in FINL UA FL RL VFC TNF NKE PVH WRC GES Source: eCom, Morgan Stanley Researchthe 15-20% range, above the vitamin / supplementeCommerce industry growth. US-centric companies have higher online salesDrug Stores: Convenience is the focus, not price penetrationWe do not view eCommerce as a significant threat for Under Armour, which gets about 90% of its sales from USdrugstore names. We believe customers shop at these stores customers has the highest penetration of sales from online, atfor the convenience as evidenced by the average basket of about 9%. Most of the companies we cover get about 2% ofabout $12 that contains three items. All of the major retailers sales from online. Most brands prefer to sell products throughoffer online prescription refills (for in-store pickup) and each their own websites or to control which eCommerce retailershas a website, which touts current promotions and health offer their products. Brands generally do not deal with eBay oradvice. Walgreens is arguably the online leader after its 2011 Amazon as they do not want price to be the main driver of consumers buying their brand. Under Armour is the only brand that has its own store on Amazon. The product is not 28
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retaildiscounted and UA has found that the online store reached a Apparel and footwear are still building out capabilitynew set of customers. It is still a small part of its business, Most branded apparel and footwear companies are stillhowever, and not a major growth driver for UA. building out company-owned capabilities in international markets, which should help support growth and marginInternational opportunity, bricks and mortars and online expansion. For example, Ralph Lauren only launched itsWe believe the majority of our coverage universe is still website in the UK in 2010, in Germany and France in 2011underpenetrated internationally, whether that is wholesale and in Japan in 2012. Vans’ eCommerce sites were onlydistribution, retail, or online. We believe the build out of launched in Europe in the summer of 2012. Furthermore, VFCeCommerce capabilities and continued movement towards launched China sites for its brands but does not directlyonline purchases, increases the brands ability to penetrate operate them, so sales through this channel are stillinternational markets. We highlight Vans, Ralph Lauren, and considered wholesale sales. Most companies need scaleUnder Armour as brands that currently have a larger within an individual country in order to operate their ownpercentage of online traffic from international users than eCommerce website. For example, while Nike generatespercentage of sales internationally. sales in 180 countries, it only operates its own eCommerce sites in 25 countries. Nike rolled out eCommerce capability inExhibit 33 the US in 2001, in Europe in 2008 and in Asia (Japan, Korea,% international revenues vs. % international views China) in 2011. International revenues vs. international views 70% 60% 50% 40% 30% 20% 15% 10% 10% 0% Vans Ralph Finish Under Nike Timber- The Foot Guess Lauren Line Armour land North Locker Face International revenue (%) International unique views (%)Source: Company Data, Morgan Stanley Research.Exhibit 34International eCommerce capabilities: Still nascent UK Germany France Italy Spain Japan ChinaThe North Face (VFC) Yes Yes Yes Yes Yes No NoTimberland (VFC) Yes No No No No Yes NoWrangler (VFC) No No No No No No NoVans (VFC) Yes Yes Yes No No No NoLee (VFC) No No No No No No NoUnder Armour Yes No No No No Yes 2013Nike Yes Yes Yes Yes Yes Yes YesFinish Line No No No No No No NoRalph Lauren Yes No Yes No No Yes 2013-2015Tommy Hilfiger (PVH) Yes Yes Yes Yes Yes Yes NoSource: Company Data, Morgan Stanley Research 29
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailFootwear retailers: More exposed to online threats long Online’s pricing advantage is relatively minor or non-term, depending on the brand’s distribution existentMany investors believe that footwear retailers such as Foot On average, Foot Locker and Finish Line had a 3-5% pricingLocker and Finish Line are negatively exposed to online advantage relative to Zappos. When looking at the lowest-competition. While this is theoretically true, Finish Line and priced shoe available on Amazon, Foot Locker and FinishFoot Locker have strong eCommerce capabilities and derive Line had an 8 and 6% price disadvantage. However, the11% and 8% of total sales from online, respectively. Prior marketplace may not always have the desired size and orsurveys that we have conducted found that consumers list color for the consumer; Amazon’s disadvantaged“having physical stores” as the third most important attribute merchandise offering allows Foot Locker and Finish Line tofor selecting an online retailer. This puts Foot Locker and provide a superior customer experience, which may lead toFinish Line in good position to continue to take share. eCommerce market share gains.Brand distribution decisions drive footwear retailer Exhibit 36success Better prices vs. Zappos…As the landscape exists today, Foot Locker and Finish Line Average price advantage vs Zapposappear to remain protected from pure online retailers because 1%they both receive exclusive products. As long as the brands 0%continue selling under this strategy, Foot Locker and Finish (1%)Line should continue to be well-protected. (2%) (3%)We conducted an online survey and analysis looking at the (4%)top 100 SKUs for the first six months of 2012. Our analysis (5%)found that these premium athletic footwear retailers hold aproduct advantage and are not as vulnerable to price as (6%)initially believed. SKU exclusivity, particularly in basketball, Foot Locker Finish Line Dicks Source: Company websites, Company Data, Morgan Stanley Researchhelps insulate Foot Locker and Finish Line from onlinecompetition (Foot Locker in particular), while the largerrunning market is much more competitive. Foot Locker and Zappos not as much as a threat as once thoughtFinish Line offered 88% and 71% of the most popular shoe When looking at the shoes where they overlapped withstyles year-to-date, while online competitor Zappos offered Zappos, Foot Locker and Finish Line both had an onlinejust 56%. Amazon offered 100% of the shoes, but only after pricing advantage on average (Dick’s on par). For instance,accounting for its third-party marketplace, which both Foot Zappos only carried five basketball shoes, and amongst thoseLocker and Finish Line take part in. Amazon owns 100% of the pricing advantages for Foot Locker and Finish Line wereZappos but manages it as a separate, standalone brand. In 19% and 30%. Zappos does not carry Jordan and very feworder to leverage Amazon’s site traffic, the company will list other premium basketball footwear brands, making itZappos’ SKU-specific price points under the heading, essentially a non-competitor in basketball. The pricing“available from other sellers.” advantage within running was much smaller— 4% for both Foot Locker and Finish Line. However, at times the cost ofExhibit 35 shipping likely offsets this small advantage. While Foot LockerFoot Locker and Finish Line offer superior selection and Finish Line frequently offer free shipping on popular Top shoes models available (%) newly released full priced items, customers usually pay shipping costs on discounted shoes that likely bring the total 100% price more in line with Zappos. 75% 50% 25% 0% Amazon Foot Finish Line Zappos Dicks Locker Sporting Goods Total Basketball RunningSource: Company Websites, Morgan Stanley Research 30
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 37…but not vs. Amazon’s 3P marketplace Hardlines Average price disadvantage vs Amazon The debate on the impact of eCommerce on Hardlines 16% Retailers is a central theme that will likely impact stocks for the foreseeable future 12% On the positive end of the spectrum, Williams-Sonoma and Liberty Interactive have been proactive in growing 8% eCommerce and appear well positioned for future growth. We see Bed Bath and Beyond as the most potentially challenged 4% in the near-medium term, with Dick’s Sporting Goods and PetSmart at risk, but likely years away from seeing 0% meaningful impact from eCommerce. Best Buy will likely Foot Locker Finish Line Dicks continue to be impacted, but this is well understood by theSource: Company Websites, Company Data, Morgan Stanley Research Street. Amazon competes much more on price, though Exhibit 38availability limits its competitiveness Current hardlines progress with eCommerceAthletic footwear retailers clearly demonstrated a pricedisadvantage versus the Amazon marketplace, which serves % sales from eCommerceeffectively as a clearance center for retailers (including Foot 0% 10% 20% 30% 40%Locker, Finish Line, and Dick’s Sporting Goods). While the WSM WSM and LINTAlowest price can often be found in the Amazon marketplace, LINTA best positionedthe desired size and color may not be available. Also free SPLS onlineshipping depends on the retailer allowing Amazon to offer the ODPproduct; if it is not offered, this could reduce the advantage BBYshould Foot Locker or Finish Line provide free shipping on DKSthat shoe. Ultimately, while there is a price disadvantage, the PETMgreater availability in dimensions of color and size as well as RSHearly exclusivity (particularly in basketball for Foot Locker) BBBY BBBY lagging, and AMZN penetration growinghelp dampen this issue, in our view. HD LOW ORLYGiven their at-risk business model, footwear retailers AAPhave begun to invest more heavily online, led by Finish AZOLine  Source:. Company Data, Morgan Stanley ResearchHowever, Amazon remains a threat. In our previousDecember 2011 survey 30% of consumers indicated they Challenged Defensiblepurchased shoes online (15% from Amazon). Both Foot Bed, Bath & Beyond Home DepotLocker and Finish Line have adjusted pricing on free shipping Best Buy Lowe’s Companiesfor some new and non-discounted to remain competitive. The Radioshack O’Reilly Automotivepickup-up in-store option introduced 3-4 years ago by the Dick’s Sporting Goods AutoZoneretailers is a popular feature that also helps consumers PetSmart Advance Auto Partscircumvent shipping costs. Given the running category’shigher vulnerability to online competition relative to basketball, Staples Genuine Parts Co.we feel Finish Line has responded more aggressively to Office Depot Williams-Sonomaintegrate eCommerce into a complete “omni-channel” strategy eCommerce has had a profound impact on the consumerin terms of website improvements and Google advertising electronics and media industries; housewares appearsinvestments. Foot Locker is still in the process of rolling out vulnerableeCommerce capabilities in Europe. With about 5% of sales coming from eCommerce, housewares appears 4-5 years behind consumer electronics and media, but will start to see comps slow as it hits the steep leg of the eCommerce S-curve. 31
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 39 create a robust online business quickly. Our work suggestsHousewares hitting the steep leg of the eCommerce that linens / softgoods are less likely to migrate online; wes-curve; pets and sporting goods still years away believe over 55-60% of Bed Bath and Beyond revenue is from eCommerce market share Category leader comps goods that are at risk. 8% 6% 7% 5% Exhibit 41 4% Home furnishings online penetration at approx. 30%, 6% CE and Media Housewares in the middle of the pack in hardlines 3% 5% Online growth for hardline retailers 2% 80% 4% HF online growth appears 1% 70% modest; Amazon.com growth 3% Pet 60% tells a different story Supplies, 0% 50% 2% Sporting -1% 40% Goods 28% 28% 1% Home Improvement, 30% Auto Parts -2% 20% 0% -3% 10% 1 2 3 4 6 5 7 8 9 10 0% Year Athletic wear furnishings improvement Auto parts Sporting Books electronics supplies Pet supplies Consumer goods Office Home eCommerce market share Category killer comps HomeSource: Company Data, ComScore, Internet Retailer, Veronis Suhler Stevenson , AmericanPet Products Association , Nielsen Consumer Panel Data, Packaged Facts, IBISWorld , CEA,BEA, NSGA, Morgan Stanley Research Current online penetration Future buyers Source: AlphaWise, Morgan Stanley ResearchIn our February 2012 report, Amazon Raiding the LivingRoom, Not the Closet, furnishings was a category where an Impacts still meaningfully long-dated in pet supplies.increasing percentage of consumers planned to shop at We estimate Pet Supply eCommerce market share is aboutAmazon with an expected increase from 17% to 31% of 3%, and believe it will be a few years before we might see acategory shoppers over the course of the following six negative impact on comps. We published a report onmonths. Further, our AlphaWise survey on housewares September 4, “AlphaWise Survey: Online is More Bark thansuggests that Amazon has gained about 9% share with 18-34 Bite for Now,” which explores our recent survey andyear olds as it increasingly focuses on the core female and eCommerce dynamics.35+ year-old furnishings consumers. Sporting goods impact also not imminent, but debateExhibit 40Amazon appears to be gaining share in Bed Bath continues to percolateand Beyond’s key furnishings demographic of 35+ While eCommerce penetration in the sporting goods category(Morgan Stanley Pillow Talk Survey) is at 5%, we believe the 48% of Dick’s Sporting Goods AMZN share of HF age group revenue derived from footwear and apparel could shield it 10% somewhat from eCommerce impacts near-term, especially as no single player has consolidated share in sporting goods. 8% Still, as brands like Under Armour and Nike continue to ramp owned sites and online-only sites ramp in sporting goods, we 6% see this as a growing area of debate. 4% Omni-channel is the key buzzword amongst Hardlines 2% retailers. 0% With the majority of hardlines retailers being relatively mature 18-34 35-54 55+ from a brick and mortar footprint perspective, leveraging their May 12 Aug 12 physical presence is a key focus of online strategies.Source: AlphaWise, Morgan Stanley Research Combining the in-store experience with user-friendly online platforms to further engagement, loyalty, and commerce.Bed Bath and Beyond appears most impacted by this trend,as it currently derives less than 1% of revenue online and itsdecentralized distribution infrastructure limits the ability to 32
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailSoftlines Additionally, several retailers have begun maximizing inventory efficiency by sharing inventory between their storeSoftline retail’s online sales is generating outsized and online channels. American Eagle Outfitters, Chico’s,growth Coach, Gap (at select stores), J.C. Penney, Nordstrom,Our analysis suggests 80% of US apparel sales occur in Kohl’s, Limited Brands, Macy’s, Saks, Tiffany & Co. andstores as compared to 15% online and 5% via TV, catalog Urban Outfitters can pull merchandise from online inventoriesand other means. Interestingly, the majority of online apparel to satisfy store demand. ANN INC., Coach, Gap (i.e., Gap andsales (over 10% of the 15%) accrue to traditional store-based Banana Republic brands), Nordstrom, Macys, Tiffany & Co.retailers, while eCommerce retailers garner less than 5% and Urban Outfitters can pull from store inventory to meetpenetration. Apparel retail eCommerce sales are experiencing online demand. Notably, Coach, Nordstrom, Macys, Tiffanyoutsized growth, so we expect online apparel sales to & Co. and Urban Outfitters can flow inventory seamlesslyincrease as a percent of total over time with traditional store- between stores and online. (See “Inventory Fulfillment” inbased retailers leading the way. We estimate 2011 apparel Exhibits 46-51), thereby improving gross margins via reducedeCommerce sales grew by a low teens percentage, while markdowns and faster inventory turns.traditional retail stores delivered only low single digit growth. Both heightened competition and technology advancementsIn addition, our survey data indicates a high intent to buy prompted apparel retailers to ramp up eCommerce andclothing online among consumers (about 51%) – ranking third technology investment. Most have begun translating the in-after books (74%) and consumer electronics (53%). Indicating store experience online through broadened onlineoutsized on-line sales growth and increasing y/y penetration assortments, order fulfillment initiatives including crosswill likely continue. channel fulfillment and same day delivery, real-time live chats and video merchandising. In addition, integrating loyaltyThis secular shift towards online shopping, especially among programs online and free shipping generate a competitiveyounger consumers, and emerging online-only competition advantage, in our view.have compelled apparel retailers to develop, expand andenhance their online platforms. Softlines retail is one of the most defensible retailExhibit 42 categories against online-only competitionConsumers have a relatively high intent to buy Comparable, lower priced product assortments provideclothing online online-only retailers, such as Amazon, a key competitive Will buy online among future category buyers advantage in categories with easy SKU comparability such as 80% hardlines and other commoditized categories (e.g. books, Buy online in next 12 months 70% music, movies, etc.). However, this strategy does not readily 60% translate to apparel where quality, style, fit and brand 50% differentiate products. Specialty retailers, and to some extent 40% Average department stores, control who can sell their product and how 30% 20% those channels can discount. According to our calculations, 10% specialty and discount retailers’ (e.g., department stores, 0% Walmart and Target) proprietary and exclusive brands Athletic wear Books Shoes Sporting Clothing Auto parts supplies furnishing improvement Pers & Jewelry represent at least 60% of US apparel sales (see Exhibit 43). electronics Groceries Pet supplies Office HHLD goods Home Cons. Home We see no reason a vertically integrated specialty retailer or department store would undercut their own business bySource: AlphaWise, Morgan Stanley Research allowing a retailer, such as Amazon, to sell their exclusive branded product at a lower price. Even the eCommerceeCommerce growth enhances apparel retailers’ sales and retailers’ tax advantage is eroding with recent (e.g. California,margins Texas) and future legislation (New Jersey, South Carolina,eCommerce provides retailers another way to interact with Tennessee).current customers and attract new customers who prefershopping online or don’t live near a store location.eCommerce also allows retailers to drive sales without a largestore base. eCommerce’s lower overhead costs enable highersales flow-through to operating profit. 33
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 43 Select softline retailers offer free shipping on a limited basisWe estimate about 60% of apparel distribution is only – either on a promotional basis (e.g. Aeropostale, Limitedcontrolled by traditional retailers Brands, Children’s Place and Tiffany & Co.) or via loyalty programs (e.g. Abercrombie & Fitch). When these retailers Other are not on promotion they likely make a profit on shipping Other 3% Mass fees. As consumer demand for free shipping grows, they may 12% Merchants need to expand their free shipping programs to stay Off-pricers 14% competitive. While this would likely drive increased sales, it 8% could also erode and / or eliminate shipping charge profits. Mass Department Merchants Store A number of specialty retailers and department stores have 2% 11% made significant strides in reducing ship times, and Department Nordstrom is even testing same day delivery, enabling the Store retailers to keep pace with online only retailers in terms of 17% speed of service. However, speed of service does not standout as a consumer priority, according to our survey data. Specialty Specialty 1% Only 36% of online shoppers indicated they would buy online 32% more if online retailers offered same day delivery. That said, consumer attitudes towards delivery times will likely change if Non-store Branded: Store Branded: Retailer does not control Retailer controls apparel same day delivery becomes more common, in our view. apparel distribution distribution (about 60% of (about 40%) US apparel sales) In addition, our prior survey work indicated about two-thirds of apparel buyers prefer to see, touch or try on the productsSource: Company Data, Morgan Stanley Research before they buy. This puts online only apparel retailers at aWe also believe specialty retailers and department stores disadvantage vs. their multi-channel (stores plus online)trump online only retailers on convenience as shoppers can competitors. Several specialty retailers have indicated a highbuy and return both online and in stores. Our AlphaWise percentage of their customers research products online butsurvey data indicates online shoppers have a clear preference still purchase at a store after seeing and trying the item on.for convenient return options – either free shipping (about78% of online shoppers) or return to store (about 60%) (see Consequently, softline retailers (in particular, American EagleExhibit 45). Buy online and pick up in store appears less Outfitters, ANN INC., J.C. Penney, Macy’s and Urbanimportant. Only 18% of online shoppers said they prefer to Outfitters) are leveraging their store bases and customers’pick-up products ordered online from a store or other physical preference to touch and try on product by using their stores aslocation. showrooms (see “Showrooming” in Exhibit 46 – Exhibit 51). The retailers display an extended merchandise assortment inAccording to our AlphaWise survey data, customers strongly store, which is only stocked at distribution centers. Thisprefer low-cost or free shipping. Nearly 90% of frequent online strategy provides retailers with a cost effective way to offerbuyers indicated they would buy online more if retailers offer more product choices and expanded sizes (e.g., extendedfree shipping and 85% said they typically chose the cheapest apparel sizes), while minimizing inventory risk.shipping option. Where specialty retailers may fall short is breadth ofA number of softline retailers offer free shipping year-round brand offerings online(e.g., American Eagle Outfitters, ANN INC., Coach, Gap, Customers who prefer shopping multiple brands at once, in our opinion, are more likely to visit an eCommerce site (suchJ.C. Penney, Nordstrom, Kohl’s, lululemon athletica and as Shopbop, Zappos, or Bluefly) over a specialty retailers’ siteMacy’s). Chico’s, Express and Saks offer free shipping year- or store. However, we still think department stores are highlyround to all or select loyalty customers and on a promotional competitive with eCommerce retailers given their significantbasis otherwise. At Urban Outfitters, the Urban Outfitters breadth of brands and SKUs, multi-channel shopping optionsbrand offers free shipping all year, while Anthropologie and and loyalty programs.Free People provide free shipping on a promotional basis. 34
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailInternational Opportunities capabilities on their US sites, allowing customers to set language and / or currency preferences (among other things).We believe international expansion represents a A handful of retailers have also developed localized country-significant long-term sales growth and margin specific online content, including Urban Outfitters, Coach, andopportunity for softline retailers Tiffany & Co. Coach operates eCommerce sites in Japan andMichael Kors, Limited Brands, Abercrombie & Fitch, Coach, China, which both ship domestically. Macy’s plans to sellGap, lululemon athletica, Tiffany & Co. and Urban Outfitters private branded goods on Chinese eCommerce site omei.comhave already established international store growth strategies starting Spring 2013.(outside North America) and nearly all softline retailers utilizeeCommerce to sell internationally. In fact, among the 18 Exhibit 44softline retailers with established US eCommerce platforms, International shipping by retailer16* ship outside North America (including Coach, which ships Ship outside No. of Ship outside No. ofdomestically within Japan and China) (see Exhibit 44). The the US? countries the US? countriesexceptions are ANN INC. and Kohl’s. We expect ANN INC. AEO Y 70+ JWN Y 90+ ARO Y 100+ KSS Nwill introduce international shipping in the relatively near term. ANF Y 70+ LTD Y 200+On the other hand, Kohl’s has indicated international shipping ANN N LULU Y 50+is not a priority. CHS Y 40+ M Y 100+ COH* Y 3* PLCE Y 90+ EXPR Y 60+ SKS Y 100+Developing an international online presence enables retailers GPS Y 90+ TIF Y 10+to i) test and study a new market, ii) build brand recognition, JCP Y 80+ URBN Y 130+and iii) grow sales with a relatively lower capital commitment Total / Avg. 16 Y* / 2 N 85+ Source: Company Data, Morgan Stanley Research(as compared to opening stores). Most softline retailers are in * Note: COH ships internationally to Canada and ships domestically within Japan and Chinathe early stages of implementing their global eCommercestrategies. Some retailers have adopted international-friendlyExhibit 45Shoppers have a high preference for inexpensive shipping and convenient returns % Strongly Agree / Somewhat Agree 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% I would buy online more often if retailers offer free shipping When buying products online, I would choose the cheapest shipping option I would buy online more often if I dont have to pay shipping for return or exchange /I would buy online more often if I can return exchange products bought online at a store I would prefer buying online from traditional retailers with physical I would buy online more often if delivery can be arranged during the hours I am home I would buy online more often if online retailers offer same day delivery I wish online retailers could offer more payment options I would prefer to pick up products ordered online from a store or other physical locations I am willing to pay more for faster Online Buyer shipping of online purchases Non Online Buyer If I have a choice, I would prefer using cash to pay for online purchasesSource: AlphaWise, Morgan Stanley Research 35
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWe surveyed 18 companies within our specialty and iv) Most retailers have implemented cross channeldepartment store universe on their existing eCommerce fulfillment to some extent. 12 of the 18 retailers surveyedstrategies and initiatives, focusing on shipping costs and can pull merchandise from online inventories to satisfytimes, inventory fulfillment and overlap, loyalty programs and store demand, while 8 can pull from other stores’use of “show-rooming” (i.e., displaying merchandise in-stores inventories. In addition, 7 retailers can pull from storebut only carrying the inventory at distribution centers). A few inventories to meet online demand. Leaders in crosskey survey findings include: channel fulfillment include Coach, Nordstrom, Macy’s, Tiffany & Co. and Urban Outfitters, which have alli) Free online shipping is ubiquitous. All softline retailers, established seamless inventory integration (i.e., except Abercrombie & Fitch, offer free shipping to all implemented store to store, store to online, and online to customers either year round or promotionally. Abercrombie store fulfillment). & Fitch only offers free shipping through its loyalty programs. Interestingly, Abercrombie & Fitch, Aeropostale, Express, lululemon athletica and Children’s Place are not utilizingii) Generally, to receive free shipping, softline retail cross channel fulfillment, although lululemon athletica and customers must meet a minimum order threshold. Children’s Place have taken steps to do so. We believe Notably, Nordstrom and lululemon athletica are the only channel integration between stores and online provide a softline retailers that offer free shipping year round without significant competitive advantage and margin opportunity. a minimum threshold. Substantially all softline retailers offer free shipping without a threshold on a promotional v) Softline retail order delivery takes 3 to 4 days, on basis at certain times of the year. In addition, Chico’s average. Saks and Tiffany & Co. are standouts with 1-2 offers free shipping without a threshold through its loyalty day and 1-3 day average delivery times. Meanwhile, at program. least 15 retailers offer a next day delivery option and Nordstrom is currently testing same day delivery. Weiii) Free online returns are less common: Only Nordstrom, expect average delivery times will fall as more softline Urban Outfitter’s Urban Outfitters brand and Gap’s retailers offer next day and / or same day delivery. Piperlime brand offer free online returns (i.e., free to ship back to the distributions centers). 36
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 46Specialty retail and department store eCommerce strategy survey results AEO ARO* ANF ANN CHS COH1) Free Shipping Yes, everyday free shipping isa) Do you offer free shipping (yes / no / sometimes on a Sometimes (special sales or Yes, on a promotional available for members of our Yes (sometimes on a thresholdpromotional basis / proprietary credit card customers only)? (if Yes holiday time frames), and offer Yes, everyday basis CLUB PROGRAMS (The Club basis)no please skip 1b) free shipping to loyalty members for A&F; ClubCali for Hollister) For Holiday: $100 (11/1-12/19 -- ground shipping cut-off); No minimum for loyalty members. Thanksgiving Week - Cyber Varies by brand - $150 forb) Is there a minimum $ spend threshold to receive free $100; promotional basis free with Threshhold typically $175 for Ann For non-loyalty, amount varies, Monday: $75; o/w: weekend / 1 members at A&F; $100 for $150shipping? If yes, how much is it? no minimum and $125 for LOFT but the most common threshold is day free shipping promos members at Hollister $125 throughout year at similar thresholdsc) What is the average shipping charge for orders that do not Estimate = $8, which includes $7 US $7 Average is between $12-15 $8.95 for Ann, $7.95 for LOFT $10ship for free? expedited shipping Categories level at certain times,d) Do you offer free online returns? For defective/damaged items Not at this time No No, except for rare promotions No BTS jeans, bras and footwear2) Ship Timesa) What is your average ship time on online orders (# of days, 3-5 days 3-6 days for standard ground On average, 3-5 days On average, 4 days 2-3 days 2-3 dayseg. 3-5 days or 1-2 days)? No, although do offer Store Pick- up, allowing visitors to place anb) Are you currently testing same day delivery? No NA Not at this time Not currently testing Not currently order online and pick-up in a store nearby Yes, if ordered before 1pm ESTc) Are you currently testing next day delivery? Already offer NA Already offer Already offer Not currently and no Saturday delivery Currently do same day shipping,d) Do you plan to test same day shipping within the next 3 Potentially; closely monitoring the Possibly. No firm plans right Yes NA Likely although do not have a plan foryears? market now same day delivery3) Inventory Fulfillment Not at this time, though aa) If an item at a store is out of stock can your sales associates Yes - store-to-door NA consumer can do so on a mobile No Yes Yespull from online inventory? deviceb) If an item at a store is out of stock can your sales associates NA Not at this time Yes Yes Yespull from other store inventory?c) If an item online is out of stock on your web site can you pull Not yet NA Not at this time Yes No Yesfrom store inventory to fulfill the order?d) Are you currently testing or in the process of implementing Yes - fulfill from store (early In the process of looking into Not at this time Yescross channel fulfillment? stages) cross channel fulfillmentSource: Company Data, Morgan Stanley Research*Note: ARO outsources its e-commerce to GSI Commerce, and therefore does not strategically control its website. 37
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 47Specialty retail and department store eCommerce strategy survey results (continued) AEO ARO* ANF ANN CHS COH4) SKU Overlapa) How many of your store SKUs do you offer online and / or 100% of store SKUs offered For the most part, assortments 100% of store SKUs available All store SKUs are offered on- 100% of store SKUs offered Majoritywhat % of your store SKUs are offered online? online are harmonized between channels online line online Exact amount not publicly disclosed (yet), but seeingb) How many of your online SKUs and / or what % of your online Do have online-only, but wont positive trends on size extensions 10% of online SKUs are Roughly 35% ~5% 30%SKUs are exclusive to online? comment on the % (smaller, larger, shorter, longer), exclusive to online color depth, and online exclusives like swimwear for Soma5) Loyalty Program Currently do not offer a loyaltya) Is your loyalty program integrated online? Yes Yes for P.S. brand; NA for Aero Yes Yes Yes program in North America Yes, including free shipping, Email notifications andb) Are there any additional benefits for loyalty program members Special email offers and online exclusive content, such as Yes Yes, but could do more promotions, personalizedonline? exclusive promotions playlists, and early access to messages, and free shipping seasonal assortment6) "Showrooming" No, although the web isa) Do you use stores as showrooms by displaying merchandise accessible in all stores for Yes, testing select stores forat your stores which can only be ordered from distribution NA No Yes No customers to browse items that footwearcenters (i.e. are not stocked in stores)? may not be offered or available in a particular storeb) For what categories are you using stores as showrooms (e.g. Footwear NA Primarily wedding and shoeshome, big ticket, shoes, etc.)?c) At how many stores have you used showrooming (small %, Roughly 100% NA Small percentageall, etc.)?d) Do you have plans to test using stores as showrooms? If Yes, eventually, likely all/most NA Not at this time No current plansso, for which categories? categories over time*Note: ARO outsources its e-commerce to GSI Commerce, and therefore does not strategically control its website.Source: Company Data, Morgan Stanley Research 38
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 48Specialty retail and department store eCommerce strategy survey results (continued) EXPR GPS JCP JWN KSS* LTD1) Free Shippinga) Do you offer free shipping (yes / no / sometimes on a Yes, on a promotional basis andpromotional basis / proprietary credit card customers only)? (if for all A-List credit card Yes Yes Yes Yes Yes, on a promotional basisno please skip 1b) customers $50 threshold at Gap, ON andb) Is there a minimum $ spend threshold to receive free ~$150; all orders for A-list credit BR; Piperlime on all order sizes. $50 or free ship to store with no Typically $75. Sometimes $50 on No Yesshipping? If yes, how much is it? card customers Luxe loyalty customers receive minimum promotional basis (e.g. Holiday) free shipping on all orders Standard shipping: $5.95 forc) What is the average shipping charge for orders that do not $7 for standard shipping at Gap, $15 for two business days. $25 orders <$25, $6.95 for orders ~$7ship for free? ON and BR (per website) for next business day $25.01-$50 and $8.95 for orders $50.01-$75d) Do you offer free online returns? Yes at Piperlime; otherwise no Yes No No2) Ship Times Depends on shippinga) What is your average ship time on online orders (# of days, Standard: 5-9 days and priority methodology chosen. (Standard 3-5 days 3-6 business days About 5 dayseg. 3-5 days or 1-2 days)? air: 2-3 days shipping is 3-5 days per website)b) Are you currently testing same day delivery? No No No Yes No No Orders placed by 2pm Monday-c) Are you currently testing next day delivery? No Already offer No Already offer Thursday will arrive next business Available for an additional cost day for free Would consider in the future; tiedd) Do you plan to test same day shipping within the next 3 Potentially to pilot of order on-line, deliveryears? from store running this fall3) Inventory Fulfillment At some stores. Depends on Currently can order from an iPad,a) If an item at a store is out of stock can your sales associates No whether the store has an online Yes Yes Yes (in-store kiosks) and will be able to order frompull from online inventory? terminal POS in Spring 2013b) If an item at a store is out of stock can your sales associates No No No Yes No Nopull from other store inventory?c) If an item online is out of stock on your web site can you pull Testing shipping from stores in No Yes, at Gap and BR brands No Yes Nofrom store inventory to fulfill the order? metro areasd) Are you currently testing or in the process of implementing Yes Nocross channel fulfillment?* Note: KSS shipping data comes from the company website.Source: Company Data, Morgan Stanley Research 39
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 49Specialty retail and department store eCommerce strategy survey results (continued) EXPR GPS JCP JWN KSS* LTD4) SKU Overlap Broadly speaking, the majority ofa) How many of your store SKUs do you offer online and / or Expanding online selection to Most assortment available online and 90%+ ~1.5Bn SKUs online All store SKU’s are offered onlinewhat % of your store SKUs are offered online? reach parity with stores stores Select instances. For example, ~23% of goods online areb) How many of your online SKUs and / or what % of your online Old Navys plus offerings are shipped directly from vendors; Low percent A significant percentageSKUs are exclusive to online? exclusively online and maternity these goods are only available offerings are primarily online online5) Loyalty Program Yes (online purchases apply fora) Is your loyalty program integrated online? Yes Yes Yes Yes No loyalty program loyalty members)b) Are there any additional benefits for loyalty program members Free standard shipping for A-List Shipping benefits for higher levels Noonline? credit card customers6) "Showrooming"a) Do you use stores as showrooms by displaying merchandiseat your stores which can only be ordered from distribution No No Yes No No Nocenters (i.e. are not stocked in stores)?b) For what categories are you using stores as showrooms (e.g. Furniture Nohome, big ticket, shoes, etc.)?c) At how many stores have you used showrooming (small %, Small %all, etc.)?d) Do you have plans to test using stores as showrooms? If Not at this time Noso, for which categories?* Note: KSS shipping data comes from company website.Source: Company Data, Morgan Stanley Research 40
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 50Specialty retail and department store eCommerce strategy survey results (continued) LULU M PLCE SKS TIF URBN1) Free Shippinga) Do you offer free shipping (yes / no / sometimes on a Yes, over $50 for Urban and on a Yes, to SFA card holders and topromotional basis / proprietary credit card customers only)? (if Yes Yes Sometimes Yes, on a promotional basis promotional basis for other others on a promotional basisno please skip 1b) brands Macys.com: $99 and Bloomingdales.com: $150.b) Is there a minimum $ spend threshold to receive free Sometimes utilize threshold $50 at Urban, promotions vary at No Cosmetics at Macys and Usually $60 or $75 Sometimes $175shipping? If yes, how much is it? (~$150) other brands Bloomingdales: $50. Search and Send from a store: $50c) What is the average shipping charge for orders that do not Standard shipping in $9.95. $5 $15-$16ship for free? Expedited shipping costs more No, but have used it as an Exploring the option of free Yes for Urban. No for otherd) Do you offer free online returns? occasional promotion on No No No returns brands Bloomingsdale.com2) Ship Times Depends on customer location and service choice but average 2-a) What is your average ship time on online orders (# of days, 5-7 days is standard NA 2-3 days 1-2 days 1-3 days 3 days. 6 western states next dayeg. 3-5 days or 1-2 days)? from Reno (but only 15% ships from there) Q1 will implement order online pick up same day. If we seeb) Are you currently testing same day delivery? No No No No No demand we will consider same day delivery Place the order by 10am ESTc) Are you currently testing next day delivery? Already offer Already offer Yes, at additional cost Yes, in some cases Already offer and will receive tomorrowd) Do you plan to test same day shipping within the next 3 TBD. Maybe in select major Exploring TBD Perhaps No (See above)years? metro areas3) Inventory Fulfillmenta) If an item at a store is out of stock can your sales associates No Yes No Yes Yes Yespull from online inventory?b) If an item at a store is out of stock can your sales associates No Yes (292 fulfillment doors) No Yes, through the locator system Yes Yespull from other store inventory? On a limited basis (testing now);c) If an item online is out of stock on your web site can you pull No Yes (292 fulfillment doors) No will be fully operational in mid- Yes Yesfrom store inventory to fulfill the order? 2013d) Are you currently testing or in the process of implementing Yes Yes See abovecross channel fulfillment?Source: Company Data, Morgan Stanley Research 41
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 51Specialty retail and department store eCommerce strategy survey results (continued) LULU M PLCE SKS TIF URBN4) SKU Overlapa) How many of your store SKUs do you offer online and / or Almost 100% same selection NA 100% Not disclosed ~4,000 SKUs online Mostwhat % of your store SKUs are offered online? online as in stores Not currently offering exclusive Almost all china / crystal isb) How many of your online SKUs and / or what % of your online online - have done so in the past 0% - all online is available in store 5% Not disclosed exclusive to online. Otherwise, aSKUs are exclusive to online? with classic styles. May look to somewhere pretty low amount do this again in the future5) Loyalty Program Some degree with Anthropologie program but still developing.a) Is your loyalty program integrated online? No loyalty program Yes Yes Yes NA Other two brands will launch loyalty this coming yearb) Are there any additional benefits for loyalty program members No No NAonline?6) "Showrooming"a) Do you use stores as showrooms by displaying merchandiseat your stores which can only be ordered from distribution No Yes, selectively No No No Testingcenters (i.e. are not stocked in stores)?b) For what categories are you using stores as showrooms (e.g. No Depends NA Shoeshome, big ticket, shoes, etc.)?c) At how many stores have you used showrooming (small %, None Small % just testingall, etc.)?d) Do you have plans to test using stores as showrooms? If Maybe if expand online to more No NA NAso, for which categories? SKUsSource: Company Data, Morgan Stanley Research 42
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWestern Europe Retail Exhibit 52Geoff Ruddell Online spending in the UK is much higher than inEdouard Aubin most other marketsAnisha Singhal Internet retail spending per capita 2011 (US$)Executive Summary / Key Takeaways United Kingdom 723Best-positioned: ASOS Denmark 5291. Online penetration varies significantly across Western Europe. About South Korea 466 15% of non-food sales and 5% of food sales are now transacted online USA 417 in the UK (one of the highest rates in the world), but in Southern France 398 Europe, online spending remains minimal. Sweden 3812. "Click and Collect" services are proving very popular in both the UK Japan 348 and France, though it is not yet clear whether this is merely because Germany 295 these services are offered for free by most retailers. Switzerland 2913. The impact of the online shopping revolution in the UK goes well Belgium 239 beyond the retail industry. It is beginning to have a profound impact on Canada 136 the property industry and increasingly, on the very fabric of society. Italy 70 Spain 45Western European eCommerce trends are so diverse thatit is difficult to generalize China 17While it may be legitimate to treat the US as a single market Source: Euromonitorwhen it comes to looking at online shopping trends, we think itmakes little sense to look at Western Europe in this way. According to official government statistics, 9% of UK retail sales in 2011 were transacted online.The level of online development varies so significantly from Exhibit 53one country to another that we believe the use of ‘average’ Around 9% of all UK retail sales (and about 15% ofdata is potentially misleading. non-food sales) were transacted online in 2011 £ mnThe United Kingdom has a higher level of online sales per 800 Average weekly value for Internet retail sales 12%capita than any other country in the world… 700 Internet sales as a percentage of total retail salesAt one extreme, we have the UK, which has the highest level 10% 600of online spending in the world. 8% 500 400 6% 300 4% 200 2% 100 0 0% Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Source: ONS, Morgan Stanley Research Importantly, the data include food retail spending (where online penetration is around 5%), so the online penetration in non-food averages is around 15%, though this average also masks significant variations by product category. 43
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailAs Exhibit 54 shows, in some categories more than a third of Exhibit 55sales are now transacted online. As we will go on to discuss, There is a clear correlation with broadband accessthis is not only having a profound impact on the store based and online penetrationretail industry, but the very fabric of UK society. Households with broadband internet access (%, 2011) 100%Exhibit 54 90%Online penetration in the UK varies significantly by Netherlands Sweden UKcategory 80% Norway Germany Online penetration of UK retail sectors in 2012 70% France Music & Video 79% Spain 60% Books 47% Portugal Electricals 39% 50% Italy Greece Clothing & Footwear 12% 40% Homewares 11% 0% 2% 4% 6% 8% 10% Online penetration (2011) DIY & Gardening 6% Funiture/Flooring 6% Source: Euromonitor, Mintel, Morgan Stanley Research Food & Grocery 5% While we struggle to identify interesting online Health & Beauty 5% ‘megatrends’ in the less developed Southern European markets, we do think there are some noteworthy themesSource: Verdict, Morgan Stanley Research emerging in the UK…whereas the eCommerce revolution has barely begun in Given the low level of online retail development in Southernsome Southern European countries Europe, we think it rather futile to try to spot onlineAt the other extreme are the southern European markets of ‘megatrends’ in these markets.Portugal, Spain, Italy and Greece. In these countries, onlinesales still account for less than 1% of retail spending and the However, we think there are a number of very noteworthytraditional retail industry, and society more widely, has barely themes emerging in Northern Europe, particularly, but notbeen impacted thus far. exclusively, in the UK.We believe there is a variety of factors behind this Over the next few pages, we identify 10 such themes anddivergence briefly consider each in turn.It is beyond the scope of this report to look in depth at whyonline sales have taken off much more rapidly in some 1) Online grocery retailing is becoming mass-market…European markets than in others. However, we believe that Online grocery retailing in the US has had limited traction tothere are number of contributory factors including lower date, accounting for less than 0.5% of the market today.broadband penetration (see Exhibit 55), a greater reliance on However, it has become a mainstream way of shopping in thecash as a means of payment, language issues, a low historic UK.take-up of catalogue / home-shopping and customerreluctance to pay for delivery.   44
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 56 Nevertheless, UK online grocery sales now exceed £5B perUK penetration of online grocery is significantly annum, representing almost 5% of the entire market, andhigher than other European markets and the US online sales continue to grow at 10-20% per annum (whereas Penetration of online sales the broader grocery market is barely growing at all). (home delivery and click & collect - 2012e) 4.6% 2) …and it does not necessarily require a store base for picking… Although there is no longer any question about UK consumers 2.7% willingness to embrace online grocery shopping (the old arguments about consumers wanting to select their own fresh produce, etc, have long since been disproved), the debate about how best to service such demand remains ongoing. 0.9% 0.9% 0.3% 0.3% 0.4% Five or six years ago, the conventional wisdom was that it 0.2% made sense for groceries to be picked directly from the shelves in retailers’ stores. Such an approach required littleGermany Spain Portugal US NL Belgium France UK capital investment from the retailers and meant that journeySource: Mintel, Kantar, Morgan Stanley Research times to customer homes from local stores were very shortIt is now more than 15 years since Tesco first introduced an and not relevant to the seller.online grocery service and three of the four major UK chainshave offered nationwide coverage for several years. However, online grocery shopping has now become so popular that in some areas of the UK (particularly in theOur AlphaWise survey suggested that more than 46% of UK London area where sales densities are already very high) it ishouseholds have now tried online grocery shopping and that becoming impossible to ‘pick’ enough orders this way without12% use it regularly. severely disrupting the service provided to those customers still wanting to shop in those stores.Exhibit 5746% of UK households have now tried online In recent years, therefore, Tesco has opened four online-onlygrocery and 12% use it regularly picking facilities (which it refers to as ‘dark stores’) in SouthPercentage of respondents who agree with the statement East England and around 80% of its online orders in the 38% London area are now being picked in this way. Asda and Waitrose have also built similar facilities to take pressure off 20% their store estates. 16% 13% 12% These developments, we believe, may yet provide some vindication for Ocado, a listed UK online-only grocery retailer I have never Buy other I have tried online I occassionally do I regularly shop for that has been servicing orders for more than a decade from a bought anything products on the food shopping but an online food food online on the Internet Internet, but have have now stopped shop dedicated and highly mechanized facility to the North of never shopped for London. This one facility is now generating sales of more than food £650MM per annum (though, somewhat worryingly, in ourSource: Company Data, Morgan Stanley Research view, Ocado is still generating very little profit on this level ofMost of those who do use such services, however, do not do turnover) and a second site is under construction (at a cost ofso exclusively. Some of the retailers impose minimum order more than £200MM).sizes, while delivery fees (typically £3-5, depending on thedelivery slot requested) also encourage consumers only to 3) …though it may yet require one for pick up!buy groceries online when they have a large order to place. We think, though, that it would be very premature to write-offThus, a typical online grocery shopper will only use such the role of grocery stores.services once or twice a month. Although it may yet prove to be more beneficial to collate orders in dedicated facilities, there is another trend emerging 45
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailthat suggests stores may still have an important role to play in 8.5% by 2015 (back in 2011 it was predicting 6.1%online grocery retailing. penetration by this date). We believe that there are two main reasons why theIn June 2000, Auchan (a private French retail group that service is proving to be so popular with Frenchgenerated €44B of sales in 2011) introduced a drive-thru consumersservice, which allowed customers to order their shopping First, the French food retail market is unique in that groups ofonline, but rather than waiting for the goods to be delivered to independents (Leclerc, Intermarché and Système U) have atheir home, offered them the chance to come to their local very meaningful market share (42% combined in 2012), whilestore to pick up the collated order. In Auchan’s case, orders their presence in most other European markets is minimal.are put directly by the unit’s employees into the trunks of Under this system, the store manager is also the store ownercustomers’ cars, so that they do not even have to step out of (in the vast majority of cases, he owns the real estate).their vehicles. This is very similar to the McDonald’s drivethrough system, except that the orders have generally already The members are restricted, by the group with which they arebeen paid for, which means that waiting time at the drive affiliated, and in the number of stores in which they may operate (only one in the case of Leclerc and Sytème U, four inthrough unit is minimal (customers generally identify the case of Intermarché). This means that a number of thesethemselves by simply showing some ID or their credit card). members have ample cashflow to recycle (a number of these stores were opened 20-30 years ago and debt has been fullyThis service proved to be remarkably popular and it has paid down). As such, Leclerc, Intermarché and Système U’ssubsequently been copied by other French grocery retailers members’ main focus is on how they can ultimately enhance(including Leclerc, Carrefour and Casino) and as of October the value of their net worth (i.e., maximize the real estate2012, there were more than 1,820 stores in France offering value of their supermarket and the sold shopping centeronline pick up services (i.e., more than in the rest of the world around the store, to be sold to other members uponcombined). Some of these units are now generating annual retirement), rather than worrying too much about the ‘true’sales exceeding €20MM, more than a standalone ‘regular’ marginal return on capital employed.supermarket. Exhibit 59Exhibit 58 Independents (Leclerc, Intermarché and Système U)Grocery “Click and Collect” now accounts for 3% of have been particularly aggressive in rolling outtotal sales in France drive through units in France Grocery click & collect segment net sales (€MM, TTM) in France between Jan-11 and Nov-12 Système U 29% 2,000 Intermarché 24% 1,600 Leclerc 14% 1,200 Casino 12% 800 Carrefour 9% 400 Auchan 9% 0 Cora 3% P1-11 P2-11 P3-11 P4-11 P5-11 P6-11 P7-11 P8-11 P9-11 P10-11 P11-11 P12-11 P1-12 P2-12 P3-12 P4-12 P5-12 P6-12 P7-12 P8-12 P9-12 P10-12 P11-12 Source: Editions Dauvers, Morgan Stanley Research Note: the graph shows the share of each player’s in the total number of drive through units operated in France in August 2012.Source: Kantar, Morgan Stanley Research Second, and related to the first point, the vast majority of theAccording to consulting firm Kantar, in 2010, less than 3% of drive through offers in France remain free of charge.French households had tried a grocery pick-up service (whichaccounted then for a market share of 0.9%). However, by As the channel has proven to be so popular among customers,4Q12 over 11% of French households had used such a integrated groups such as Carrefour or Cora have feltservice at least once over the past 12 months (the channel’s compelled to introduce similar services. This has led amarket share reached 3.0% in October) and Kantar now number of observers to question if the growth of this segmentestimates that the channel could reach a market share of is offensive or defensive and / or if its expansion will prove to 46
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailbe detrimental to the food retail industry’s profitability in the As Exhibit 60 illustrates, in FY 2005/6 a total of 22% of Argos’long term (increased capacity, impact on non-food sales sales were delivered to home, but this total has actually fallenwithin the store as impulse buying decreases, etc). in recent years, despite the rapid growth in online sales.Having seen the success of “Click and Collect” services, a The growth at Argos has come from customers orderingnumber of the leading UK grocers have recently introducedsimilar trials. By the end of this year Tesco expects to have online, but picking goods up from the store (i.e., “Click and150 to 170 stores offering “Click and Collect” groceries (up Collect”), a channel that has grown from 6% of sales in FYfrom 0 in January 2011), with Asda looking to roll out quickly 2005/6 to 28% in FY 2011/12 (in H1 of the current financialto 100 stores following a successful six-store trial. year this figure has risen further to 30%).The drive-through model being rolled out in the UK currently In total, 39% of Argos’ sales were ordered online last year, butdiffers on two important aspects from that of France: First, the more than 70% of these were picked up from store rather thanservice is not free. In the case of Tesco, the minimum charge delivered to customers’ homes. Some of the products thatis £2 (depending on the time of the day) vs. £3-5 for home Argos sells are very bulky (e.g., Sofas and large screen TVs).delivery, as a comparison. On many of these items, Argos does not offer customers theSecond, picking is done within the store (while in most cases option of picking up from a store. Therefore, we estimate that,in France, picking is done in a small dedicated fulfillment area, when given the choice, customers opt to collect goods from aimmediately adjacent to the store, in order to maximize store on more than 80% of online orders.efficiency). In France, most drive though units are immediatelyadjacent to the stores, but some are standalone units literally Although we suspect that this may seem an extraordinarilymiles away from the main store (with the picking done from a high proportion to some retailers, it is not particularly out ofdedicated fulfillment area at the drive through location). line with other UK non-food retailers, as Exhibit 61 illustrates.4) “Click and Collect” is proving very popular, but we Exhibit 61suspect it is providing retailers with a false sense of “Click and Collect” is proving very popular forsecurity… many retailers…“Click and Collect” services are also very important in UK non- Click and collect (% of online orders which are collected in store)food retailing. Perhaps the most dramatic illustration of this 100%comes from Argos, which is one of the UK’s largest non-foodretail businesses (its turnover in FY 2011 / 12 was £3.9B). 80% 60%Argos was an early pioneer of multi-channel retailing and formany years has offered its customers a choice as to how to 40%order goods (either in one of its 700+ stores, or via the 20%telephone or Internet) and how to take receipt of them (eitherpick them up from the store or have them delivered to their 0% Next Marks and Dixons Argos Halfordshomes). Spencer Source: Company Data, Morgan Stanley ResearchExhibit 60The way consumers shop Argos is changing rapidly Indeed, consumer research conducted by Mintel shows that2005/6 Instore Telephone Internet Total Instore 68% 5% 6% 78% 41% of Internet shoppers have ordered goods online for in-Received Home delivery 11% 4% 7% 22% store collection. Total 79% 9% 12% 100% 16% reduction in 22% increase in The proportion of participation of participation of total sales "traditional" "click & collect" delivered to home transactions has fallen2011/12 Instore Telephone Internet Total Instore 52% 2% 28% 81%Received Home delivery 7% 1% 10% 19% Total 59% 3% 39% 100%Source: Company Data, Morgan Stanley Research 47
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 62 Exhibit 64… and consumer research shows that 41% of Price, not convenience, appears to be the mainInternet users say they bought something online to reason why UK consumers use “Click and Collect”collect in-store services % of Internet users who had ordered… I am willing to pay more for faster shipping of online 17% purchases 81% I would prefer to pick up products ordered online from a store or other physical locations than having them 18% delivered I would buy online more often if online retailers offer 34% same day delivery I would buy online more often if delivery can be 57% arranged during the hours I am home 41% I would buy online more often if I didnt have to pay 73% shipping for return or exchange When buying products online, I would choose the 82% cheapest shipping option I would buy online more often if retailers offer free 83% shipping ...from the Internet for home delivery ...from the Internet to collect in store Source: AlphaWise, Morgan Stanley ResearchSource: Mintel, Morgan Stanley Research In our experience, the management teams at many offlineBroadly, we think that there are three reasons why “Click and retailers appear to be taking considerable comfort from theCollect” is proving so popular in the UK: immediacy (see high proportion of Internet orders that are “Click and Collect”,Exhibit 63), convenience (in the UK it is not generally possible claiming that this data justifies continued investment in theirto leave a parcel on someone’s doorstep if they are not in, so store portfolios.someone needs to be at home to receive deliveries) and cost(in-store pick up is free, whereas there is often a charge for Exhibit 64, however, suggests consumers are not coming tohome delivery). the stores because they still want to do so, but rather because it is cheaper to do so. As online delivery costs continue to fall,Exhibit 63 this does not strike us as a particularly defensible position.43% of Argos “Click and Collect” orders are pickedup within 4 hours of the order being placed 5) Store-based retailers do have an advantage when it Time between click and collect % of click and collect sales comes to returning items… Within 1 hour 17% Although our AlphaWise survey suggests that many Within 4 hours 43% consumers only use “Click and Collect” services to save Within 8 hours 52% Within 24 hours 54% money, it would appear that most consumers genuinely find Within 48 hours 100% the role of stores helpful when it comes to returning unwanted items.Source: Company DataOur survey data suggests that the most important of the Inditex (the worlds largest clothing retailer and owner of Zara),three factors is cost has stated that about 80% of its online orders are returned toIn our most recent AlphaWise survey, only 18% of stores. Other European apparel retailers have providedrespondents agreed with the statement that they preferred to similar statistics (Next reports around 60%, Marks & Spencerpick up goods from a store rather than have them delivered to more than 70%).home. However, 82% stated that they would choose thecheapest shipping option (which in the UK is usually “Click Although this, too, may be partly cost driven (i.e., consumersand Collect”). not wanting to pay the postage for returns), many retailers (including Zara and Marks & Spencer) offer free returns. We believe that the main reason why the proportion of goods returned via stores is so high is simply because it is easier to drop goods into a local store than it is to repackage them and post them back (which often involves queuing up in a post office or waiting at home for a courier). 48
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail6)…but it is becoming clear that many retailers will need The variation illustrated in Exhibit 66 is not attributable simplyless space in the future with a growing distinction to geographic factors and the impact that the recession hasbetween Primary and Secondary locations… had on different regions. There is also a clear distinctionAlthough stores continue to play an important role, it is emerging between Primary and Secondary selling space.becoming very clear to many UK retailers that consumershopping patterns are changing and that this will require them We believe the advent of online shopping (as well as theto make significant changes to their store portfolios. growing availability of non-food goods in UK supermarkets) has created a growing division between shopping activity thatOf the quoted retailers, the most extreme downsizing plan is merely functional (what we term ‘maintenance shopping’)announced to date has been that of Mothercare (the UK’s and that undertaken as a leisure activity.leading baby equipment retailer), which is planning to reduceits UK store count by more than 50% (it is targeting 200 by The new shopping channels that have emerged have allowedMarch 2015, from 425 stores as recently as 2008). consumers to fulfill their maintenance shopping needs more quickly and more conveniently than they were able to do 15 orArgos, Arcadia, B&Q, Currys, Aurora Fashions and Sports 20 years ago. Not so long ago, the typical UK consumer spentDirect, however, have also all announced that they are much of Saturday trudging up and down the local High Streetlooking to reduce the number of stores from which they trade in order to acquire necessary, but unexciting goods. Today(though in some cases their lease commitments will make most such items can be purchased at the same time as thedownsizing a slow and potentially expensive, process). weekly food shop or ordered online for delivery through one’s letterbox.Combined with the difficult macro-economic situation, thestructural trends for retailers to need less selling space is Because consumers are now able to acquire ‘maintenance’beginning to have a profound effect on the UK property goods in these ways, ‘going shopping’ is increasinglymarket. something that consumers do because they want to, rather than because they need to. This move from functionalThe Local Data Company, a specialist independent third party shopping to leisure shopping, we believe, is an important one,data provider, tracks vacancy rates in about 700 UK High because it changes what consumers expect from theirStreets (by using a team of more than 50 in-the-field shopping trip and, thus, where they are likely to go.researchers who physically inspect each location regularly).Its data suggest that around 1-in-7 UK stores is currently Most consumers would struggle to describe a visit to theirvacant, but that this average masks huge variations, as local parade of shops as a pleasurable experience. However,Exhibit 65 shows. visiting a major shopping mall (such as one of the twoExhibit 65 Westfield shopping malls opened in London in recent years)Vacancy rates are nearly 40% in some towns is, for many people, a ‘day out’. Town centre vacancy rates across the UK % Thus these prime locations continue to prosper and still enjoy 40 almost 100% occupancy rates (despite charging very high rents), while many more secondary locations are now in real 35 trouble. 30 25 20 UK national average 15 11.44 10 5 0Source: Local Data Company for Morgan Stanley Research 49
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 66 8) Shopping online is increasingly becoming a leisureFoot traffic on high streets has been declining activityfaster than across UK nationally Although declining foot traffic patterns suggest that 105 consumers do not enjoy visiting their local shops, there is 100 growing evidence to suggest that online shopping is becoming 95 a leisure activity in its own right, rather than merely a way for 90 consumers to save time. 85 80 Indeed, consumer research from Mintel shows that 45% of UK 75 consumers now view online shopping as a form of 70 entertainment (40% of men and 49% of women), while our 65 recent AlphaWise survey suggests that the majority of UK and 60 2006 2007 2008 2009 2010 2011 2012 German consumers believe that online browsing is better than (YTD) or at least as good as browsing in a store. High Street National Exhibit 67Source: BRC, Springboard-ATCM, Experian, Morgan Stanley Research Most consumers agree that browsing online is7)…which is creating significant social issues that go well better or just as good as browsing in stores "Browsing products on websites is better than or just as good as browsing in stores"beyond retailingOne of the problems of high vacancy rates is that they can 40% 35%become self-fulfilling. 30% 25%Few retailers operate genuine ‘destination’ stores and most, 20%therefore, are reliant on passing foot traffic. However, when a 15%town centre has a high number of vacancies, the level of foot 10%traffic tends to decline (because the town centre has become 5%a less attractive place to go shopping). This results in a lower 0% Strongly agree Somewhat Neither agree Somewhat Stronglylevel of sales at those remaining stores, leading more of them agree nor disagree disagree disagreeto close and, hence, a higher vacancy rate. UK Germany Source: AlphaWise, Morgan Stanley ResearchIn a speech last year at Oxford University, Phil Wrigley(formerly the CEO of clothing retailer New Look and currently We believe that the ‘entertainment’ factor is much higher inChairman of Majestic Wine) described this vicious circle as a some categories than in others. In fashion, for example, many“death spiral”. consumers may be keen to ‘window shop’ the latest trends and products, whereas fewer will want to browse moreThe fact that so many traditional UK High Streets now appear commoditized goods such as groceries.to be in serious, perhaps terminal, decline has ramificationsthat go well beyond the retail sector. We suspect that it is this greater ‘browsability’ that explains why Zara has more ‘likes’ on Facebook than Amazon does,Only around 75% of households in the UK have access to a despite the latter having more than 50x the level of onlinecar and many of the more vulnerable members of society rely sales 2.on local facilities. The “death” of high streets, therefore, hasbecome an important political topic in recent years in the UK.Indeed, last year the government commissioned an in-depthstudy on the topic by Mary Portas (a former retail executivewith a very high public profile in the UK), though its findingshave been met with a lukewarm response by many retailers. 2 Amazon’s total sales are almost 5x those of Zara. Inditex (Zara’s parent company) has not disclosed the proportion of Zara’s sales being made online, but most commentators assume it is somewhere between 5 and 10%. 50
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 68 Exhibit 70Zara has more ‘likes’ on Facebook than Amazon Traffic to online retailers seems to trend togetherFacebook likes (mn) 11030 10025 9020 80 7015 6010 50 40 5 30 0 20 Walmart Zara Amazon H&M Abercrombie Best Buy Tesco Argos & Fitch Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12Source: Facebook, Morgan Stanley Research ASOS New Look River Island Topshop Source: Google Trends, Morgan Stanley ResearchAnother illustration of the way that online shopping isbecoming a leisure activity is the growing level of consumer Engagement with blogs and use of social media for retailengagement with blogs and the use of social media for retail purposes has also been rising with the increase of onlinepurposes. As one might predict, this level of engagement is penetration.currently much higher among younger consumers, but weanticipate that it will not be long before older consumers catch 9) Mobile represents a new frontierup. Another important trend is the impact that mobile devices are having on the online retail market. With 50% of UK mobileExhibit 69 users now owning a smartphone, mobile commerce is quicklyUK consumers are discussing their purchases becoming an important retail channel in its own right.online, especially the younger demographic Exhibit 71 23% 22% 24% 24% Around half of UK mobile phone owners have 21% 19% smartphones 18% 14% 55% 11% 7% 50% 45% 16-24 25-34 35-44 45-54 55+ Posted reviews online of purchases 40% Clicked Facebook "Like" button or tweeted about purchasesSource: Mintel, Morgan Stanley Research 35%We also think Exhibit 70 is an illuminating way to demonstrateour thesis that shopping online is becoming a leisure activity 30%in its own right. It shows the number of Google searches Q1 11/12 Q2 11/12 Q3 11/12 Q4 11/12 Q1 12/13 Q2 12/13being undertaken for various UK retailers. We think it Source: Vodafone, Morgan Stanley Researchinteresting to note that activity levels for different retailers arehighly correlated, suggesting to us that consumers are Most leading UK retailers have now launched mobile‘browsing’ between sites. Moreover, there appears to have optimized sites or smartphone apps and the share of visitsbeen a notable dip in activity in the UK around the time of the through mobile devices is dramatically increasing. As anLondon Olympics – a period when most UK consumers were example, Exhibit 71 shows how the proportion of visits fromglued to their television sets. mobile devices to the ASOS website has risen from virtually nothing to more than 20% in just two years. 51
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 72 Exhibit 73ASOS’ visits from mobile devices now account for UK and Germany are among the top five countriesmore than 20% of total visits in urban GDP Visits to mobile site as a % of total visits Urban GDP (US$ tn) 35% 14 30% 12 25% 10 8 20% 6 15% 4 10% 2 5% 0 Russia Brazil Australia Italy Germany US UK Japan China France Canada Spain 0% Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Historic Management forecast Source: World Bank, Morgan Stanley ResearchSource: Company Data, Morgan Stanley Research Exhibit 74According to latest data from IMRG (the UK’s industry body High population density allows more efficientfor Internet retailers), 21.1% of all visits to eCommerce sites fulfillment and deliveryand 11.6% of all online sales in the UK now come from mobile People per sq kmdevices. 400 351 350Many retailers (including M&S and Asda) are now rolling outfree in-store Wi-Fi and even equipping staff with iPads to help 300 259them interact with customers. The online revolution in Europe, 250 234therefore, appears to be entering an important new phase. 200 14410) UK and Germany among the largest 150international markets for Amazon and eBay 100Along with Japan, the UK and Germany each represent about 50 34 2311-15% of Amazon’s net sales ($6.3B each at the mid-point in 9 3 02011). For eBay (including revenue from PayPal), UK and Japan UK Germany China US Brazil Russia AustraliaGermany each represent about 13% of net sales ($1.5B each Source: World Bank, Morgan Stanley Researchin 2011). It is no surprise that these two international marketsare the largest for Amazon and eBay given their attractive Due to the high population density, Amazon Prime membersdemographic characteristics. UK and Germany rank among in UK and Germany receive free one day shipping on eligiblethe top five countries in terms of urban GDP and have a very items whereas in the US, Prime members receive free twohigh population density. day shipping. According to our AlphaWise survey, Amazon and eBay are the top two favorite retailers among UK consumers with 92% and 57% of online shoppers having purchased products from these two sites respectively. Argos, Tesco and Marks & Spencer are the next three largest retailers in terms of online purchases among UK survey respondents. 52
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWestern Europe Luxury RetailLouise Singlehurst François-Henri Pinault, Chairman and CEO, PPR, quoted in Women’s Wear Daily, December 6, 2012:Online sales channel still small, but we see “If you look at [online] sales, it’s not very big, maybe 2 or 3significant opportunity over the long term percent. But one customer in five, on average, will go online before going into stores. So the influence of the onlineThe eCommerce channel is small for luxury, but growing channel on the offline channel is great. You can be a smallgreater than 20% per annum brand or a big brand like Gucci, but you cannot offer yourWe believe online represents on average only 5% of sales for customers an experience in your stores that is completelythe global luxury brands. This is partly explained by the different from what you offer them online… The next step willexpensive nature of the goods (high ticket price), in-store be to transform the e-commerce experience of our brands intocustomer service and product education. However, there is the luxury experiences as we do in our stores.”plenty of evidence to suggest a growing appetite ofconsumers willing to purchase online (Yoox.com, Net-a- Exhibit 76porter.com). This is particularly true for the leather and Online luxury revenues have increased 25% y/y inaccessories segment (where one size ‘fits all’). According to 2010 and 2011Bain, the online luxury market will reach about €7B sales in Online luxury revenues, EUR bn2012, growing over 20% each year since 2009. 8 30 7 25Luxury brands should treat online as complementary to 6 5.6 20the offline store network in our view 4.5Unlike offline retail, we see the online channel as 4 3.6 15complementary to the store network and helps improve retail 10productivity. Consumers are carrying out product research at 2 5home and discussing brands on social network sites, with thepreference to make the purchase in store. This is due to 0 0several factors (a broader product selection, customer advice, 2009 2010 2011 2012eVIP programs). We also believe this is beneficial to the Full-price sales (LHS) Off-price sales (LHS) YoY growth % (RHS)brands, with the increased likelihood of cross-selling across Source: Bainproduct segments with a personal service. We expectincreased investment in online platforms will be a key themeacross the luxury brands. Amongst the European brands,Burberry is leading in this field in our view.Exhibit 75Top 10 most searched luxury handbag brandsglobally 1 Coach 6 Prada 2 Louis Vuitton 7 Hermes 3 Chanel 8 Mulberry 4 Gucci 9 Marc Jacobs 5 Longchamp 10 Michael KorsSource: Digital Luxury Group 53
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailBrazil: Internet and RetailLoredana Serra sequential increases in the mix of products where it offers theJeronimo De Guzman lowest prices.Franco Abelardo Growing C class penetration should drive future eCommerce growthExecutive Summary / Key Takeaways In Brazil, there are five consumer classes (A-E) that are defined by the possession of specific durable goods (such asBest-positioned: MercadoLibre (covered by Scott Devitt) ovens and TVs), versus by income levels, like in the United1. Growing middle class penetration should drive future eCommerce States. Our AlphaWise survey was conducted of consumers growth. in classes A-C, as consumers in D-E do not generally have Internet access and are not expected to materially impact2. Price and convenience have been main drivers of adoption; eCommerce over the next several years. Brazil has a shipping, payment terms, and security can drive further growth. population of 194MM inhabitants, of which 25% are in classes3. High penetration of high-ticket electronics/appliances currently but A-B (48MM), and 49% is in class C (95MM). significant room for growth in new lower-ticket categories. Brazil Internet penetration and online shopping is still4. Traditional linked retailers dominate eCommerce space in Brazil; significantly below US levels…   core customers vary significantly by site. Internet penetration among A-C consumers in Brazil is 56%, which is still considerably below the US at 81%. In addition,Summary AlphaWise data suggests that only 56% of Brazil InternetThe eCommerce industry in Brazil has grown at a rapid pace users have actually made a purchase online, as compared to(29% CAGR over 2007-2012), but current penetration 85% for the US. Therefore, we estimate about 32% ofremains low, particularly among middle-income consumers – Brazilians have bought products on line, which is less than thewhich should drive further growth. Our analysis by category US at 69%.also shows significant room for continued eCommerce Exhibit 77penetration across many categories, particularly in books, Internet penetration: Brazil vs. USclothing and shoes. (B) % of Online eCommerce (A) Internet users that have shopper penetrationCost / scale advantages are key since lower prices are the penetration shopped online (A x B)primary driver of online shopping, according to our AlphaWise A / B (48 mn pop) 78% 68% 53%data. In addition, faster / more reliable delivery, addressing C (95 mn pop) 45% 47% 21%payment security / privacy concerns and ease of processing Brazil Total 56% 56% 32%returns are also important drivers for growth. Further, we US 81% 85% 69%believe that eCommerce retailers linked to established Note: Brazil data is for A / B/C consumers only Source: Cetic.br, World Bank, Morgan Stanley AlphaWise.traditional companies have an advantage in meeting theseneeds, given their existing scale, trusted brands, and (in some …mainly due to low penetration among C classcases) integrated platforms that allow for returns at the consumers physical stores. Using AlphaWise and Celtic.br data, we estimate Internet penetration for A / B classes is about 78%, and of thoseAmong consumers, B2W (with its three main brands: Internet users, almost 68% have made a purchase online,Americanas.com, Submarino.com and Shoptime.com) leading to an eCommerce shopper penetration of aroundcontinues to lead in penetration among online shoppers, 53%. For the C class, 45% has Internet access and 47% offollowed by MercadoLibre and CBD’s three brands Internet users have purchased online, equating to a 21%(Extra.com, CasasBahia.com, PontoFrio.com). However eCommerce shopper penetration rate. This discrepancy inMercadoLibre is the leading third-party (3P) marketplace and eCommerce penetration rates suggests that the C classis generally favored by the (faster growing) C class of online should be the main driver of eCommerce penetration over theconsumers. Our proprietary pricing analysis shows B2W next several years.appears to be using low prices to drive sales growth, with 54
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailHigher C class penetration could bring significant Exhibit 79growth Historical Brazilian eCommerce marketIn Exhibit 78 below, we analyze the potential impact to Brazil 07-12e 2007 2008 2009 2010 2011 2012e CAGR (%)eCommerce from higher penetration of C class consumers. If Population (mn) 184 186 189 191 192 194 1%the C class were to increase to the 53% penetration of A / B Internet users (mn) 62 66 73 77 87 94 9%classes, it would result in 30MM incremental C Class online % of population 33% 36% 39% 40% 45% 49%shoppers, or a 65% increase in the number of online eShoppers (mn) 10 13 18 23 32 42 34% % of total Internet users 15% 20% 24% 30% 37% 44%shoppers in Brazil (vs .the current total of 46MM). However, Annual spend / eShopper (R$) 663 621 602 632 586 536 (4%)this would not necessarily translate directly to a proportional Y/Y Growth 6% (6%) (3%) 5% (7%) (9%)increase in eCommerce volume, as the C class is less Market size (R$ bn) 6.3 8.2 10.6 14.8 18.7 22.3 29% Y/Y growth 43% 30% 29% 40% 26% 19%wealthy than the A / B class. % of total retail 1.6% 1.9% 2.2% 2.7% 3.1% 3.4% Source: IBGE, Cetic.br, e-Bit, Euromonitor, Morgan Stanley ResearchUsing the same analysis for the A / B class penetrationgrowing to US levels, the total number of online shoppers …but still have significant room to grow could rise by another 8MM, or 17%. According to Euromonitor, eCommerce sales represent 3.4% of the total retail market in the country, below the globalExhibit 78 average of 6.5%, US average of 10.1% and levels as high asIf C class eCommerce penetration reached A / B 14.7% for South Korea. We adjust eCommerce estimates tolevels, Brazil would add 30MM incremental exclude auto dealers, gas stations and food service places.shoppers eCommerce Looking forward, we expect eCommerce to continue growing shopper Total users Incremental penetration (mn) users (mn) faster than overall retail sales, though at a slower pace than in recent years. For the next five years, our industry modelCurrent C class: 21% 20 - projects eCommerce market growth of 18% on average perIf penetration increased to A/B level: 53% 51 30 year in Brazil, reaching R$43B or 4.5% of the retail market byCurrent A/B class 53% 26 - 2016e. The main driver should continue being the growth inIf penetration increased to US level: 69% 34 8 online shoppers, as Internet penetration increases and moreSource: Morgan Stanley Research of the existing Internet users begin to shop online, partially offset by lower average spending per shopper.eCommerce merchandise sales have grown fast… Online sales in Brazil should reach R$22.5B (US$12B) in Exhibit 802012, according to e-Bit (a local research company). Since MS estimated Brazilian eCommerce market2007, the Brazilian eCommerce market grew 29% on 11-16eaverage, driven mainly by a higher number of shoppers, 2011 2012e 2016e CAGR Population (mn) 192 194 200 1%which grew 34% over the same period (please note that thetotal eShoppers from e-Bit differs slightly from the amount we Internet Users (mn) 87 94 118 6%get based on the Cetic.br and AlphaWise data). The annual % of population 45% 49% 59%spend per shopper has decreased by about 4% per year, eShoppers (mn) 32 42 84 21%however, this has been mainly driven by: 1) changes in the % of total Internet users 37% 44% 71%mix of shoppers (more lower income shoppers), 2) lowerprices of electronics / appliances, and 3) shifting mix of items Annual spend / eShopper (R$) 586 536 510 (3%)purchased towards lower-priced categories. Y/Y growth (7%) (9%) --% Market Size (R$ bn) 18.7 22.3 42.6 18% Y/Y growth 26% 19% 16% % of total retail 3.1% 3.4% 4.5% Source: IBGE, Cetic.br, Euromonitor, Morgan Stanley Research 55
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailPrice and convenience have been the primary Exhibit 82drivers of adoption, while improving shipping, Main barriers to buying onlinepayment terms and security can drive further Base: Have Not Purchased Online (LTM) Brazil US Global Concerns about security of payment 37% 32% 30%growth Easier to return products bought in stores 30% 39% 29%Better pricing (or financing payment terms) is the primary Products lost or damaged during shipping 29% 6% 16%reason that Brazilians shop online, followed by Shipping costs are too high 25% 36% 26% Need to see and touch the products 21% 38% 41%convenience   No credit cards/other payment options 21% 5% 10%Payment flexibility is valued more by shoppers in Brazil than Delivery takes too long 20% 6% 13%in the US (17% versus 3%), while the convenience of having Dont have enough trust in online retailers 18% 12% 19%products delivered – one of the top reasons for shopping Enjoy shopping in stores 17% 25% 20%online in the US – is cited by only 20% of Brazilian online More convenient for to buy in stores 13% 22% 18% Dont trust the quality of products online 13% 13% 16%shoppers. Better customer service in stores 8% 11% 10% More choices of products in stores 6% 3% 6%There are some differences in drivers by class   Products are not available online 4% 4% 4%A / B class shoppers are more likely to value price Having products delivered is inconvenient 1% 5% 3%comparison tools than C class shoppers (39% vs. 30%) and Other reasons 7% 9% 6% Source: AlphaWise, Morgan Stanley Researchthe ability to shop anywhere / anytime (42% vs. 24%); while Cshoppers put more weight on the ability to read online reviews Improvements in financial security and shipping(19% vs. 8%). offerings can drive accelerating penetration...Exhibit 81 Concerns over security of online payment and use of personalMain reasons to buy online information (37%) is by far the main roadblock for eCommerceBase: Have Purchased Online in LTM Brazil US Global expansion in Brazil, particularly among A / B consumers (43%It is cheaper 47% 41% 49% vs. 35% for C consumers). Concerns with damage ofI save time 36% 30% 34% products, shipping costs, and the length of delivery are alsoI can shop from anywhere at anytime 35% 32% 34% among the key barriers cited by consumers. The ability toIt is easier to compare prices 34% 25% 32% easily return products at stores, versus online, is cited by oneMore choices of products 22% 27% 27%More convenient to have products delivered 20% 31% 27% third of those who do not shop on line, especially among A / BThe products are not available in stores 18% 32% 21% class shoppers (37% vs. 27% for C class shoppers).I get free shipping 17% 29% 18%More payment flexibility/installment terms 17% 3% 5% …and gives online operations owned by traditionalThere is more product information 15% 8% 13% retailers an advantageI can read customer reviews 13% 19% 17%I can find higher quality products 8% 2% 4% We believe a trusted brand name gives traditional retailers anOther reasons 3% 4% 2% advantage regarding security concerns. In addition, the abilitySource: AlphaWise, Morgan Stanley Research to easily return items can also be an advantage for traditional retailers that have integrated eCommerce and offline operations, such as Magazine Luiza. Improvement in shipping speed / cost to regions outside of São Paulo and Rio de Janeiro can also drive further penetration Currently, about 55% of respondents outside of Rio and São Paulo receive their purchases in six days or longer, compared to 30% for inhabitants of these two cities. In addition, concerns about shipping costs being too expensive and the damage / loss of products during shipping are greater outside of these regions. We expect this should improve as online retailers are improving their logistics capabilities to better serve these cities. 56
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailRecently, B2W initiated an ambitious plan to change its Exhibit 84logistics platform from centralized distribution in São Paulo …and concerns about shipping costs andto a decentralized model with warehouses spread across the loss/damage are higher Total SP+RJ Rest of SE Other Regionscountry. The goal is to get closer to the customer, reducing Worried about productsboth delivery terms and shipping costs to more distant states / lost/damaged during shipping 29% 22% 34% 32%cities. The plan was initiated in 3Q12 with four new Shipping costs are too high 25% 20% 26% 27%distribution centers (three in the Southeast and one in the Source: AlphaWise, Morgan Stanley ResearchNortheast). B2W also plans to open 10 more distributioncenters over the next three years. B2W will invest 50% of its Payment mechanisms are also a barrier for consumers inestimated R$1B capex budget for 2013-2015 in this logistics the C classinfrastructure. 25% of C class online users who don’t shop online cite lack of credit card or other payment options required for onlineMagazine Luiza is also decentralizing distribution, but purchases as a barrier, compared to 13% for A and B classfollowing a different approach. Magazine Luiza plans to consumers. This is consistent with the lower credit carddistribute eCommerce merchandise using the eight penetration for lower income classes (45% for C’s vs. 78% fordistribution centers that currently serve its traditional A and 63% for B consumers).operations in the Southeast, South and Northeast regions,rather than opening new warehouses. With this consolidation, Exhibit 85Luiza expects to reduce the average delivery time (as well as Main barriers to buy online by classtime to collect returned products) by 56%, and also reduce the Income class Base: Have not purchased online (LTM) Total A/B Cfreight charged for deliveries outside São Paulo state by 60%. Concerns about security of payment 37% 43% 35% Easier to return products bought in stores 30% 37% 27%MercadoLibre has mentioned that offering fulfillment Products lost or damaged during shipping 29% 29% 29%could be a long-term possibility, but better integrating Shipping costs are too high 25% 25% 25%shipping within its current platform is a higher priority. Need to see and touch the products 21% 21% 21%MercadoLibre plans to add a technology layer within their No credit cards/other payment options 21% 13% 25% Delivery takes too long 20% 22% 19%platform that integrates shipping information into the purchase Dont have enough trust in online retailers 18% 15% 20%process. Once the technology is built, MercadoLibre will begin Enjoy shopping in stores 17% 16% 17%incentivizing sellers to ship via MercadoLibre, by improving More convenient for to buy in stores 13% 17% 11%listing placements for sellers who use the service, and offering Dont trust the quality of products online 13% 12% 14%discounts on shipping. Although 3P shipping would never Better customer service in stores 8% 12% 7%have the consistency of first-party (1P), MercadoLibre is More choices of products in stores 6% 6% 7% Products are not available online 4% 3% 4%working to make it as seamless as possible. Having products delivered is inconvenient 1% 1% 1% Other reasons 7% 7% 8%Exhibit 83 Source: AlphaWise, Morgan Stanley ResearchDelivery speeds are usually slower outside of themain metro areas… Exhibit 86 Total SP+RJ Rest of SE Other regions Brazil credit card penetration by class (2011)Same day delivery 2% 3% 3% 2%Next day delivery 4% 6% 2% 3% 78%2 to 3-day delivery 19% 29% 15% 14% 63%4 to 5-day delivery 27% 32% 26% 24%6 days or longer 47% 30% 55% 57% 45%Total 100% 100% 100% 100%Source: AlphaWise, Morgan Stanley Research 21% A B C D Source: AlphaWise, Morgan Stanley Research 57
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailNeed to see / touch products is surprisingly less of a Exhibit 87barrier in Brazil Online penetration by category (online as % of totalAlthough this is the top barrier cited by US and global spend among those who have bought category in last twelve months)respondents for not shopping online, with 38% and 41% ofrespondents, respectively, just 21% of the Brazilian sample Brazil US Global Consumer electronics 29% 27% 27%cite it as a barrier. We see this as a positive for further Leisure travel 34% NA NAInternet adoption, though part of the difference may stem from Books 27% 42% 37%a higher eCommerce penetration in Brazil of “standardized” CDs, DVDs and Blue-Ray discs 22% NA NAproducts such as electronics and appliances and a lower Large home appliances 18% 8% 15% Sporting goods 13% 14% 17%penetration in more customized goods such as clothing and Beauty and cosmetics products 9% NA NAshoes. Athletic apparel & athletic shoes 10% 14% 18% Home furnishings & accessories 9% 10% 12%eCommerce is likely to continue to grow as 64% of all Shoes 8% 15% 17% Auto parts & accessories 7% 6% 10%respondents strongly / somewhat agree with the statement Clothing 6% 17% 22%that for “most products, it is increasingly more advantageous Home improvement items & tools 6% 6% 8%to buy online”; this is consistent across segments. Office & school supplies for home use 4% 9% 11% Personal care & household products 4% 5% 9%High penetration for higher ticket electronics / Groceries 1% 1% 5%appliances, but significant room for growth in new Source: AlphaWise, Morgan Stanley Researchlower-ticket categories Traditional retailers still dominate eCommerceConsumer electronics, leisure travel, books, CDs / DVDs space in Brazil; core customers vary significantlyand appliances have the highest penetration in Brazil  by siteRelative to the US and global benchmarks, the eCommerce B2W sites (combined) still have the highest share ofpenetration of electronics and appliances in Brazil is slightly online purchasers...higher than the average for our global sample. We note the Of total consumers in our sample who bought a product onlineBrazilian sample is based on people who have Internet in the last twelve months, 58% have purchased a product ataccess, which does not represent a broad sample of the one (or more) of the three B2W Sites (Americanas,entire population. Submarino, and Shoptime). This compares to 37% for MercadoLibre and 33% who have purchased at one of CBD’sGlobal benchmarks suggest further room to increase three sites. Among individual sites, Americanas.com andpenetration across many categories Submarino.com have the first and third highest penetration, atBooks, clothing, shoes, athletic apparel, office suppliers, 46% and 28%, respectively.sporting goods, and personal care products all havepenetration levels below US / Global benchmarks. The …and are “favorites” among consumers who shop theirrelative under penetration is most pronounced in books (27% sitesvs. 37% globally), clothing (6% vs. 22% globally), and shoes 27% of our online consumer sample considers one of the(8% vs. 17% globally). three B2W sites their favorite, compared to 18% for MercadoLibre, and 8% for CBD sites. Among those that have shopped at Americanas.com, 28% consider it a favorite, compared to 33% for Submarino.com, both high levels. However, MercadoLibre over indexes as a favorite relative to its level of penetration: It ranks as the top favorite site (even though only 37% of our sample has shopped there in the last year), and 44% of those that have bought at MercadoLibre do most of their purchases there. On the other hand, CBD sites (Extra, Casas Bahia, PontoFrio) have good penetration – particularly on a combined basis – but a lower proportion of their shoppers do most of their 58
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailshopping there (14-17% for each individual site). This is also Exhibit 89true for Saraiva, Walmart, and Magazine Luiza. Profile among those that consider site a favorite Any B2W Any CBD Compra All online site site MELI Facil Net Shoes shoppersTraditional retailers still dominate Age category 18 - 24 21% 28% 26% 13% 26% 20%Among the top 15 sites by penetration, only four are not linked 25 - 34 30% 28% 29% 19% 44% 30%to companies with traditional operations: MercadoLibre, 35 - 44 24% 13% 23% 38% 15% 21%Comprafacil and Dafiti. Together, these sites are the favorite 45+ 25% 33% 22% 32% 15% 29% Social classsite for only 33% of respondents. In addition, 63% of A&B 61% 53% 48% 44% 59% 54%respondents strongly/somewhat agree in preferring buying C 39% 48% 52% 56% 41% 46%online from traditional retailers with physical stores than Gender Male 45% 63% 55% 44% 76% 52%eCommerce retailers. Female 55% 38% 45% 56% 24% 48% Source: AlphaWise, Morgan Stanley ResearchDemographics of most loyal shoppers varysignificantly by site comScore data suggests different website trafficThose who selected any B2W site as a favorite are skewed trends by retailertowards A / B classes (61%) and female shoppers (55%). We performed two comScore traffic analyses, measuringLoyal CBD shoppers have a social class split similar to the unique visitors and total visits. For the purposes of thisoverall online shopper population, but they skew more analysis, we note both B2W and CBD have three distinctlytowards male (63%) and younger consumers (28% ages 18- branded websites (B2W: Americanas, Submarino and24). MercadoLibre and CompraFacil are similar in their skew Shoptime; CBD: Extra, Ponto Frio, and Casas Bahia). Whentowards C class consumers (52% and 56% respectively), but tracking unique visitors, we measure the sites separately,MercadoLibre appears to skew younger and more towards because there may be overlap or duplicates between themale consumers. sites. However, when measuring total visits, we sum the subsidiary properties of B2W and CBD. It’s important to noteExhibit 88 that total visitors are not as comparable for MercadoLibre vs.Website penetration other sites, given that it is an online marketplace, with visits by % that rate % that favorite (among both buyers and sellers (vs. buyers only for other sites). rate favorite those that % that bought (overall) shopped there) Among the top 3 competitors, B2W appears to have theAmericanas.com (B2W) 46% 14% 28% weakest traffic trends, with a 2% decline Y/Y in total visitsMercadoLibre.com 37% 18% 44% across its three websites. Looking at its individual sites,Submarino.com (B2W) 28% 11% 33% Submarino appears to have the weakest trend, with a 4%CompraFacil.com 24% 6% 24%Saraiva.com 22% 4% 16% decline in unique visitors. This is consistent with our surveyExtra.com 18% 3% 17% data, which shows that the site is losing momentum, as it isWalmart.com 18% 3% 15% considered the favorite by 16% of long tenured shoppers (>5CasasBahia.com 17% 3% 14% years) in our survey group but only by 6% of newer shoppers.MagazineLuiza.com 17% 3% 13%Carrefour.com 12% -- 0% While MercadoLibre has had a strong growth in totalPontoFrio.com 12% 2% 14% visits (15%), its total unique visitors have grown by 7%,Shoptime.com 12% 2% 18%Dafiti.com 10% 2% 15% suggesting more visits per unique user.RicardoEletro.com 10% 2% 14% The opposite is happening with CBD (Nova Pontocom), whichAny B2W Site 58% 27% 42% had a 10% growth in total traffic, but total unique visitorAny CBD Site 33% 8% 21% growth ranging from 14-18% across its three websites.Note: Favorite site refers to site where consumers shop the most.Source: AlphaWise, Morgan Stanley Research Among smaller competitors, the main standouts are Dafiti, Walmart, and Magazine Luiza, with above average growth rates In fact, despite its low base of unique visitors, Dafiti is the site with the highest number of incremental unique visitors (in absolute terms). On the other end of the spectrum is Comprafacil, which has had a large 21% decline in unique 59
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailvisitors and a 28% decline in total visits. This likely stems from B2W appears to be using low prices to drive sales growththe company’s recent financial difficulties. According to our proprietary price tracker, in 2H12 (up to November), B2W sites posted prices less than or equal to theExhibit 90 lowest competitor’s price on 54% of the products evaluatedTotal visits by competitor across categories. This compares to 40% in 1H12 and 27% in YTD YTD Y/YTotal Visits (000) 2011 2012 Growth 2011. Its price competitiveness is the greatest in appliances 1 MercadoLibre 469,829 541,129 15% and electronics, two categories with the highest online 2 B2W 274,284 268,608 -2% penetration in Brazil. We base our analysis on pricing data we 3 Nova Pontocom 164,489 181,533 10% pull on a bi-weekly basis from price comparison websites on 4 Magazine Luiza 60,189 71,767 19% over 1,500 different products.  5 Walmart 41,384 59,259 43% 6 Dafiti 20,914 56,181 169% Exhibit 92 7 Livraria Saraiva 45,921 53,210 16% % of products where B2W price is less than or 8 Maquina de Vendas 37,660 50,695 35% equal to lowest competitor price 3Q12 vs. 3Q12 vs. 9 Carrefour 33,974 35,726 5% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 2Q12 3Q1110 Comprafacil 46,224 33,390 -28% Appliances Total (Sum of Selected Players) 1,303,605 1,481,270 14% Air conditioner 23% 31% 29% 45% 39% 40% 67% 27 pp 38 ppNote: B2W is the sum of visits to Americanas, Submarino and Shoptime websites; Nova Stove 21% 25% 20% 13% 39% 40% 61% 21 pp 41 ppPontocom is the sum visits to Extra, Ponto Frio and Casas Bahia websites; Maquina de Washer 19% 38% 26% 23% 31% 46% 69% 23 pp 43 ppVendas is the sum of visits to Ricardo Eletro, Insinuante, Eletroshopping and Citylar websites. Microwave 39% 44% 39% 31% 59% 55% 57% 2 pp 18 ppSource: comScore, Morgan Stanley Research Refrigerator 27% 38% 30% 17% 34% 41% 57% 16 pp 27 pp Median 23% 38% 29% 23% 39% 41% 61% 20 pp 32 ppExhibit 91 ElectronicsUnique visitors by website Video game DVD player n/a 20% 65% 50% 32% 36% 56% 24% 40% 50% 67% 78% 75% 69% 8 pp -9 pp 43 pp 33 pp YTD YTD Y/Y Music player 19% 8% 6% 19% 31% 56% 83% 27 pp 77 ppUnique Visitors (000) 2011 Avg 2012 Avg Growth Camcorder 35% 47% 59% 33% 25% 71% 82% 11 pp 23 pp 1 MercadoLibre 13,019 13,941 7% Camera 28% n/a 43% 43% 25% 39% 76% 37 pp 33 pp Home theater 20% 23% 28% 9% 68% 55% 73% 18 pp 45 pp 2 Americanas (B2W) 5,676 6,042 6% TV 16% 30% 28% 21% 24% 32% 63% 31 pp 35 pp 3 Submarino (B2W) 4,670 4,499 (4%) Median 20% 38% 32% 24% 31% 56% 75% 19 pp 43 pp 4 Magazine Luiza 2,942 3,621 23% Computing Monitor 8% 31% 12% 20% 73% 21% 22% 1 pp 10 pp 5 Casas Bahia (CBD) 2,806 3,289 17% Printer 34% 32% 19% 25% 53% 39% 63% 24 pp 44 pp 6 Pontofrio (CBD) 2,664 3,130 18% Notebook 17% 17% 15% 16% 33% 46% 55% 9 pp 40 pp 7 Dafiti 1,212 3,062 153% Median 17% 31% 15% 20% 53% 39% 55% 16 pp 40 pp Books 50% 35% 18% 51% 64% 31% 34% 3 pp 16 pp 8 Walmart 1,964 2,936 50% Median 50% 35% 18% 51% 64% 31% 34% 3 pp 16 pp 9 Extra (CBD) 2,425 2,767 14% Phones 10 Livraria Saraiva 2,207 2,508 14% Landline 63% 43% 32% 31% 22% 41% 37% -4 pp 5 pp Cell/Smartphone 40% 30% 12% 4% 7% 17% 30% 13 pp 18 pp 11 Ricardo Eletro 1,424 1,866 31% Median 51% 37% 22% 18% 14% 29% 33% 4 pp 11 pp 12 Carrefour 1,813 1,850 2% Overall median 23% 32% 28% 24% 36% 41% 63% 22 pp 35 pp 13 Comprafacil 2,315 1,820 (21%) Source: AlphaWise, Morgan Stanley Research 14 Shoptime (B2W) 1,441 1,556 8%Source: comScore, Morgan Stanley Research 60
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailChina Internet Exhibit 93Richard Ji eCommerce – a ‘sweet spot’ in ChinaPhilip Wan Transaction As % of ChinasTimothy Chan value (Rmb bn) retail sales 4.0 10%Executive Summary / Key Takeaways 8% 3.01. We believe eCommerce in China will continue to benefit from rising 6% domestic consumption and higher online shopping penetration. In 2.0 4% particular, B2C marketplaces will gain traction and capture greater 1.0 eCommerce market share. Improving logistics and online payment 2% services, as well as increasing smartphone penetration should boost 0.0 0% eCommerce adoption in the coming years. 2008 2009 2010 2011 2012e 2013e 2014e 2015e2. eCommerce currently represents about 5% of China’s total retail Transaction value (Rmb bn) As % of retail sales sales. Compared to the developed countries (9-10% for US and Source: iResearch, Morgan Stanley Research UK), China is relatively underpenetrated and has significant room for upside. Total online shopping transaction value is expected to grow3. As B2C marketplaces enjoy higher scalability, broader product over 50% to Rmb1.2T in 2012, contributing about 5% of total selection and a wider customer base, they will continue to gain China’s retail sales, up from about 2% three years ago, yet traction in China’s eCommerce market. still below 9-10% for the US and UK.4. Chinese eCommerce leaders are enjoying robust market expansion China eCommerce – still under-penetrated: but suffer from weak margins because of intense competition, lack According to the China Internet Network Information Center of scale, and large investments in customer acquisition and (CNNIC), total Internet users in China reached 538MM at the fulfillment capacity. end of June 2012, more than the size of the entire US5. Leading advertising services providers have been the indirect population. That said, the Chinese online population is far beneficiaries of the eCommerce boom in China. from saturated, as it represents only 40% of the population, versus 70-80% for developed countries, such as the US, the UK, Japan and South Korea. We estimate that the ChineseeCommerce – a ‘sweet spot’ for China’s online Internet penetration will reach 50% by the end of 2015, whichmarket should bode well for eCommerce development in China.While eCommerce is still at an early stage in China, it hasemerged as one of the fastest-growing sectors, driven by Exhibit 94surging domestic consumption, rising Internet penetration, China Internet penetration: Far from saturationand greater online shopping adoption. We estimate that total Internet As % of total population (mn) populationonline shopping transaction value (B2C and C2C) will 1,000 60%exceed Rmb2.5T (or over US$400B) in 2015. 800 50% 40% 600 30% 400 20% 200 10% 0 0% 2009 2010 2011 2012e 2013e 2014e 2015e China Internet population Penetration e = Morgan Stanley Research estimates Source: CNNIC, Morgan Stanley Research 61
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailRelative to developed countries, eCommerce is under- or a few product categories and assumes higher inventorypenetrated in China. To date, less than 40% of the Chinese risk. Scalability may be lower than marketplaces due to aInternet population has shopped online, up from 22% in 2007 narrower customer base.but still significantly below the 70% level in the US. In otherwords, eCommerce has penetrated less than 20% of the Inventory-heavy marketplace operators distribute productsentire Chinese population. sourced from third-party vendors and take inventory, such as 360buy (electronics focused) and Dangdang (books andExhibit 95 media, mother and baby products). These companiesChina eCommerce is still under-penetrated maintain product quality control with lower inventory risk than Online shopping penetration in China self-branded players, yet suffer from lower pricing power due to little product differentiation. 38% 39% 35% Inventory-free marketplaces, such as Taobao / Tmall, offer 28% the broadest product selections and enjoy the widest 25% addressable customer base, hence higher scalability. 22% Inventory-free marketplaces attract third party merchants to distribute on their platforms and charge commissions based on transaction values. These companies enjoy the lowest inventory risk among the three models but have weaker 2007 2008 2009 2010 2011 1H12 product quality control, which may lead to a poor customer shopping experience.Source: CNNIC, Morgan Stanley Research Exhibit 97Within China’s eCommerce market, apparel is the most Pros and cons for eCommerce modelspopular online shopping category, contributing 27% of total Marketplace Marketplaceonline shopping transaction market share, followed by 3C Self-branded (inventory heavy) (inventory free)(computers, communication, and consumer electronic) and Pricing power Higher Lower Lowerelectronic home appliance (18%), cosmetics (5%), and Product quality control Stronger Medium Lowerbooks and media (3%), according to iResearch. Product offering Narrower Wider Wider Sales and marketing effort Higher Lower LowerExhibit 96 Scalability Lower Medium HigherOnline shopping transaction by category in China Inventory risk Higher Medium Lower Source: Company Data, Morgan Stanley Research Apparel, 27% footware, bags B2C – marketplaces continue to gain traction: 3C and home According to iResearch, total transaction value for China’s 18% appliance B2C market increased seven fold from Rmb21B in 2009 to Rmb179B in 2011, representing about 23% of total online Cosmetics 5% shopping transaction value, up from 8% in 2009. We expect the B2C market to expand 50% per annum and to contribute Books and over 40% of total online shopping transaction value in China 3% media by 2015. Others 47%Source: iResearch (2011), Morgan Stanley ResearchThere are three key eCommerce business modelsin China: self-branded, marketplace (inventory-heavy), and marketplace (inventory-free):Self-branded eCommerce companies typically enjoy higherpricing power and stronger product quality control. However,a self-branded online distributor usually focuses on a single 62
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 98 Rmb19.1B (US$3B) transaction value, more than tripling lastB2C – capturing share in China’s retail market year’s amount of Rmb5.2B and equivalent to about 1% of B2C transaction value (Rmb bn) As % of total online China’s total retail sales volume in October. Moreover, Tmall shopping in China 500 35% itself generated Rmb13.2B transaction value on November 11, 2012, up 290% y/y. 30% 400 25% Exhibit 100 300 20% Tmall produced record high daily GMV on Nov 11 GMV for Tmall on November 11 200 15% (Rmb bn) 10% 100 13.2 5% 0 0% 2009 2010 2011 2012e B2C As % of totalSource: iResearch, Morgan Stanley Research 3.4Compared to the US, the retail industry in China is highlyfragmented. According to Euromonitor, the top 20 retailers 0.9 0.1represent less than 10% of the retail market share in China, 2009 2010 2011 2012far below the 40-50% in the US and UK. We believe thisfragmentation offers an opportunity for eCommerce leaders Source: Company Data, Morgan Stanley Researchin China to capture market share from traditional offline Most B2C companies still suffer from low margins due toretailers. intense competition, lack of scale, and heavy investment inExhibit 99 customer shopping experience. Many of them have becomeTmall leads China’s B2C market more aggressive in their marketplace strategy. Online marketplaces offer higher margins than self-distribution Tmall 55% because the operators charge commissions from third-party merchants without taking inventory risk. Depending on 360buy 22% different categories, the commission rate typically ranges Suning 4% between 1-10% of the transaction value. For instance, Dangdang has been optimizing its self-distributed general Amazon 3% merchandise business by reducing its exposure to categories Tencent 5% with higher inventory risk or lower margins, such as fashion and consumer electronics. On the other hand, it has been Dangdang 1% expanding these categories via its online marketplace by Others 11% attracting third-party merchants.Note:B2C market share in terms of transaction value in China We believe Alibaba Group, which dominates the eCommerceSource: iResearch (3Q12), Morgan Stanley Research market in China with the largest B2B (Alibaba.com), B2CThe B2C market in China is championed by Tmall (fully (Tmall) and C2C (Taobao) platforms, as well as the largestowned subsidiary of Alibaba Group), which operates a online payment services business (Alipay), will be a distantmarketplace that offers an alternative distribution channel for winner. While Alibaba Group is still a private company,retailers. According to iResearch, in 3Q12, Tmall has more investors may invest indirectly through Softbank and Yahoo!,than half of the B2C market in terms of GMV (gross which owns about 32% and 23% of Alibaba Group,merchandise value) or transaction value. To date, Tmall respectively. Note that, in September, Yahoo! completed thefeatures over 70,000 major multinational and Chinese brands initial sale of shares in Alibaba Group by receiving US$7.6Bfrom more than 50,000 merchants. Leading brands such as (US$6.3B in cash and US$800MM in preferred shares ofUNIQLO, L’Oreal, P&G, Nike, Levi’s and Gap have opened Alibaba Group) in exchange for about 20% of its stake inflagship retail storefronts on its platform. Notably, on Alibaba. According to agreements between Yahoo! andNovember 11, 2012, with a special promotion as the ‘single’s Alibaba Group, Yahoo may sell half of its outstanding sharesday’, Taobao and Tmall produced a record high of at the time of an Alibaba IPO. Yahoo! may then sell its 63
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailremaining shares at its discretion following a lock-up period Logistics – a bottleneck for eCommerce in Chinapost-IPO. According to the China Logistics Association, there are more than 25,000 registered logistics services providers in China.Customer acquisition – improving scalability: The inefficiency of delivery services has lead to high deliveryLeading eCommerce operators have generally observed costs, high product return rates, long delivery time, anddeclining customer churn rates (according to CNNIC) by limited capacity to support the robust online shoppingimproving the customer shopping experience. For example, demand.eCommerce operators have broadened product selections,improved delivery and customer services (e.g., unconditional In response, some leading eCommerce players, such asexchange / refund). 360buy, have developed their own delivery services. In addition to better service quality control, owning the last-mileExhibit 101 delivery allows companies to have direct customerLower customer churn on better services connection, which may be critical for collecting customer Customer churn rate feedback, facilitating product exchange / refund, and cash 25% collection. Self-delivery services often help significantly 21% reduce product return (50% lower in some cases) and hence 20% lower inventory risk. Aside from door-to-door delivery, 15% 14% leading eCommerce players now offer pick up points in major 10% 10% cities for customers who require more flexibility in delivery 10% time. 5% 4% 5% 3% Heavier investments in logistics services have resulted in 0% Dangdang Amazon 360buy Tmall lower near-term profitability. Fulfillment expenses, which 2010 2011 mainly consist of warehousing and shipping costs, are the largest cost item for eCommerce players and typically* Churn rate = % of customers lost who have purchased in the previous 6 monthsSource: CNNIC, Morgan Stanley Research account for 50-60% of total operating expenses. Because of intensifying competition, eCommerce companies have beenWe believe greater spending per customer should help drive offering customers attractive delivery (i.e., same-day or next-leverage on sales and marketing expenses as a percentage day delivery) and expanded refund policies (unconditionalof revenues going forward. We estimate the cost to acquire a product returns). However, many eCommerce leaders havenew customer is typically 5-10 times higher than that of a recently scaled back their delivery discounts to customers.repeat customer. According to CNNIC, average spending per Since 2012, instead of offering free shipping for all orderonline shopping customer was Rmb3,900 in 2011, up 20% sizes, 360buy and Amazon China started to bill an Rmb5from 2010. Moreover, online shoppers have stepped up the shipping fee for orders below Rmb39 and Rmb29,frequency of online purchases in 2011, with over 30% of respectively. For Dangdang, its delivery policy for the top 200them shopping online more than 10 times within six months, cities remains unchanged (free for order size above Rmb29),up from 22% a year ago. but the company has raised minimum order size to Rmb99 for other cities in more remote locations.Exhibit 102Increasing online purchase frequencies in China Exhibit 103 No. of online purchases in 6 months Chinese B2Cs: Scaling back delivery discount 40% Minimum order size for free delivery Company Before Now 30% Dangdang (top 200 cities) Rmb 29 Rmb 29 20% Dangdang (other cities) Rmb 29 Rmb 99 Amazon N/A Rmb 29 10% 360buy N/A Rmb 39 Source: Company Data, Morgan Stanley Research 0% 1-2 times 3-4 times 5-10 times > 10 timesSource: CNNIC, Morgan Stanley Research 64
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailFor Amazon, fulfillment expenses as a percentage of sales According to CNNIC, penetration of online payment anddropped from 15% in 2000 to 9% in 2004.This improvement online banking services have nearly doubled from mid-towas largely driven by greater scale and hence operating high-teens in 2007 to over 35% of Chinese Internet usersleverage. Dangdang’s fulfillment cost as a percentage of now. According to iResearch, total online paymentsales declined from 19% in 2007 to 13% in 2011, yet it is still transactions grew from Rmb94B in 2007 to over Rmb2.2T in300-400 bps higher than Amazon’s current level. In our view, 2011, representing a 120% CAGR.this gap may narrow further as logistics efficiency in Chinaimproves via transportation infrastructure upgrades and Exhibit 106industry consolidation. Online payment transactions are on the rise in ChinaExhibit 104 Chinas online payment transaction (Rmb bn)Amazon: Enjoyed scale and logistics efficiency as 2.5it expanded into new product categories Fulfillment cost as % of sales 2.0 1.5 19.2% 15.8% 1.0 13.8% 12.6% 13.1% 15.0% 0.5 12.0% 10.0% 9.1% 8.5% 0.0 2007 2008 2009 2010 2011 2000 / 2007 2001 / 2008 2002 / 2009 2003 / 2010 2004 / 2011 Source: iResearch, Morgan Stanley Research Amazon (2000-04) Dangdang (2007-11) Due to growing mobile Internet penetration in China, mobileSource: Company Data, Morgan Stanley Research commerce has gained popularity. According to CNNIC, totalOnline payment – driving online shopping penetration Chinese mobile Internet users more than tripled over theBecause of low credit card penetration, credit risk has been a past three years to 388MM by the end of June 2012,major bottleneck for eCommerce development in China. The representing 70% of total Chinese online population, up fromevolution of online payment, especially the escrow-based 40% in 2008. Notably, Taobao generated a GMV of Rmb12Bsystem offered by Alipay, mitigates the settlement risks for on its wireless channel in 2011, up nearly six times from aonline transactions. While the majority of transactions year ago, accounting for 2% of Taobao’s total transactiongenerated by B2C leaders (e.g., 360buy, Dangdang, value. The company expects its mobile GMV to exceedAmazon etc.) are still cash on delivery (COD), improving Rmb50B in 2012. In addition, other eCommerce playersonline payment services should help facilitate online have experienced robust transaction and traffic growth fromshopping going forward, in particular mobile commerce. their mobile platforms. For instance, Ctrip, a leading online travel booking services provider in China, now generatesExhibit 105 about 10% of its total hotel bookings from its mobileOnline payment / banking: Gaining traction in applications. According to Dangdang, 5-7% of its total orderschina and about 15% of total traffic come from mobile devices. The Penetration to Chinese Internet users company has recently partnered with 99Bill to enable 35% 36% payment services on mobile devices, which may help boost 33% 32% 30% 31% transaction and conversion rates on its mobile platform. 25% 25% 19% 19% 18% 16% 2007 2008 2009 2010 2011 1H12Source: CNNIC, Morgan Stanley Research 65
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 107 starting in 2012. Notably, over 40% of China’s group-buyingAlipay leads China’s online payment market websites have closed down since September 2011. According to Tuan800.com, among the active group-buying Alipay 47% sites, only 70-80% update their product offering on a weekly basis. Tenpay 20% Exhibit 108 Group-buying market: cooling down in China Total group buying websites in China Unionpay 12% 6,000 99Bill 6% 4,000 Others 15% 2,000Market share in terms of online payment transaction in ChinaSource: Analysys (3Q12), Morgan Stanley Research 0 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12According to Analysys, Alipay (an affiliate of Alibaba Group) Source: Tuan800.com, Morgan Stanley Researchand Tenpay (operated by Tencent), together representnearly two-thirds of total online payment transactions in As eCommerce players in China become more diligent onChina. Due to the synergy between its sister companies marketing ROI (return on investment), online trafficunder the Alibaba Group (Alibaba.com – B2B, Taobao – gatekeepers in China, such as Baidu (paid search), QihooC2C, and Tmall – B2C), we believe Alipay should continue to (navigation site), Tencent (social networking services) andmaintain its leadership in China’s online payment market. On Sina (Weibo) should continue to benefit. Notably, in 2011,the other hand, Tenpay, via Weixin (the largest mobile retailer and general merchandise was the second largestcommunity in China operated by Tencent with over 200MM advertising category for Google in the US, yet eCommerceregistered users), may gain share in China’s mobile does not rank within the top five categories for Baidu,commerce. Notably, Tenpay has now integrated with Weixin implying more upside. On the other hand, as Tencent andto provide mobile payment services, allowing users to pay by Sina continue to monetize their SNS via expanding socialshaking their smartphones or scanning the QR codes for advertising as well as open platform services, their massivecertain merchandise. user base (over 400MM users each) and the power of viral marketing should continue to drive traction from eCommerceAdvertising – a side beneficiary of eCommerce: Leading companies.advertising services providers have been the indirectbeneficiaries of the eCommerce boom in China. Qihoo – The company owns the largest online security user base in China (over 400MM), a leading web browser (30%After rounds of private financing, many eCommerce and unique visitor market share), and the most traffickedgroup buying leaders in China stepped up their advertising navigation website (or personalize start-up page). Currently,spend during 2011. According to Baidu, the paid search Qihoo generates half of its total advertising sales fromleader in China, eCommerce was the fastest-growing eCommerce customers, with Taobao contributing low-teensadvertising category, posting triple digit growth in 2011. of the total. Qihoo introduced its proprietary search engine inLeading online portals and video websites, such as Sina, August 2012 and has already captured 10% of China’s totalSohu, Tencent, Netease, and Youku, also saw robust search traffic. Qihoo plans to start monetizing its trafficadvertising expansion from eCommerce clients, who ranked towards the end of the year and we believe its pay foramong one of the top spending categories during certain performance (charging customers on a per click basis)periods. advertising services will attract more marketing dollars from eCommerce operators.That said, after aggressive marketing, eCommerce / groupbuying sites became more rational in their promotion strategy 66
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailTencent – Tencent has stepped up its focus on its B2C Sina – Sina’s Weibo platform has emerged as a key trafficeCommerce business, and started reporting it as a separate acquisition channel for eCommerce websites. We believesegment in 2012. In 3Q12, eCommerce sales contributed Sina’s Weibo attracts sophisticated online users who10% of Tencent’s total revenues. Notably, Tencent launched typically enjoy higher level of personal income than theits B2C marketplace (buy.qq.com) in October 2011. Apart average Internet population, hence it fits well with thefrom taking on inventories, Tencent’s platform is linked with demographic of online shoppers. Sina started advertisingmajor vertical B2C players in China, including 51Buy services on its Weibo platform in 2Q12 by offering banner(electronics appliances), KeLa (jewelries), V+ (apparels), and advertising that has attracted mostly brand advertisers. InTianTian (cosmetics). In our view, Tencent’s eCommerce addition to time-based banner advertising, the companybusiness enjoys synergies with its community platforms – plans to introduce new advertising solutions that offer CPMQQ IM, QQ Email, QQ Weibo, Q-Zone (virtual name SNS) (cost per thousand impressions) or pricing on anand Pengyou (real-name SNS) – which helps drive traffic via engagement basis, which should be more appealing toviral marketing (users’ sharing and recommendation etc.). eCommerce companies who demand more cost-effectiveTencent’s targeted SNS advertising system, Guang Dian and higher ROI marketing.Tong, has emerged as a new growth driver for its advertisingbusiness, which overtook Sina as the leading advertisingplayer by size for the first time in 1Q12. 67
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailChina RetailRobert Lin retail segments. According to Euromonitor, eCommerce inAngela Moh China accounted for Rmb160B in revenue in 2011 or about 1.8% of retail sales. By 2015, we believe eCommerceExecutive Summary / Key Takeaways penetration could increase to about 4% of retail sales or Rmb560B. While we expect eCommerce growth to outstripBest-positioned: Sun Art, Intime, Belle and Prada growth in traditional retail (CAGR of 9% from 2011-15), wePotentially Challenged: Gome (not covered), Li Ning, and Anta believe multi-line retailers will face a different level of impact,1. Multi-line retailers: We believe a comparison between market size depending on their product mix. and market share of the offline players is a simple yet effective Exhibit 109 measure of the threat posed by eCommerce. A higher level of offline The retail market is expected to increase from market concentration translates into a higher risk of disruption from Rmb8.7T in 2011 to Rmb13.6T by 2015e, at a CAGR online players. The sub-segments from highest to lowest risk in China of 9.3% are consumer electronics retailers (highest), department stores (medium) and hypermarkets (lowest). Market value of organized retail Rmb mn Food Retail Non-Food Retail Internet2. Scale, differentiation and cash burn: The key challenges for a 9,000 majority of eCommerce players in China are lack of scale, lack of 8,000 7.9 tn / differentiation and a fast pace of cash burn, potentially leading to Rmb tn (2011 or 2015e) +9.7% 7,000 / CAGR multiple years of losses and multiple rounds of fundraising. Therefore, 6,000 offline players that are well capitalized with strong cash flow 4.9 tn / 5.0 tn / generation have ample means to invest in their online operations to 5,000 +14.3% +7.0% take part in the eCommerce growth. 4,000 3,000 3.5 tn /3. Brands: Brands that control their retail channel by self-operating own 2,000 +9.1% 160bn (2011) 560bn (2015e) stores and efficiently managing inventory within their store network / 1,000 +24% channels in China are strongly positioned to capture share in the 0 eCommerce channel. 2012e 2013e 2014e 2015e 2002 2003 2004 2005 2006 2007 2008 2009 2010 20114. Marketplace focus: Unlike the US, about 80% of eCommerce Source: Euromonitor, Morgan Stanley Research; e = based on Euromonitor estimates market share in China is dominated by a marketplace-driven ecosystem. This creates retailing complexity and conflicts for brands Exhibit 110 that adopt a multi-layer wholesale business model to distribute their Non-food retail, food retail and eCommerce revenue products. are expected to be 58%, 37%, and 4% of overall retail revenue by 2015, respectively.5. “Smarter” shoppers: We believe the urgency for all retailers and Market value by retail segments brands to incorporate a mobile strategy will be greater than a pure eCommerce online strategy. Based on our APAC TMT team’s estimates, the Rmb bn +9.3% Other Non-Food Retail number of smartphone subscribers in China will reach 510MM or 13.6 tn CAGR about 80% of 650MM Internet users by 2014. We estimate China will 4% Apparel Specialist 510 bn have a 25% share of the global smartphone market by 2014. 8.7 tn Mixed Retailer 2% 58% 7.9 tn Electronics & 160 bn AppliancesMulti-line retailers: At-risk or defensible stocks 57% Other Food Retail 4.9 tn Potentially challenged Best-positioned 37% Supermarkets 41% 5.0 tn Gome (not covered) Sun ART, Intime 3.5 tn HypermarketsMulti-line retailers face a different level of disruption from 2011 2015ethe rise of eCommerce. Source: Euromonitor, Morgan Stanley ResearchChina’s retail segment is highly fragmented. This combinedwith a growing economy and continued urbanization allowsboth offline and online retailers to consolidate their respective 68
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailGiven the fact that eCommerce is still in a nascent period of Exhibit 112growth and generally lacks accurate industry data, we believe The pace at which multi-line retailers establish anan effective way to measure of the eCommerce threat faced eCommerce presence depends on factors such as scale, online complement and product offering.by offline retailers is to compare market size and market Retail format Hyper- Departmentshare of the top players for retail sub-segments. A higher Business drivers Electronics market storelevel of offline market concentration translates into a Timing to establish online presence? Sooner Laterhigher risk of eCommerce disruption. Complement from online presence? Higher LowerBased on Euromonitor data on the below sub-segments and Key driver to business model? Scale Locationkey findings from our AlphaWise survey, the sub-segments Business model Retailer Landlordfrom highest to lowest risk are consumer electronics retailers Inventory risk Higher Lower(highest), department stores (medium) and hypermarkets /food retail (lowest). Product standarization Higher Lower Fashion risk Lower HigherExhibit 111A higher level of offline market concentration Source: Company Data, Morgan Stanley Researchresults in higher risk from online players. Exhibit 113 Market Value of Top 5 Retailers The more scale becomes the key advantage, the Rmb bn Others sooner the retailers in a sub-segment must establish an online presence to take market share 4,000 3.5 tn Top 5 Gross sales by leading retailers by format (2011) 3,500 Top 5 Mkt Share (RMB mn) 3,000 100,000 2,500 2,000 75,000 1,500 861bn 800bn 50,000 1,000 8% 9% 27% 500 25,000 - 0 Grocery Mixed Retail Electronics Suning Gome Sun ART Parkson Golden IntimeNote: Mixed Retail means department store players under Euronmonitor’s definition EagleSource: Euromonitor, Company Data, Morgan Stanley Research; Electronic Hypermarket Department Stores Note: Gome revenue exclude Parent Company’s stores revenue and VAT. All retailers areThe opportunity to establish an effective omni-channel HK-listed retailers except Suning. Suning’s revenue recognition different than that of otherstrategy depends on the retailer’s product offering, scale HK-listed retailers. Source: Company Data, Morgan Stanley Research;and cash flow generationThe key challenges for a majority of eCommerce players in Better technology adoption and advanced last mile fulfillmentChina are lack of scale, lack of differentiation and a fast pace are currently key competitive advantages for a few leadingof cash burn, potentially leading to multiple years of losses eCommerce players in China. For leading offline retailers,and multiple rounds of fundraising. Therefore, offline players scaled sourcing, lower-tier city penetration, positive cash flowthat are well-capitalized with high free cash flow generation generation and robust balance sheets are key competitivehave ample means to invest in their online operations in order advantages. Given the high degree of cash burn by a majorityto take part in the growth of eCommerce in China. of online players due to irrational price competition, many online retailers are facing a shortage of internally generatedWe have summarized business drivers that drive multi-line capital to expand their operations. Therefore, we believe theretailers to establish an online presence in Exhibit 112. well-capitalized traditional retailers may still have time toBecause consumer electronics retailers offer standardized, adopt an omni-channel strategy in order to take market sharehigh ticket items, we believe this sub-segment will need to from both weaker online and offline players.establish an online presence much sooner than other formats. The following chart shows that leading box retailers (i.e., Suning in consumer electronics and Sun ART in hypermarket) generate strong operating cash flow that should allow them to 69
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailincrease their infrastructure investments in order to compete Exhibit 115online. While the department stores do not enjoy scale Smartphone penetration will drive Internet usagebenefits due to their concession based business model, they and potentially eCommerce Smartphone subscribersenjoy higher operating margin resulting in higher conversion Population / Units (mn) % Internet usersof sales into cash flow. 1,000 Internet users 100% Smartphone subscribers 79%Exhibit 114 800 3G subscribers 80% 69%High level of operating cash flow and strong Cum. Smartphone shipped since 2007balance sheet of leading retailers should help drive 600 Smartphone sub % Internet users 53% 60%online and offline expansion 400 32% 40% 2011 OP cash flow OCF as % (Rmb mn) gross sales 22% 200 20% 8,000 20% 0 0% 6,000 15% 2008 2009 2010 2011 2012e 2013e 2014e e = Morgan Stanley estimates 4,000 10% Source: CNNIC, Gartner, Morgan Stanley Research 2,000 5% Smartphone growth in China will impact both online and offline retailers: 0 0% Suning Gome Sun ART Parkson Golden Intime Eagle  Real-time price transparency – Compare prices on a global basis real time in-store or online. OP Cash Flow (LHS) OCF As %GSP (RHS)Source: Company Data, Morgan Stanley Research  Real-time communication – Targeted social and brand marketing to their core customers as well as potential newSmartphone adoption will be both a disruptor and customers.an enabler to online and offline retailers.Smartphone adoption may be an enabler of eCommerce and Mobile commerce will be driven by the high-end smartphonewill likely be a key driving force behind Internet penetration in subscribers (10% of smartphone subscribers or 16MM as ofChina, going forward. Therefore, the urgency for both online 2011).and offline retailers / brands to initiate a mobile strategy will Exhibit 116be greater than a pure online strategy, we believe. Based on Current subscriber mix in China implies potentialMorgan Stanley’s Asia Pacific Internet, Telecom and mobile commerce outperformanceTechnology teams’ estimates, the number of smartphone 100%subscribers in China will reach 510MM or 80% of 650MM 90%Internet users by 2014; up from 164MM smartphone 80%subscribers or 32% of Internet users in 2011. 70%Based on our Asia Pacific, ex-Japan technology team’s 60%estimates (led by Jasmine Lu), China is estimated to have General Subscribers 50%25% of the global smartphone market by 2014. To put this High-end Subscribers* 40%into perspective, the cumulative number of smartphones 30%shipped in China between 2007 and 2014 would be 800MMunits based on the team’s estimates (please see Hardware 20%Technology – China Smartphone Market – The Sweetest 10%Poison dated June 2, 2012). 0% China US High-end Subscribers Definition: China – subscribers with US$15+ Monthly ARPU US – subscribers with US$50+ Monthly ARPU Source: Company Data, Morgan Stanley Research 70
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailIncreased smartphone adoption will pose a number of top selling brands, we believe the industry potentially ischallenges for offline retailers. “Show-rooming” may susceptible for eCommerce disruption. Our AlphaWise surveyencourage offline retailers to accelerate uniform pricing indicates that among the respondents that frequently checkstrategy for in-store and online platforms, which may prices online, about 30% believe consumer electronics andnegatively impact margins. home appliance categories are a lot cheaper online.However, mobile technology may also strengthen the Exhibit 118relationship between offline retailers and their customers and Consumer electronic and home appliances rankedsuppliers. For example, Golden Eagle (a leading Chinese #1 and #3 in terms of Internet retailing value in 2011department store chain in Jiangsu) is the first department Internet retailing by category Rmb mn % chg y/ystore in China to implement various mobile technology 80,000 1.8innovations: 1) real-time feedback to concessionaires on 1.6sales, margin and inventory management; 2) wireless check- 60,000 1.4 1.2out technology to reduce customer waiting time and 3) future 1.0 40,000roll-out of a mobile app to allow customers to research, pre- 0.8 0.6order and / or purchase products via smartphone for delivery 20,000 0.4or pick-up. 0.2 - - Toys and Healthcare Beauty & Appliances Apparel Food & Other Products Furnishing Home CE Care Games Drink MediaExhibit 117 HPC HomeGolden Eagle’s SAP implementation coupled withadoption of mobile technology allows real time KPIanalysis by management and suppliers to improve 2010 2011 Growthsales, margin and inventory management Source: Euromonitor Data, Morgan Stanley Research 360Buy is an example of a consumer electronics online 12 retailer that is growing exponentially faster than offline retailers due its aggressive pricing strategy and targeted selling approach. As mentioned previously, the concentrated structure of the consumer electronics industry (offline retailers Suning and Gome dominate the market) and the cyclical nature of this industry result in a higher level of eCommerce disruption Exhibit 119 The concentrated CE market shares of Suning and Gome accentuate the “pain” inflicted by a fast growing eCommerce player like 360Buy Estimated revenue (online + offline) of key CE retailers Rmb mn CAGR (2007-2011) 100 Suning: +22% Gome: +15% 80 360Buy: +177% 60Source: Golden Eagle, Morgan Stanley Research 40 20Consumer Electronics (Most Vulnerable):Consumer electronics and home appliance categories ranked 0#1 and #3 in 2011 in terms of Internet retailing value, 2007 2008 2009 2010 2011according to Euromonitor. As consumer electronics tends to 360Buy Gome Suningbe standardized merchandise with a concentrated number of Source: Company Data, Morgan Stanley Research 71
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailOn the other hand, a high percentage of consumers demand  External – Requirement of exclusivity and customerauthentic consumer electronics and are unwilling to purchase experience make online migration slower for high-end“knock-off” items, according to our AlphaWise survey. brands: Global luxury and high-end brands are focusing onTraditional consumer electronics retailers, such as Suning a retail-driven business strategy and de-emphasizing theirand Gome, may still be able to gain online market share via wholesale business for the following reasons: 1) bettertheir own online portals if they establish consumer trust and customer experience; 2) enhanced brand image; 3)provide better service / user experience. More importantly, increased customization; 4) minimization of counterfeits andwe believe these offline retailers must leverage their higher 5) less pricing conflict (or arbitrage opportunities by parallelsourcing scale and greater cash flow to provide more importers) in different regions. We believe these factors willcompetitive pricing (both online and offline), invest in supply make the pace of online migration for high-end brandschain integration and rationalize unproductive stores. slower than that of mid-end brands. While we do not rule out the possibility of these high-end brands setting up theirExhibit 120 own online sites and virtual stores, we think the percentagePercentage of online buyers rejecting “knock-off” of products sold online by these brands will be low.products 100%  Internal – Business execution is key: The obvious 80% benefits from a concession based business model are low 60% inventory risk and high cash flow generation. The key risks 40% to concession based business model are lack of brands, product differentiation and pricing control especially for low- 20% mid end department stores. The key differentiating factors 0% for department stores are store location, size and offering of Clothing Shoes Athletic Consumer Cosmetics apparel & electronics (females the stores, sales productivity for brands, ability to drive shoes only) traffic and promotion, appropriate brand mix for local Gross monthly household income: consumers, high-quality customer service, VIP stickiness Low (<RMB 6k) Mid (RMB 6-15k) High (>RMB 15k) Average   and adoption of technology innovation to reduce fixedSource: AlphaWise, Morgan Stanley Research overhead. These key drivers are determined by the execution of department stores.Department stores (moderately vulnerable):Chinese department stores are “landlords” that operate the  Internal – Product and service mix to change over time:concessionaire business model, receiving “variable rental Over the long-term, we believe eCommerce could takeincome” from sales generated by the brands. Therefore, toassess disruption from eCommerce, we must determine share from department stores, especially in categories withwhich key factors the operators can and cannot control, high online penetration. Apparel, shoes and sportswearincluding: represent 40-55% of department stores merchandise mix. These categories could be vulnerable to eCommerce External – The percent and pace of migration online for disruption given their high online penetration. We believe mid-end brands is key: Similar to offline retailers, strong high ticket merchandise that requires higher quality and online brands will likely outsell less known online brands, in product authenticity, such as jewelry, luxury products and our view. Therefore, decisions by major brands on how cosmetics, are less vulnerable to eCommerce disruption. quickly they adopt the online channel and what percentage The allocation of space from variable concession income to of their products are sold online will determine the level of fixed rental income could also be controlled by department disruption from eCommerce. From a mid-end brands’ stores. perspective, the key considerations for online migration are: 1) the habits and purchasing power of the core customer As seen below, Hong Kong-listed chains represent a only group, 2) brand positioning (too much and too frequent “small” portion of mixed retailers’ value, making the “crowd- discounting online translates into less opportunities to raise out” effect from eCommerce there less noticeable in the near prices in the future); 3) online merchandise gross and term. In our view, the online migration trend of mid-end operating profits; and 4) online and offline channel inventory brands is key. control. We think the migration online by the mid-end brands will be more measured in order to balance their market share and profitability. 72
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 121 Food retailers (low risk):“Crowd out” effect from eCommerce less We believe hypermarket operators such as Sun ART andnoticeable near-term given “smaller” market shares CRE are best-positioned given that consumers in China prefer(Mid-end brand’s migration online has greater long- purchasing food products from physical stores. Based on ourterm impact) AlphaWise survey, grocery and jewelry are the two categories HK-listed chains % market share in which offline retailers are gaining market share from online 7.0 players. 6.0 1.0 1.0 Low ticket size, low gross margin of fresh and packaged food 5.0 1.0 1.1 1.3 and high last mile fulfillment costs result in a loss making 4.0 1.1 1.2 0.9 1.0 business model for online grocers that lack scale. In order for 3.0 0.7 1.5 1.8 online grocers to become profitable, they will need to adopt 1.1 1.3 1.0 both: 2.0 1.0 1.8 1.9 1.9 1.9 2.0  Focusing on route density and 0.0 2007 2008 2009 2010 2011  Shift product mix to higher margin product categories Parkson Golden Eagle Intime NWDS such as HPC, apparel and other servicesSource: Euromonitor, Company Data, Morgan Stanley Research Given an online grocer’s business model will need to be fairly concentrated in order to benefit from scale, diversifiedOther key factors used to measure the degree of eCommerce hypermarket chains, such as Sun ART, that are exposed todisruption in the department store segment include: lower tier cities, will likely not lose market share to online Low market share concentration – The combined retailers in the near-term. We believe consumers will continue revenue of HK-listed department store chains still to prefer offline retailers of food, packaged food, FMCG and represents a relatively small portion of overall mixed HPC over online alternatives. retailers’ revenue. The five HK-listed department stores under coverage represent only 7% of mixed retailers’ Brands: potentially challenged and best-positioned market share in China as shown in above Exhibit 121. Potentially challenged Best-positioned Li Ning Belle Affluent, older demographic – Core VIP customers of Anta Prada leading department store chains are affluent and older than those of the core eCommerce consumers. Defensible brands are either high-end positioned and / or Lower tier cities – Exposure to lower tier cities where operate primarily their own retail network. online penetration is relatively lower than Tier 1 cities. We believe brands that control their retail channel by self operating their own stores and effectively controlling their “See and touch” – According to our AlphaWise survey, the merchandise pricing and inventories within their store need to “see and touch” was one of the top three reasons network / channels in China are strongly positioned to capture why respondents refrain from buying online. share in the eCommerce channel:To put all of the above into perspective, determining which  Luxury brands – Companies, such as Prada are well positioned given their strong brand and focus on the high-trends most strongly influence the position of the leading end market.department store chains is still relatively unclear. However, ingeneral, we believe chains with higher quality stores (location,  Jewelry – According to our AlphaWise survey, thissize, traffic and products) selling high-end products will likely segment has the lowest online penetration of 33%, and webe more defensible than those that are low-to-mid end expect it to decline by 10% over the next 12 months. Givenpositioned. We favor Golden Eagle, Intime and Springland. the high average selling price of jewelry products (i.e.,We especially highlight Intime, which already has a stake in gold, gem-set, platinum, karat-gold etc.), we believesuccessful eCommerce portal, Yintai.com. Chinese consumers prefer to shop in-store at reputable jewelry retail stores than online. 73
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail Footwear – We favor Belle given its multi-brand and multi- brands, B2C virtual stores and B2B2C platforms. They channel strategy that has dominated the mid-high end may sell similar SKUs at different prices, which could dilute footwear segment in the offline retail environment. Given the brand’s image over time if brands do not take greater Belle controls the majority of its retail stores, is vertically control over pricing and inventories. integrated, and has infrastructure support throughout China, it is well positioned to capture market share in the  Potential pricing cap for weaker brands – Given the footwear category via the online portals, such as Taobao sportswear industry is mired with excess inventories, the and / or Tmall, as well as its own online portal yougou.com. eCommerce portals have become a popular alternative for the brands and their distributors to sell outdated productsExhibit 122 at a steep discount. Therefore, weaker brands may bePrefer high-end and retailing driven brands to unable to raise prices in both an offline and onlinemass-end and wholesale driven brands environment if there are too many outdated lower price Luxury products in the system. Defensible 1 PRADA  Proliferation of online only brands – While it will evolve in the future, our AlphaWise survey shows China’s 0.5 eCommerce demographic is currently younger and price sensitive. This is a channel perfect for mass-end products 0 (branded or non-branded). Therefore, smaller online only Bosideng Belle brands have grown rapidly, selling at lower prices and can -0.5 Anta Li Ning Daphne potentially take share from traditional channel brands. While their market share may still be small compared to offline brands, they are new threats, especially in the -1 Mass At-Risk casual and sportswear categories. -1.0 -0.5 0.0 0.5 1.0 Wholesale (100%) Retail (100%)Source: Company Data, Morgan Stanley Research Key takeaways from our AlphaWise survey In October and November 2012, we conducted an AlphaWiseAt-risk brands are mass end positioned and / or survey of 1,000 Chinese customers. Our sample respondentsadopt a multi-layer wholesale model: are sophisticated consumers that reside in Tier 1 and Tier 2Unlike the US, approximately 80% of eCommerce market cities. These consumers are young and belong to the top 10%share is dominated by a marketplace driven ecosystem in of income bracket that are frequent online shoppers, 91% ownChina. This creates retailing complexity for brands that adopt a smartphone and 64% have mobile internet access. Keya multi-layer wholesale driven business model to distribute findings include: 1) pricing is the key reason to buy online; 2)their products. The dominance of the marketplace platforms lack of trust and the need to “see and touch” are key reasonscreates conflict for brands as well as its online and offline for not buying more online and 3) consumers would buy moredistributors / retailers. This is particularly true for the online if they can return / exchange products bought online atsportswear and mass-end apparel categories: a store. Multi-layer offline wholesale business model at odds in a boundary-less online ecosystem – Most wholesale Profile of online survey respondents driven brands distinguish distributors / sub-distributors by  98% of respondents have purchased online in the past 12 regions and rank them by quantity of products purchased months (“P12M online shoppers”) in China. However, a marketplace B2C site like  Younger demographic: median age of 31 yrs Tmall.com, which is a virtual landlord charging entrance fees and taking a percentage of sales, the tiering system  Skewed towards top 10% of Chinese households: 76% of respondents have gross monthly income above of these distributors does not exist. Therefore, a Rmb8,000, belonging to top 10% of China’s income group. distributor becomes ‘boundary-less’ as it could sell both P12M online shoppers tend to have higher monthly income online on Tmall and offline in its stores. This could disrupt at Rmb15,218 versus only Rmb8,523 of those non-P12M the brands regional wholesale distribution business shoppers. models in the offline world. Potential long-term brand dilution – There are many parties selling online sportswear products, including the 74
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail Live in smaller households: 64% of respondents live in Exhibit 123 household sizes with 3-4 people; 23% live in households Online penetration trend by category with 5+ people. Clothing Shoes New online shoppers: 80% of respondents have less Books than 6 years of online shopping experience. Athletic apparel & athletic shoes Sporting goods IncreasingSome surprising data points Consumer electronics online Frequent online shoppers: 78% of P12M online Home furnishings & accessories penetration shoppers purchased online more than once per month. Office & school supplies for home use Home improvement items & tools High penetration of mobile devices: 91% of respondents Large home appliances own smartphones; 61% own tablets, 29% own an Personal care & household products eReader. Auto parts & accessories High penetration of mobile Internet: 64% of respondents Pet food & pet supplies Decreasing online have Internet access on mobile phones Groceries penetration JewelryKey observations about our AlphaWise survey 0% 20% 40% 60% 80% 100% Current online penetrationObservation 1: The higher the online penetration, the Future online penetrationlarger the threat to traditional retailers   Source: AlphaWise, Morgan Stanley ResearchBased on our AlphaWise survey results on online penetrationby category, as shown in Exhibit 123 categories from most to Observation 2: Over the next 12 months, surveyleast at risk are: respondents are curtailing purchases in most categories due to weak sentiment Top three high-risk categories: 1) Clothing, 2) Shoes, While online penetration is growing for most of the at risk and 3) Books: These categories have the highest online categories, it is worth noting that respondents plan to reduce penetration rates, and penetration is expected to grow purchases of the following categories over the next 12 even higher over the next 12 months. months, both online and offline – HPC products, Athletic Apparel & Shoes, Clothing and Consumer Electronics. Relatively risky categories: 1) Sporting goods, 2) Athletic apparel and athletic shoes, 3) Home Jewelry and groceries showed share gains for traditional furnishings and accessories: Online penetration in these retailers but sporting goods and home improvement categories is expected to increase by 14%, 8% and 7% showed share losses over the next 12 months respectively. As shown in Exhibit 124 the number of respondents planning to purchase offline jewelry and groceries is growing faster Low risk categories: 1) Jewelry, 2) Groceries: Current than those that plan to purchase these categories online. On online penetration rates of these two categories are the the other hand, offline retailers in sporting goods and home lowest among all categories, and are expected to further improvement are losing share to online players. decline by 10% and 7% over the next 12 months. 75
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 124 Exhibit 125Percentage change in number of respondents Low prices, price transparency and convenienceplanning to purchase over the next 12 months are the top reasons for consumers to buy online  Change in number of respondents (%)* Low prices 52% Online Offline Easier to compare prices 41% Categories with online/offline gaining gaining gaining or losing shares together shares shares Save time 40% 60% Broad selection 39% 40% Can shop anywhere, anytime 31% 20% Can read customer reviews 28% More product information 20% 0% Convenient to have products delivered 13% -20% High quality of products available 10% -40% Products not available in stores 8% -60% Flexible payment/installment terms 8% Office&school supplies Athletic apparel&shoes Auto parts&access. Large home appliances Pet food&supplies Home furnishings Groceries Books Sporting goods Home improvement Shoes Jewelry Clothing HPC CE Free shipping 6%   Source: AlphaWise, Morgan Stanley Research Observation 4: Lack of trust seems to be the key obstacle for shoppers to shop more online:  Lack of trust: 45% of respondents that do not shop online Online Offline OverallSource: AlphaWise, Morgan Stanley Research   indicated 1) lack of trust in online retailers and 2) lack ofObservation 3: Price is a key driver to buying online trust in products bought online, as the biggest obstacles to Compare prices online: 87% of online shoppers indicated start buying products online. that they compare prices online prior to making online purchases.  Prefer to return/exchange products bought online at a store: 90% of online shoppers indicated that they would Frequently compare prices online vs. offline: 82% of shop online more often if they would return / exchange online shoppers indicated that they always/frequently products bought online at a store. Other emerging markets compare prices between online vs. offline retailers. Top such as Russia and Brazil also recorded a high percentage three product categories are 1) Clothing, 2) Shoes and 3) of respondents for this statement. This is in contrast to that Athletic apparel & shoes. of developed markets, which have on average, only 52% of online shoppers favoring this preference. We believe this is Favorite online retailer offers low prices: 44% of online attributable to online product quality concerns by online shoppers identified “Low prices” as one of the top three shoppers in emerging markets. most important reasons for choosing that retailer as their favorite online retailer, the highest percentage among all  Physical stores still matter: Despite the increasing other options. threats coming from the online market, we believe the presence of physical stores remains irreplaceable in Shipping costs matter: Most respondents indicated a certain aspects. As shown in Exhibit 127, offline shoppers greater willingness to shop online if they could still prefer to shop in store given their need to “see and return/exchange goods without having to pay for shipping touch” the products, as well as convenience to buy and (74%), or if shipping were free (73%). Ease of returns is return products in store. also an important consideration to shopping online. 76
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 126 Exhibit 127Lack of trust and need to “see and touch” products I would buy online more if…*are the top obstacles to buying online Strongly agree Somewhat agree Lack of trust in online retailers 45% I dont have to pay shipping for return Do not trust quality of online products 45% 74% 20% or exchange Need to see and touch products 27% More convenient to buy in stores 27% Retailers offer free shipping 73% 21% Easier to return products in stores 23% Possible lost/damaged during shipping 23% Online retailers offer same day 64% 22% Online payment/personal info security 23% delivery Long delivery time 18% I would buy online more often if I can High shipping costs 18% return/exchange products bought 62% 28% online at a store Enjoy shopping in stores more 9% Delivery can be arranged during the Better customer service in stores 9% 55% 30% hours I am home More product choices in stores 9% Products not available online 5% 0% 20% 40% 60% 80% 100% Inconvenient to deliver products 5% As % of total respondents (n=1,000) Dont have credit cards/others 5%   * Percentage of respondents who strongly/somewhat agree with the statements. Other reasons 5% Source: AlphaWise, Morgan Stanley ResearchSource: AlphaWise, Morgan Stanley Research 77
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailRussia Internet Exhibit 128Edward Hill-Wood Russia is underpenetrated relative to global peersNicholas Ashworth Online/total retail salesMaryia BerasnevaLiz A. Rich UK 10.2% US 10.1%Executive Summary / Key Takeaways China 5.7%1. Nascent eCommerce sector approaching tipping point - Penetration set to increase from 2% to 5% of retail sales by 2015 France 5.3%2. Key drivers are increasing broadband penetration and credit card usage. Distribution remains major barrier to growth Germany 4.8%3. Vibrant local eCommerce ecosystem emerging with search (Yandex), Russia 1.9% classifieds (Avito) and key eCommerce verticals such as Fashion (KupiVIP) and Travel (Oktogu) Source: Euromonitor, Morgan Stanley Research estimates for Russia4. Market leader by sales, Ozon, is among the fastest growing private …to a global leader eCommerce companies globally. From this low base, our market research indicates that Russia is set to become one of the most dynamic markets globally. In theory, demand for online commerce in Russia should beRussia on the rise higher than average due to the physical constraints onWhile current levels of eCommerce penetration are low competition and limited product choice that derive from a veryrelative to the US and Western Europe, we expect Russia to low density of Russia’s 140MM population outside of Moscowdevelop into one of the largest and most dynamic eCommerce and St Petersburg.markets globally. Significant barriers to entry have enabledlocal Russian eCommerce companies to amass an estimated We forecast Russia eCommerce may grow at a 35% CAGR90% market share. Additionally, we believe Russia’s leading through 2015 to $36B, 4.5% offline retail sales penetration.search destination site, Yandex, is a key beneficiary of our We anticipate further growth in eCommerce penetration toforecast 2011-2015 eCommerce CAGR of 35% in Russia. $72B in 2020, 7% penetration of offline retail sales. Despite this growth, our estimates will still lag developed, WesternRussia eCommerce: From laggard…. markets by around a decade.We estimate Russia eCommerce sales will reach $12B in Exhibit 1292012 or 1.9% of the $670B Russia offline retail sales. Relative Russian eCommerce market forecast: 44% CAGRto its global peer group, Russia is currently underpenetrated. 2012-14Both the US and UK surpassed the 2% eCommerce (RUB bn)penetration threshold in 2003 and 2005, respectively. 2,500 8% Value of eCommerceAdditionally, Russia is also underpenetrated relative to other 7% Online/Total retail (%)large emerging markets; both China and Brazil are 5%. We 2,000 6%believe Russia’s significantly lower broadband penetration, 5%relatively low household income, low usage of credit cards 1,500(many B2C orders are paid ‘cash-on-delivery’), distrust of 4% 1,000online payments and quality of products, and sub-optimal 3%postal / freight distribution infrastructure all weigh negatively 2% 500on eCommerce penetration. 1% 0 0% 2009 2010 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e Source: Euromonitor, Morgan Stanley Research estimates (e) 78
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMoscow and St. Petersburg are unique regions within Russia.  Consumer electronics and books have the highestDespite the two cities representing 15% of the country’s eCommerce penetration and are poised to maintain thispopulation, we estimate they account for 60% of Russia strength in the future (over 60% of shoppers bought aeCommerce sales due to higher broadband penetration, product from each of these categories online and planhigher disposable household income and higher population to make purchases within these categories online in thedensity and correspondingly more favorable postal and next 12 months).logistics infrastructure. We estimate the two regions will beable to sustain eCommerce sales growth of 30% through  Groceries have not migrated online in any meaningful2020 vs. the broader country at 20%. fashion due to issues over distribution, inventory spoilage, and the perceived need to see merchandiseExhibit 130 before purchase. Currently in the US, online groceryOnline sales: Regions (ex Moscow and St. sales account for less than 0.5% of the market.Petersburg) contribute 55% of forecast growth to2012 …with a lag 100% We found that Russia exhibits similar barriers to transacting online as the US / UK, specifically: 80% Volga Region 60% Ural Federal Southern Federal  Russians are relatively newer to eCommerce. In our Siberian Federal survey, 48% of Russians had their first eCommerce North-Western 40% Far East transaction in the last two years (vs. the US at 10%) Central Federal and only 16% have been buying products for over six 20% years (vs. 62% in the US). Additionally, 63% of Russian Internet users bought a physical good online in the past 0% 12 months vs. 85% in the US. 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020eSource: Morgan Stanley Research estimates  The tenure of an average Russian online shopper is three years (vs. eight years for a US online shopper).A similar trajectory to western markets… Consistent with what our US colleagues have found, theDue to the limited availability of accurate eCommerce industry higher income demographic has been shopping onlinestatistics, we interviewed several leading, private eCommerce longer than the lower income demographic; in Russia,companies and worked with our AlphaWise Team to survey five years.1,000 Russian consumers. Our survey included a statisticallysignificant sample size that is representative of the country’s  Fifty-four percent of those who have not purchaseddemographic distribution. Conclusions based on the entire online in the last 12 months cited the need to see andsample have a margin of error of +/-2.5% at a 90% confidence touch merchandise before purchasing (vs. 38% in thelevel. While there are plenty of idiosyncrasies, we found that, US). We believe this will continue to decline as moreat a fundamental level, online consumer behavior in Russia commoditized product categories shift online andtracks in line with most Western markets. consumers become more accustomed to shopping  An online shopper in Russia is more likely to be female online. (64%) and from the 30 to 39 years old (72% vs. 62% for 18 to 29 year olds and 66% for 40 to 49 year olds).  Other friction points for eCommerce include a lack of Online shopping is also significantly more prevalent trust, in online payment security (27%), product quality among households with higher incomes (household (28%) or the online retailers themselves (27%). Product income of RUB 30K+). The average age of an online returns / exchanges are also seen as a drawback shopper (who shopped in the last 12 months) is 44 (vs. (29%). 45 in the US). Russia has its own idiosyncrasies  The rationale for eCommerce usage is familiar - Key We also found key differences in consumer demand in reasons cited in our survey were lower price (47%), Russia, relative to Western markets. We believe these saves time (36%), convenience (location, time) (33%) differences are largely supply side, distribution and / or as well as online customer reviews (32%). payment constraint-driven. 79
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail While convenience of delivery is one of the top reasons the primary method of payment, comprising close to 60% for shopping online in the US, only 19% of Russian online of transactions (per a recent PWC study). shoppers cited it as a benefit. Instead, lack of Exhibit 131 merchandise selection in-store accounted as a more important driver (27% of respondents). Russian consumers favor COD as their method of payment for eCommerce shopping Differences in consumption by eCommerce category 2009 2012 differ in Russia vs. the US. While both markets show Cash on 59 58 similar levels of online purchasing propensity for athletic Delivery apparel / footwear and books, Russia’s online sales of 49 Web money 49 auto parts, home appliances (both small and large), home furnishings, home improvement products, personal 20 Bank card 32 care and sporting goods are higher relative to the US. By contrast, clothing and footwear are more popular online 27 Bank transfer 23 categories in the US vs. Russia. Despite this dynamic, clothing and footwear are two of the fastest growing 0 SMS payment 12 categories for Ozon, according to management. 0 Terminal 11Ample evidence of strong growth potential Source: PWC, Morgan Stanley ResearchOur AlphaWise survey and industry checks suggest thatRussia eCommerce sales may see an inflection point in the  Russia continues to see expansion of its eCommercecoming two years. We note the following: market. New business growth, access to capital / funding We forecast Russia Internet penetration to grow at a 4% and scale of operations are all on the rise. Aside from CAGR between 2012-2015. Assuming constant Ozon, we note the rapid growth in reported sales at population levels, Internet users could reach 87MM in newer companies such as Avito (classifieds), KupiVIP 2015 vs 53MM in 2012. (fashion private sales), Biglion (group buying), Oktogo.ru (online travel booking), Game Insight (mobile gaming), While experimentation is growing, there is substantial Lamoda (online fashion direct sales retailer), Wikimart upside from increased frequency of purchase. The (online marketplace), and AnywayAnyday (online airline average number of online purchases is 10 times per tickets). annum in Russia vs. 15 times in the US. Around 18% Exhibit 132 purchased online at least 2-3 times per month, as eCommerce should sustain strong levels of growth compared to 28% in the US. and reach about 7% of total retail sales by 2020 One of the key points of friction for broader eCommerce 16% penetration is payments. Relatively low access to credit 14% cards and consumer concerns regarding the safety of 12% online payments have both been notable hurdles. About 10% 67% of surveyed respondents suggested they would 8% purchase more online if eCommerce retailers offered 6% other payment methods. There is incremental evidence 4% that this is changing, however. According to an August 2% 2012 study by MasterCard, 74% of Russians possessed 0% bankcards as of 2011 with 40% using their bankcards for 2009 2010 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e a retail purchase vs. 27% the previous year. That said, Online/Total retail (%) Online/Non-Food (%) mass-market credit card adoption still appears restricted Source: Company Data, Morgan Stanley Research estimates (e) to specific categories like online travel (there is an incentive to pre-book printable tickets vs. receiving them A developed eCommerce ecosystem in the mail). Elsewhere, cash on delivery (“COD”) remains Russia’s leading eCommerce companies have adapted their business models to meet the country-specific headwinds. For 80
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailexample, group-buying market leader Biglion has 10MM people listing items for sale on the site. It recentlyincorporated both a selective eCommerce and a customer raised $75MM in funding, and has said it may diversify itsreview component to its coupon-based business model. business to include also traditional retail and auto/ property markets. Search: The vast majority of Russian consumers use Exhibit 135 search engines to research products information (87%) and compare prices (81%). Yandex leads (56%) Google Key Russian eCommerce and other Internet-related sites (38%) as the predominant search engine used prior to Service used by frequent Russian shoppers (1x per month) consumer purchases, both online and offline. Yandex is Ozon.ru 55% especially strong among consumer demographics with Avito.ru 22% longer tenure (>5 years) and the highest household Biglion.ru 22% incomes. Furthermore, Yandex is developing search eBay.com 25% verticals and price comparison sites to drive eCommerce Slando.ru 13% KupiVIP.ru 16% traffic, which accounts for 15% of the company’s revenue. MVideo.ru 13% Yandex’s Market has grown to 13.4MM unique monthly Amazon.com 19% users with 2.4MM searches (1.5% of total) specific to the Yandexmarket.ru 13% clothing category. Sapato.ru 15% Molotok.ru 10%Exhibit 133 E5.ru 7%Yandex benefits disproportionately from Wikimart.ru 4%eCommerce search in Russia with 61% of traffic AnywayAnyday.ru 2% Source: AlphaWise, Morgan Stanley Research Past 12 months Regular Total Online shoppers (1 per month) Exhibit 136Google 38% 38% 36% Ozon is the clear eCommerce leader in RussiaYandex 56% 59% 61% Percentage of online shoppers who purchased from the retailer in P12MOther 6% 4% 3% 60%Source: AlphaWise, Morgan Stanley Research 50%Exhibit 134 40%Use of search engines for online and in-storepurchases 30% 20% 1 10% 0.8 Do not use a Looking for search engine for these 0.6 product information 0% 0.4 Ozon.ru Avito.ru Biglion.ru eBay.com Slando.ru KupiVIP.ru 0.2 Frequent online shoppers Regular online shoppers Infrequent online shoppers 0 Source: AlphaWise, Morgan Stanley ResearchLooking for consumer Looking for reviews and ratings retailer information Food retailers are unlikely eCommerce participants… Delivering fresh produce over long distances without high Looking for coupons, deals, discount Comparing prices route density is a tough logistical task, not to mention the codes, etc. difficulties in attaining economic efficiencies. Of Russia’s four publicly traded food retailers, only one, X5, is making a push into eCommerce. It has rebranded its online offering as Online purchases In-Store purchases “E5.RU”, which launched in 2012 with 400K SKUs. However,Source: AlphaWise, Morgan Stanley Research unlike Western food retailers, home delivery is the exception - the majority of orders (around 90%) are classified as “Click Classifieds: Our surveys suggest that Avito (founded in and Collect” orders with payment processed at the time of 2008) is now the leading classified listings site in Russia, pick-up. While courier services are available, they currently which is typically a “winner takes all” business. Avito’s constitute only a small share of X5’s online sales volume site generates 30MM monthly users and more than (10%). 81
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailOur survey indicates the primary friction point that prohibits Ozon could reach about $1B of sales by 2014, if it were togreater consumer adoption is the desire of the consumer to track our eCommerce market estimatescheck the quality of the produce before purchasing. As Ozon’s pro forma revenue grew +91% y/y to $232MM inpreviously stated, payment-method is another key issue (for 1H2012. If Ozon’s growth trajectory were to track with ourall online retailers), as the consumer still does not trust the eCommerce category estimates, it could reach $1B ofsafety of online payment system, as well as a low penetration revenue by 2014. We would expect best-in-class eCommerceof credit / debit card usage. However, because Russia has the retailers to reach EBITDA margin levels similar to those oflargest Internet audience in Europe, X5 sees a large total Amazon, currently around 5-10%.addressable market for its eCommerce offering. The companybelieves it can reach >200K visits to its website per day by the Ozon is pursuing a strategy to address key friction pointsend of 2012. for eCommerce growth in Russia, specifically: 1. Distribution: In the absence of a reliable and trusted…but other retailers appear better positioned. national postal system, Ozon has developed aWithin the consumer electronics category, M.video is a distribution system that now covers 75% of the country’sleading retailer in Russia, and the company is focused on population through 2,100 pick-up points in 130 cities. Thegrowing its eCommerce presence by combining its traditional company’s “O-Courier” platform has close to 50% of theoperations with its online presence. Through 1H12, M.video points of presence relative to the largest retailers, with asaw Internet sales of +93% y/y, driven mainly by new traffic target of 4,000 points of presence by 2014. In some(88 of the 93 points of y/y growth) and basket size (making up regions, Ozon outsources fulfillment and distribution tothe remaining +5 percentage points of growth). That said, partners such as Euroset. While not a core business, theeCommerce comprised only 2.6% of M.video’s 2011 company also offers a fulfillment service to 70 smallerconsolidated sales, up incrementally from 1.8% in 2010. merchant partners. To facilitate this, Ozon has built a second warehouse that measures 16,200 SqM that canExhibit 137 store 6-7MM merchandise units.A quarter of food retail spend is in the Urals, Siberiaand Far East regions 2. Payments: 80% of Ozon’s sales are collected by cash onFood retail sales % 2007 2008 2009 2010 2011 delivery. Customers remain resistant to using onlineCentral federal district 34.7 33.5 33.7 34.1 34.3 payments. However, Ozon is developing new forms ofMoscow region 6.1 6.4 6.1 6.2 6.2Moscow 19 17.1 17.3 17.5 17.4 accepting payments and credit card usage continues toNorth-Western federal district 9.4 9.2 9.4 9.4 9.3 increase (now over 10%). According to management,Saint Petersburg 4.1 4.1 4.2 4.2 4 credit card payment-mix in the travel category hasSouthern federal district 8.5 8.8 8.7 9.1 9North Caucasian federal district 3.8 4 4.6 4.8 5 reached 60%.Volga federal district 17.9 18.4 18.3 18.1 18.1Urals federal district 10.4 10.8 10.3 10 9.6 3. Information: The lack of credit card usage has limitedSiberian federal district 11.5 11.6 10.9 10.6 10.8 Ozon’s ability to collect valuable payment data from itsFar-Eastern federal district 3.9 3.7 4.1 4 3.9 100 100 100 100 100 customers – a clear disadvantage relative to the level ofSource: RosStat, Morgan Stanley Research information Amazon has on its customers. To bridge this information gap, Ozon management has said it plans toOzon: A case study enhance its loyalty program, which should increase the level of customer-specific knowledge and enable Ozon toOzon is by far the largest eCommerce company in Russia. differentiate its customers by segment.With 11M registered users, Ozon is often referred to as the“Russian Amazon.” The company’s 1,700 employees offer Ozon’s growth by product categorymore than 2.2MM items to a daily audience of 750K unique While books and consumer electronics (which globally isvisitors. It is a private company, the key shareholders being traditionally a loss-making category) have been the dominantBaring Vostok Private Equity, Index Ventures, ru-Net Ltd, product categories for Ozon, the company has disclosedRakuten, Intel Capital, Holtzbrinck, and Cisco. In September higher levels of growth in the apparel / footwear, home goods,2011, the company raised $100MM, of which 95% was and cosmetics categories. This could be attributable to theinvested into Ozon’s four key businesses. consumer’s limited offline merchandise selection in these categories. Ozon increased its exposure to softline goods in February 2012 when it acquired Sapato.ru, a footwear and 82
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailaccessories eCommerce specialty retailer. Sapato.ru offers Exhibit 139more than 200,000 shoe types from over 200 brands. In Ozon is more established relative to the overalladdition, Ozon established a separate online travel agency category, especially with longer tenured customersbusiness, OZON.travel, which sells tickets from 500 airlinesand offers bookings for 160,000 hotel rooms. 40%In our survey, Ozon showed the highest penetration among 30%online shoppers (41% of respondents purchased on the sitewithin the past 12 months), followed by Avito (21%), and 20%Biglion (16%). Ozon was ranked as the favored site by 1 in 4online shoppers with a large gap to number 2, as the chart 10%shows.Exhibit 138 0%25% of shoppers view Ozon as favorite place to buy Less than 1-2 years 3-5 years 6-10 years More thanonline; 41% have purchase at Ozon in the last year a year 10 years Ozon.ru 25% Ozon Russian e-Commerce eBay.com 8% Source: AlphaWise, Morgan Stanley Research Avito.ru 6% The challenges facing Ozon are common to all Biglion.ru 5% Russian eCommerce companies Yandexmarket.ru 3% 1. Unexpected regulatory change. There are no current KupiVIP.ru 3% plans for meaningful changes to current legislation, MVideo.ru 3% however, we would anticipate a greater initial focus on sectors such as social networking. Amazon.com 2% Sapato.ru 2% 2. Macroeconomic conditions. Our conviction in the Molotok.ru 2% secular shift of offline retail sales to online eCommerce sales is high, but Ozon, like any other eCommerce Slando.ru 1% participant, would be impacted by any adverse change in Wikimart.ru 1% macroeconomic conditions in Russia. However, Morgan E5.ru 1% Stanley economists do forecast relatively healthy 10% AnywayAnyday.ru 0% nominal GDP growth in Russia for 2013 and 9% for 2014.Source: AlphaWise, Morgan Stanley Research 3. Competition from international players. A potential entry by Amazon into the Russian market could materiallyThe following chart shows the average tenure of an Ozon increase levels of competition. That said, the barriers tocustomer is four years, compared to less than three years for entry are significant, and our channel checks do notthe broader Russia eCommerce market. indicate Amazon is preparing to enter the Russian market. eBay, however, has established a foothold. 4. While the level of counterfeit and grey market goods is generally low, this could develop into a more widespread problem for the eCommerce category if not closely regulated by authorities. 83
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailAustralia RetailThomas Kierath Consumers are increasingly able to purchase offshore atCrystal Wang prices significantly lower than domestic retail prices. Australian offline retailers have been slow to adapt to this change, but are gradually investing in online capabilities. OurExecutive Summary / Key Takeaways AlphaWise survey indicates price differences are still the mostBest-Positioned: Woolworths, Metcash, Wesfarmers important factor for Australian eCommerce consumers. While Australian offline retail prices have compressed, we expectPotentially Challenged: JB Hi-Fi, Harvey Norman, David Jones, Myer domestic prices to remain higher than offshore, given the1. eCommerce has permanently reshaped the retail landscape in relatively high labor rates and rent costs within Australia. Australia through greater price transparency and access to global retailers. A unique trend in Australia is the large amount of offshore Australia ranks relatively highly in total urban GDP and GDP buying, given lower pricing relative to local retailers. per capita, which are two metrics that favor eCommerce2. We expect continued solid growth for eCommerce, given the growth. However, Australia’s eCommerce penetration rate is relatively low starting point and high retail cost base (labor and rent) currently modest at 5.5%. leading to ongoing price differentials. Exhibit 1413. Non-food retailers are potentially challenged (JBH, HVN, DJS and Australia is part of the “G12” in terms of urban MYR). Conversely, supermarkets (WOW, MTS and WES) appear GDP… least vulnerable to market share loss to eCommerce competition. Urban GDP (US$ tn) 14eCommerce has permanently reshaped the 12Australian retail landscape. 10The Australian retail landscape has changed significantly due 8to the evolution of eCommerce. Historically, Australian offlineretailers were able to price their products at significant 6premiums to international retailers. This was primarily due to 4the high barriers to purchasing goods overseas and having 2them shipped to the mainland. The appreciating AustralianDollar further expanded pricing differences. However, 0 Russia Brazil Australia Germany Italy US UK Japan China France Canada Spainbecause broadband penetration increased, this barrier hassomewhat dissipated.Exhibit 140 Source: World Bank, Morgan Stanley ResearchAustralia eCommerce penetration Exhibit 142 …but one of the most sparsely populated nations 5.5% 4.9% People per sq km 351 3.9% 3.3% 3.4% 3.0% 259 234 144 34 23 9 3 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Sep-12Source: Company Data, NAB / Quantium, Morgan Stanley Research Japan UK Germany China US Brazil Russia Australia Source: World Bank, Morgan Stanley Research 84
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailA sparse population is an impediment to eCommerce growth According to eBay’s survey of its top 3,000 sellers inas fulfillment of online orders becomes a significant challenge. Australia, the top concerns for large Australian sellers areBased on delivery time for survey respondents, we can see in international competition, global macro weakness andthe chart below that answer online delivery takes longer than postage costs. Postage costs have increased in prominencesix days resided in sparsely populated regions. as a negative factor impacting sales growth for eBay’s top sellers from 50% of respondents in 2011 to 55% in 2012. TopWhile Australia ranks last in terms of population density, upon sellers are keen for eBay to negotiate with Australia Post forcloser analysis, the economically addressable market is much volume-based discounts and better tracking of eBaymore appealing. Most of the nation’s wealth resides on the shipments.eastern coast of Australia. The country’s large urban GDPand high GDP per capita make it a strong potential market for Overall, we believe the underlying Australian market isAmazon if fulfillment centers can be concentrated in the attractive for eCommerce and expect continued share gainssoutheastern portion of the country. from offline retail due to the reasons outlined below:Exhibit 143  Price differences with traditional retailers will remain:Australia’s highest population density cities High labor and rent costs by global standards mean that domestic retail prices likely will always be higher than online operators. Exhibit 145 Indicative price differentials: Price premium in-store has reduced across categories since a year ago furnishings / Appliances Fragrances Auto / Auto Cosmetics electronics Consumer Computer Footwear Apparel / products Home parts Books / 0% -10% -20% -17% -15% -20% -19% -21% -19% -30% -25% -22% -27% -31% -30% -40%Source: Google Maps -50% -44% -43% -60% Apr-2011Brisbane: 2,400 people per square mile -70% -64% Jun-2012Sydney: 5,400 people per square mileMelbourne: 3,900 people per square mile Note: Prices are based on 133 identical products and exclude shipping costs and thus are for illustrative purposes only. Shipping was free on all Books, Cosmetics and 70% of consumerAdelaide: 3,600 people per square mile electronics products. Source: Morgan Stanley ResearchExhibit 144  Security concerns should dissipate: The mostPercentage of respondents stating that onlinedelivery takes longer than six days significant impediment to buying online, according to our AlphaWise survey, is payment security and protection of 50% 47% 45% personal information. We think these concerns are 45% unfounded and should dissipate with greater Internet 40% 36% usage. 35% 30% 29%  Generational change: Younger consumers shop more 25% online than older consumers. Growth in online is 20% underwritten as younger shoppers age and increase their 15% retail spend. Additionally, younger customers buy more 10% 9% from offshore websites. 6% 6% 5% 5% --% Brazil Russia Australia US Japan Germany UK ChinaSource: AlphaWise, Morgan Stanley Research 85
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 146 Non-food retailers are the most at-risk andThe under-40 demographic shops online 16% more supermarkets are the most defensible fromfrequently… eCommerce Frequency of online purchases during the past year Potentially challenged and best positioned stocks Potentially challenged Best positioned 16.65 Avg, 16.28 14.97 JB Hi-Fi Woolworths Harvey Norman Metcash 14.69 David Jones Wesfarmers Myer 13.69 Non-food retailers are the most exposed to potential 18-29 30-39 40-49 50+ eCommerce disruption. This includes the consumerSource: AlphaWise, Morgan Stanley Research electronics, apparel and department stores categories. We expect retail prices to continue to deflate as AustralianExhibit 147 product pricing moves toward parity to global pricing. Sinceare more reactive to lower prices online… the uplift in volume is unlikely to offset fully the deflationary Most important reason for buying online v. in stores - pressure, so revenues will likely remain weak for these Cheaper online retailers. JB Hi-Fi is the most exposed to eCommerce 69% 67% disruption as it generates about 20% of sales from CD’s and Avg, 63% video games. The exit of Circuit City and declining same store 63% sales trends at Best Buy should serve as reminders that the commoditized nature of consumer electronics leaves offline retailers in a vulnerable strategic position. 58% Exhibit 149 18-29 30-39 40-49 50+ Online growth has significantly slowed non-foodSource: AlphaWise, Morgan Stanley Research retail sales growthExhibit 148 5.7%…and buy more from offshore websites, especially 5.0%in apparel, large appliances and jewelry 24% 21% 22%Categories 18-39 40+ Diff 4.2% 3.9%Clothing 66% 39% 27% 3.4%Shoes 52% 29% 23% 3.0%Large home appliances 27% 5% 22% 2.0% 2.1%Jewelry 64% 44% 20%Pet food & pet supplies 24% 7% 17%Books 76% 62% 14% 0.5%Home improvement items & tools 34% 21% 13%Consumer electronics 45% 34% 11%Sporting goods 38% 27% 11% Food Non Food TotalPersonal care & household products 32% 23% 9% 10Y CAGR 12m to Jul-12 Stores OnlineHome furnishings & accessories 25% 16% 9%Athletic apparel & athletic shoes 49% 50% -1% Source: Company Data, NAB/Quantium, Morgan Stanley ResearchOffice & school supplies for home use 21% 24% -3%Groceries 14% 18% -4% The department stores David Jones and Myer generate 15-Auto parts & accessories 42% 48% -6% 20% of sales from cosmetics, another category highlyNone of these categories 25% 41% -16% exposed to eCommerce. Australian non-food retailers haveSource: AlphaWise, Morgan Stanley Research been relatively slow to embrace online channels. David Jones launched its online website back in 2000 but closed it down in 2003. David Jones only reopened its online shopping website in late 2010. The pie chart below illustrates that Australian retailers have been slow to adopt online channels, as the top 15 store-based retailers represent 25% of non-food market 86
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailshare but only a 3% online share. Unlike other regions, Drivers of consumer online shopping decisions:offshore retailers have 31% market share of non-food online Key findings from AlphaWise surveysales due to lower pricing relative to domestic retailers. Price point is the number one driver of onlineExhibit 150 purchases:Non-food online market share – the top 15 store- Our AlphaWise survey shows clear evidence that pricebased retailers represent 25% of non-food market, (including shipping) is by far the primary driver of onlinebut only have 3% share online purchases.  Consumers are price conscious: 62% of shoppers (online and offline) compare prices online prior to The rest 25% Offshore purchases. online sales 31%  Lower prices shift shopping from offline stores to online: For 63% of shoppers, price is the key driver to buy Top 15 store online instead of from stores, followed by convenience. based  Lower online prices drive online sales: Consumers are 3% more active online in categories where online prices are lower than stores. Clear examples are books, consumer electronics, clothing, jewelry and shoes. Large  Low prices = favorite website: Low pricing is the top domestic feature in consumers’ favorite website (58%), followed by online pure broad selection (51%) and easy to use website (46%). plays 41%  Higher propensity to shop online with free shipping / returns: The vast majority of shoppers are willing to buySource: ABS, Company Data, Morgan Stanley Research more online with free shipping (79%) and returns (70%). Exhibit 151The supermarkets have the most defensible position given the What are the three most important reasons that youcategory’s inventory obsolescence and relatively lower consider as your favorite online retailer?margins. Additionally, Australian supermarkets were quick to Low pricesembrace online channels. Woolworths started selling grocery Broad selectionitems online in 2001 and has established a leading position in Easy to use websitethis market. Coles has a click & collect service whereby Strong online security Free shippingconsumers can make grocery purchases online and pick them High quality of productsup at specified locations on the same day. Good customer service Clear, complete product informationeBay is Australia’s largest eCommerce platform Other reasons Consumer review/ratings on website57% of eCommerce consumers purchased from eBay in the Protect customer privacypast year, with 40% of shoppers citing it as their favorite Multiple payment optionsonline retailer. eBay is unique in that it allows consumers to Physical storespurchase identical products at offshore (lower) prices Same day or next day delivery Better payment termscompared with domestic retailers. In Australia, eBay has In-store pick upevolved from a consumer-to-consumer business to become Free returnincreasingly business-to-consumer. eBay’s annual survey of Source: AlphaWise, Morgan Stanley Researchits top sellers revealed that 60% of online shoppers purchaseon eBay and that its top 2,000 sellers experienced 45% y/ysales growth in 2011. Amazon does not have local retailoperations in Australia, although 28% of respondentsindicated that they purchased from Amazon (offshorepurchases) in the last twelve months. 87
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 152  Domestic physical presence is not a large advantage:Drivers of foreign site purchase - % who have Only 50% of online shoppers would prefer buying onlineshopped on a foreign site by category from an offline retailer vs. from an online-only retailer. Lower Not available Only 40% of shoppers think a domestic store presence is cost in Australia BothClothing 45% 18% 38% important. In addition, pick-up in store is not as popular inShoes 52% 8% 40% Australia (15%) vs. UK (39%) and US (33%),Athletic apparel & athletic shoes 59% 9% 32% understandable given only 18% of shoppers prefer pick-Jewelry 47% 23% 30% up in-store vs. delivery.Home furnishings & accessories 46% 23% 31%Office & school supplies for home use 62% 12% 26% Exhibit 153Sporting goods 71% 3% 26% Only 40% of surveyed shoppers said having a storeConsumer electronics 70% 7% 23% presence in Australia is very or extremely importantLarge home appliances 50% 0% 50%Home improvement items & tools 76% 19% 5% Extremely important 19%Auto parts & accessories 45% 24% 32%Personal care & household products 69% 8% 23% Very important 21%Pet food & pet supplies 64% 9% 27%Books 54% 16% 30% Somewhat important 30%Groceries 44% 22% 33%Source: AlphaWise, Morgan Stanley Research Not very important 18% Not at all important 11%Factors not critical to online shopping behavior: Long delivery time is not an impediment for shopping Source: AlphaWise, Morgan Stanley Research online, despite Australia’s relative isolation. Even though a high percentage of survey respondents stated that online deliveries take longer than six days, only 7% of online shoppers viewed long delivery times as an obstacle to shopping online. In addition, only 36% of online shoppers would buy more often online if same day delivery were offered. 88
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailJapan Internet Exhibit 155Tetsuro Tsusaka Japan’s large urban GDP signifies a large addressable market for eCommerceExecutive Summary / Key Takeaways Urban GDP (US$ tr)Best Positioned: Rakuten, Amazon US 121. Robust eCommerce growth amidst stagnating retail sales highlights Japan 4 the attractive dynamics of the eCommerce market in Japan. China 3 Germany 32. Rakuten and Amazon are the dominant eCommerce players and UK 2 poised to continue taking market share from offline retail players. France 23. Marketplace business models, such as Rakuten and Yahoo! Japan, Brazil 2 are aggressively investing in logistics and fulfillment to compete with Italy 1 hybrid market maker / marketplace models, such as Amazon. Canada 1 Russia 1 Australia 1Amidst a declining population, maturing Internet Spain 1penetration and stagnating retail sales growth,eCommerce continues to thrive in Japan. Source: World Bank, Morgan Stanley ResearchAccording to IDC, there are 103MM Internet users in Japan, Exhibit 156representing 81% of the total population (broadband GDP / Capita and total consumption expenditurespenetration levels similar to the US and Western Europe). Flat are important for eCommerceto negative GDP growth has lead to stagnant growth in retail Countries that score a 70 or highersales over the past five years. However, eCommerce has 0 10 20 30 40 50grown at a 12% CAGR from 2007-11, increasing itspenetration of retail sales from 4% to 9%. USExhibit 154 Japan9% eCommerce penetration in Japan Canada eCommerce penetration of retail sales (Japan) JPY tn Australia 12 9.8% Switzerland 10 9.3% 8.7% 8.1% 8 7.0% Germany 6.2% 6 France 4.0% 4 UK 2 Netherlands 0 Norway 2007 2008 2009 2010 2011 2012e 2013eSource: Japan Ministry of Economy, Trade and Industry, Morgan Stanley Research ItalyWith Japanese eCommerce penetration close to US levels; GDP per capita Consumption expendituresone must ask the question, “what makes the Japanese market Note: We ranked the top 50 countries by both GDP per capita and total consumption st nd expenditures. 1 ranked received 50 points, 2 ranked received 49 points, etc. The maxso conducive to eCommerce?” We highlight Japan’s large score is 100 pointsurban GDP, high GDP per capita and high population density Source: World Bank, Morgan Stanley Researchas some of the main factors driving eCommerce penetration. 89
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailBased on the preceding charts, we believe Japan is one of Exhibit 158the most attractive international markets for eCommerce. In Amazon Prime: Japan vs. US Japan USfact, Japan was one of the first international markets that Free on any item sold by Amazon Free for orders above $25 onAmazon expanded into, back in 2000. Japan is one of the Standard shipping (non-Prime) (First-party + Third-party fulfillment eligible items (Super Saver by Amazon). Shipping). Takes 3 - 5 businessthree largest international markets for Amazon (UK and Takes 1 - 3 business days daysGermany are the other two), representing about 11-15% of Annual Prime subscription cost 3,900 Yen (~$50) $79Amazon’s total revenue in 2011 ($6.3B at the mid-point of therange). Free same day expedited shipping Free two-day shipping on eligible for eligible items. If same day not items (upgrade to one day for $3.99 Benefits of Prime available, delivery will reach within per item), Amazon Instant Video,Japan’s high population density (>350 people per square 3 days. Free scheduled shipping. Kindle Lending Librarykilometer) fosters an attractive environment for eCommerce Cash on Delivery, Convenience Amazon Locker Deliveryas it lowers shipping costs and shortens delivery times. By Other shipping options Store Pickupestablishing fulfillment centers outside large population Source: Company websites, Morgan Stanley Researchcenters, eCommerce companies can ship to Japanesecustomers quickly and have a cost advantage over retailers. Standard shipping in Japan takes 1-3 business daysOperating a retail storefront in a major population center, such compared to 3-5 business days in the US. We believe this isas Tokyo, tends to be expensive, which often leads to a due to Japan’s smaller geographic area and high populationpricing premium over eCommerce providers. In fact, “It is density, which enables delivery route density. In ourcheaper to buy online” was cited as the most frequent reason AlphaWise Survey, 34% of Japanese respondents (theby Japanese customers in our AlphaWise survey on why they highest percentage of our eight surveyed countries) cited freechose to buy products online rather than in stores. shipping as one of the three most important reasons forExhibit 157 buying products online.Japan’s high population density allows for quickerand lower-cost shipping Prime customers in Japan receive free same-day expedited shipping for eligible items and free scheduled shipping. People per sq km Meanwhile Prime customers in the US receive free two-day 351 shipping on eligible items, access to Amazon Instant Video and Kindle Lending Library. Signing up for Prime in Japan 259 does not seem as compelling as in the US given the quicker 234 standard shipping times in Japan and lack of access to streaming video and Kindle Lending Library. 144 eCommerce landscape in Japan: Contrasting a hybrid market maker / marketplace model to a pure 34 marketplace business 23 9 3 The debate on whether a hybrid market maker / marketplace Japan UK Germany China US Brazil Russia Australia business model, such as Amazon, is superior to a pureSource: World Bank, Morgan Stanley Research marketplace model, such as eBay, is not simply a US discussion. In Japan, Rakuten and Yahoo! Japan employ theIn 2010, Amazon removed its minimum of 1,500 Yen ($15 marketplace model, empowering third-party merchants to sellUSD) to qualify for free standard shipping in Japan for non- directly to consumers. On the other hand, Amazon JapanPrime customers. Free shipping for any order size is a sells owned inventory alongside third-party sellers.common move by Amazon in densely populated regions(Amazon.co.uk also introduced free shipping with no minimumpurchase). In the US, Amazon offers free shipping for ordersabove $25 (Super Saver Shipping) for non-Prime members.Below is a table comparing the differences between US andJapan for shipping costs and times. 90
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 159 has been able to establish a virtuous cycle in which newTop 10 online B2C retailers in Japan sellers lead to expanded product offerings, which then boostsJapans Top 10 internet retailers customer traffic and thus total value of financial settlements. 1 Rakuten Virtual shopping mall (Over 80MM users and 40K merchants) 2 Amazon Japan Direct-sales model (1P + 3P), leader in online media Unlike eBay’s marketplaces business that struggled through a 3 Apple Japan Sells consumer electronics restructuring period, Rakuten has a laser focus on improving 4 Yahoo! Japan Online advertising portal. Offers auctions and virtual shopping mall sales for its 40K merchants by employing personal 5 Senshukai Catalog retailer eCommerce consultants and teaching selling seminars at 6 Nissen Catalog retailer “Rakuten University.” Rakuten takes an “Ometanishi” mindset 7 AEON Group General Merchandise and Supermarket Retailer to its business, empowering merchants to form sustainable 8 Japan Co-op Consumer Co-op customer relationships. Additionally, Rakuten only takes 3% 9 Seven & I Corp Convenience Stores of the total transaction value in its marketplace through fees 10 Dell Sells PCs for hosting vendor sites, settlement fees and other fees forSource: Euromonitor support services.The dearth of traditional retailers in the top 10 online retailers Rakuten is growing its eCommerce gross merchandise salesillustrates our perspective that Japanese retailers have been in the mid-to-high teens, faster than eCommerce marketrelatively slow to embrace online channels. Only AEON and growth in the low-double digits. Rakuten offers customers anSeven & I Corp can be classified as traditional retailers. In the unmatched selection and drives loyalty through its pointsUS, there are five offline retail companies among the top 10 program. Rakuten rewards customers for using theironline retailers – Staples, Walmart, Office Depot, Sears and marketplace with points that can be applied to futureBest Buy (Internet Retailer top 10 excluding Netflix). We purchases across any product line. The sheer quantity ofbelieve the lack of competition from offline retail has allowed sellers results in over 100MM products offered to consumers,pure eCommerce players, particularly Rakuten and Amazon, a larger selection than any offline retail or hybrid marketto grow their Japanese market share significantly over the maker / marketplace eCommerce player in Japan.past decade. Exhibit 161Exhibit 160 Rakuten LTM domestic eCommerce grossMarket share of top Internet retailers in Japan merchandise salesPercent retail value excluding sales tax JPY bn 1,600 19% 2008 2009 2010 2011 17% 17% 15%Rakuten 23.6% 25.5% 27.0% 29.2% 1,200Amazon.co.jp 11.0% 10.4% 11.6% 14.9%Apple 2.1% 2.2% 3.4% 4.5% 800Yahoo! Shopping 4.2% 4.0% 3.5% 3.2% 400Senshukai 2.5% 2.2% 2.1% 2.2%Note: Only Yahoo! Shopping market share shown. Yahoo! also runs the largest auctionbusiness in Japan that generates more than double Yahoo! Shopping’s transaction value. 0Source: Euromonitor Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12Rakuten: LTM Domestic eCommerce Gross Merchandise Sales Y/Y GrowthRakuten calls itself “The Empowerment Company” because it Source; Company filings, Morgan Stanley Researchaims to help merchants design their own sites in its virtualshopping mall (“Rakuten Ichiba”) to market their products to Amazon Japan:consumers. In this virtual shopping mall model, vendors are Japan is one of the three largest international markets forresponsible for procurement and delivery, while Rakuten Amazon, representing about 11-15% of Amazon’s totalprovides marketing systems, payment processing and fosters revenue in 2011 ($6.3B at the mid-point of the range). Whileloyalty among site visitors by offering shopping points. As a we think Amazon is smaller than Rakuten in terms of grossmarketplace provider, Rakuten can offer greater selection merchandise sales, we believe it does have a leading positionthan Amazon and it does not bear any inventory risk. Rakuten 91
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailin certain verticals such as packaged and digital media. Below Relative to Rakuten, Yahoo! Shopping generates about 25%is a timeline showing Amazon’s major initiatives in Japan. of the transaction value. Yahoo’s eCommerce business (Auction + Shopping) is growing in the low-to-mid single digits,Exhibit 162 slower than eCommerce market growth in the low doubleAmazon Japan milestones digits and Rakuten’s transaction value growth in the mid-to- 2000 Launches Amazon.co.jp; sells books high teens. Mobile transactions on Yahoo! Shopping and 2001 Opens customer service center in Sapporo, Japan Yahoo! Auctions represent close to 20% of total transaction value and grew 85% y/y in the most recent quarter. Excluding 2003 Launches Amazon Web Services mobile, Yahoo’s eCommerce transaction value would be 2005 Opens Fulfillment Center in Ichikawa, Japan declining. 2007 Launches Amazon Prime Exhibit 163 2008 Launches Fulfillment by Amazon (FBA) LTM transaction value for Yahoo! shopping and 2010 Launches free shipping Yahoo! auction JPY bn 2010 Launches scheduled delivery 1,000 5% 2012 Launches Japanese Kindle store 990Source; Company Website 980 3%While one could argue that selling owned inventory alongside 970 3%third-party sellers creates a conflict of interest, there are 960benefits to being a market maker. First, Amazon’s owned 2%inventory business helps it set market pricing for third-party 950sellers. While this could mean lower profits on a unit basis for 9403P sellers, it drives lower prices in the marketplace, which 930drives greater customer adoption, leading to increased third- 920party sell-through. Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12Additionally, Amazon offers fulfillment services to its third- LTM Transaction Value: Yahoo! Shopping and Yahoo! Auctions Y/Y Growthparty sellers, allowing for quicker delivery to customers. We Source: Company Filings, Morgan Stanley Researchbelieve Amazon has 10 fulfillment centers in Japan and candeliver most products to the large population centers in one or Yahoo! Auctions comprises the majority of Yahoo’stwo days. As mentioned previously, Amazon launched free eCommerce transaction value (around 65-70%) and isshipping for all domestic orders in 2010. Rakuten’s 3P growing slower than Yahoo! Shopping. It appears thatmerchants are primarily responsible for their own fulfillment. Yahoo’s auction business is facing similar issues to thoseThis inability to bundle orders (products are delivered from a once faced by eBay’s US auction business. As part of itsvariety of sellers) makes it tough to compete with Amazon on restructuring, eBay invested in a number of initiatives thatdelivery speed. However, Rakuten is aggressively building out transitioned its US marketplace to a fixed price format from anits logistics and fulfillment capabilities to better compete with auction business. It will be interesting to see if Yahoo!Amazon. Auctions similarly restructures its business. Overall, we expect both Rakuten and Amazon to continue taking share fromYahoo! Japan: Yahoo!’s eCommerce business.Yahoo! Japan is the number one portal in Japan and derivesmost of its revenue from advertising services. On the Other eCommerce players:eCommerce side, Yahoo! Japan runs a virtual shopping mall Kakaku.com: Operates an eCommerce price search websitesimilar to Rakuten, but the majority of its transaction value with two earnings pillars – affiliated sales and system usagecomes from its auction business. eBay attempted to enter the fees (“click” charges). Both Rakuten and Amazon Japan useJapanese market back in 2000 but ended up closing down its Kakaku.com as an affiliated site. Its strength has expandedauction operations due to strong competition from Yahoo! from PCs and home electronics to consumer products. As theAuctions. dominant leader among price comparison websites, growth in shopping sales (an indicator of gross merchandise value) in the last three years has been +20% y/y in 2010, +15% in 92
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail2011 and +13% thus far in 2012. We project a 10% CAGR In 2011, Rakuten opened its first fulfillment center in Chiba toover the next three years. improve inventory management and lower shipping costs for merchants. Consumers in the area benefitted from quickerStart today: A leading apparel eCommerce player running an delivery times and scheduled delivery. Over the next feweCommerce site from operations to distribution. Within the years, Rakuten has said that it will be investing heavily inapparel field, Start today is the second largest after Rakuten. expanding its fulfillment network from one, currently, to five orGross merchandise value has been expanding steadily from six distribution centers to cover most of the population centers+20% y/y in 2010 to +15% in 2011 and +15% so far in 2012.   in Japan.A race to improve logistics Additionally, Rakuten introduced an online supermarket with aWe believe the next evolution in Japanese eCommerce is the dedicated distribution center – Rakuten Mart – in July 2012.race to build a robust logistics and fulfillment network. While This structure will enable customers to order fresh produce,Amazon has an advantage on this front, Rakuten is investing daily essential items and gourmet foods of Rakuten Ichiba,heavily to close the gap. which can be shipped the next day. Similar to how Amazon acquired Kiva to improve automation in its fulfillment centers,In the US, a central focus for marketplace businesses, such Rakuten recently acquired Alpha Direct Services, a Frenchas eBay, is improving logistics and fulfillment capabilities for eCommerce logistics company and plans to introduce itsthird-party sellers. We believe eBay acquired GSI Commerce advanced fulfillment / automation technology to its distributionpartly for its fulfillment network, although it hasn’t rolled out centers in and outside Japan.extensive fulfillment capabilities for third-party sellers yet.Furthermore, eBay is testing same-day delivery in a few US Yahoo! Japan management has also said it realizes the needmarkets. to improve its logistics capabilities and invested in a partnership with ASKUL in April 2012 to improve the quality ofAmazon introduced free shipping in 2010 and invested heavily Yahoo! Shopping’s logistics services.in fulfillment assets (today Amazon has 10 in Japan). Theseinvestments have evolved Japanese consumer expectationsto expect fast, free delivery of all product orders.This is a threat to RakutenFor a pure marketplace business, delivery tends to bedependent on third-party sellers and the inability to bundleorders increases delivery time and cost. However, Rakutenfully understands this threat and management has said thatone of its main priorities is building out its logistics platform.Exhibit 164History of Rakuten logistics 2007 Set up Logistics Business Preparation Office to explore logistics business opportunity in supporting merchants operating on Rakuten Ichiba 2008 Started offering logistics outsourcing service to merchants on Rakuten Ichiba 2008 Monthly P/L turned profitable through offering logistics outsourcing service 2009 BOD approved to establish Rakuten Fulfillment Center 2010 Established Rakuten Logistics, Inc. 2011 Rakuten Fulfillment Center in Chiba started full-scale operation 2012 Launched Rakuten Super Logistics at RFC 2012 Launched Rakuten Mart 2012 Acquired Alpha Direct Services, a French eCommerce logistics companySource: Company Filings 93
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail 94
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMORGAN STANLEY BLUE PAPEReCommerce Disruption: A Global ThemeKey Stock Calls by Region 95
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailKey Stock Calls by RegionUnited States: Internet Amazon............................................................................................................................................................................ 97 Blue Nile........................................................................................................................................................................... 99 eBay................................................................................................................................................................................. 101United States: Retail Bed Bath & Beyond.......................................................................................................................................................... 103 Costco.............................................................................................................................................................................. 104 Macy’s.............................................................................................................................................................................. 107 Nordstrom ........................................................................................................................................................................ 110 RadioShack...................................................................................................................................................................... 113 Under Armour .................................................................................................................................................................. 114 Urban Outfitters................................................................................................................................................................ 115 Walmart............................................................................................................................................................................ 118 Williams Sonoma ............................................................................................................................................................. 120Western Europe: Retail ASOS ............................................................................................................................................................................... 121Latin America: Internet MercadoLibre*.................................................................................................................................................................. 124Japan: Internet Rakuten............................................................................................................................................................................ 126Australia: Retail David Jones ..................................................................................................................................................................... 128 JB Hi-Fi ............................................................................................................................................................................ 130 Harvey Norman ................................................................................................................................................................ 132China: Retail Belle International ............................................................................................................................................................ 134 Intime ............................................................................................................................................................................... 137 Li Ning.............................................................................................................................................................................. 139 Sun Art Retail ................................................................................................................................................................... 141*MercadoLibre is covered by Scott Devitt 96
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce: Key Stock Calls US InternetAmazon.com, Inc. (AMZN) North America(covered by Scott Devitt)Thesis: Amazon continues to be a disruptive force in global eCommerce. Over the long-term, we believe the company is well-positioned to not only take share from offline retailers but also to consolidate best-in-class eCommerce retailers as well.Exhibit 165Amazon’s success continues to be disruptive but Key Takeawaysstill represents less than 5% of global retail sales  Amazon is one of the best positioned, long-term Amazon TTM net sales (US$ bn) plays on global eCommerce growth $60  The company’s 3rd-Party marketplace will $50 continue to be a key contributor to Amazon’s $40 global success, especially in emerging markets  Amazon’s expertise in logistics and fulfillment has $30 allowed the company to manage its inventory $20 turnover to a 30-day buffer vs. its payables for over 16 years $10  The company continues to invest in many $-- different opportunities, some of which are also Dec-96 Sep-97 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11 Sep-12 being pursued by global companies with substantially greater financial resourcesSource: Company DataInvestment Highlights The US retail landscape remains very fragmented. The Middle-Class American is quite evenly distributedExhibit 166Despite Amazon’s historical success, the US still throughout the US, which means so are small-businesses.represents a meaningful market share opportunity These two dynamics continue to drive a lower population density with higher incomes throughout Middle America. (US$ bns) 2,000 eBay Exhibit 167 1,800 Amazon.com For 16 years, Amazon has maintained a cash Costco 1,600 Target conversion cycle that provides a 30-day buffer 1,400 Walmart Inventory vs. payable days (through Sep-12) 1,200 Aggregate 80 1,000 Adj. US Retail Sales 70 800 600 60 Payable 400 days 50 200 -- 40 Adj. US Aggregate Walmart Target Costco Amazon eBay Retail 30 Sales Inventory days 20Source: US Census Bureau, Company Data, Morgan Stanley Research 10 -- Dec-97 Jul-99 Feb-01 Sep-02 Apr-04 Nov-05 Jun-07 Jan-09 Aug-10 Mar-12 Source: Company Data, Morgan Stanley Research 97
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailDespite slowing inventory turnover, Amazon has Amazon takes a long-term view to its capitalnegotiated favorable vendor terms. allocation decisions; execution risk is a reality.Amazon’s unique ability in logistics and fulfillment continue to Currently, Amazon is investing in three key consumer marketsdrive negative cash conversion cycles, which have helped to that we believe are highly competitive. 1) Streaming video:fund the company’s growth initiatives. Despite the company’s Through Prime Instant Video and LOVEFiLM, Amazon’s UK-growth into new product categories, Amazon has maintained based wholly-owned subsidiary, the company competes withits 30-day payable buffer with vendors. Netflix (NFLX, covered by Scott Devitt) for both subscribers and content. 2) China: Amazon China is the #4 eCommerceExhibit 168 platform in China, a rare position for Amazon. In order toAmazon is transitioning into a consumer- maintain market share, Amazon has had to invest largedestination search vertical for merchandise amounts of capital, both into its local fulfillment network as Domestic TTM average unique visitors (mn) well as into low prices to drive sales. 3) Kindle Fire: Because 100 the Android is an open-source mobile operating system, OEMs continue to struggle with OS version inconsistencies as 80 well as a content ecosystem that is highly fragmented. In an effort to control its own destiny as physical media transitions 60 to digital media, Amazon has invested heavily in 40 manufacturing its own tablet and developing a complementary Android-based OS and digital content offering. This seemingly 20 puts Amazon directly into competition with Apple, albeit each company has different goals for monetizing its customers. -- Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Exhibit 170 Despite Amazon’s historical success, the US still Amazon.com eBay represents a meaningful market share opportunitySource: comScore CQ3:12 GMV-based market shareAmazon’s marketplace has symbiotic benefits. 60%Amazon’s ability to set pricing with its 1P business enforces 50%pricing discipline among its 3rd-Party merchants. This dynamicensures that consumers shop and return. As traffic increases, 40%so does the value proposition for 3rd-Party merchants. 30%Investment RisksExhibit 169 20%Amazon’s TTM ROIC has declined from its high in2009 to a level not previously since September 2002 10% ROIC --%80% Tmall 360buy Tencent Suning Amazon Dangdang Others Source: iResearch, Morgan Stanley Research (China Internet)60%40% 3rd-Party marketplaces dominate China eCommerce. Both Tmall and 360buy operate much larger 3rd-Party20% marketplaces, relative to Amazon. Of Suning’s eCommerce 0% business, about 95% of its sales are from owned-inventory, so-20% Amazon China is at best, the #2 competitor with its amazon.cn, 1P business. Tencent derives almost all of its-40% GMV from virtual goods and gaming, so we exclude that from-60% traditional eCommerce merchandise marketplaces for Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11 Sep-12 comparative purpose.Source: Company Data, Morgan Stanley Research 98
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailBlue Nile, Inc. (NILE) North America(covered by Andrew Ruud)Thesis: We believe Blue Nile’s valuation multiple is not reflecting the future growth potential and margin benefits associated withits entry into non-engagement jewelry. Although non-engagement jewelry is a currently a much smaller percentage of its salesmix, the non-engagement opportunity is several multiples larger than engagement. We believe Blue Nile has significant costadvantages versus its offline competitors, which it will use to invest in lower prices and a ramp in marketing expense.Exhibit 171Multi-channel pricing parity limits competition from Key Takeawaysoffline retailers  Blue Nile is a multi-year investment opportunity that Blue Niles domestic offline opportunity (US$ bn) benefits from both a large addressable market and 16 secular tailwind of retail sales moving online. 14  The company enjoys a centralized, inventory-light 12 business model that operates much more efficiently than offline competitors; Blue Nile passes those 10 benefits onto the customer in the form of lower prices. 8 $14+ billion opportunity  Low probability of competition from offline retailers 6 establishing an online presence because of purchase 4 price parity that must be maintained across sales 2 channels. 0 Top 11 Blue NileSource: Company Data, Morgan Stanley ResearchInvestment Highlights eCommerce retailers continue to deliver a great value proposition.Blue Nile has the opportunity to capitalize on a largemarket with a long runway for revenue growth. While the Blue Nile’s cost efficiencies and working capital modelcompany estimates the offline non-engagement jewelry will continue to keep the company well-positioned toopportunity is about $56B, we are basing our financial model capitalize on the market opportunity and start leveragingoff the company’s opportunity to gain market share against the secular transition. Blue Nile’s business model is setupthe top 11 offline retailers, which constitute about $14B. Our very well to address the non-engagement opportunity. Weassumption for 2013 is that Blue Nile will gain about 20 bps suspect that in the near-term, Blue Nile will have to run trial-of domestic market share against this $14B opportunity. and-error merchandising tests in order for their buyers to increase efficiency. By not having to commit to buying for aneCommerce penetration continues to shift from offline to entire store portfolio, the company has the advantage ofonline; we expect this secular tailwind to continue. being able to adjust their merchandise mix more quicklyJewelry retail sales have growth at a 1.7% CAGR from without the risk of inventory obsolescence.December 2003 through September 2012. eCommercejewelry and watch sales have grown at a 16.6% CAGR Blue Nile’s sourcing relationships serve as a formidableduring that same time period, about 10x faster than offline barrier to competition in engagement; Blue Nile’s non-retail. To put this into context, our eCommerce adjusted retail engagement business is less insulated from directsales have grown at about 4% CAGR vs. non-travel competition. Blue Nile offers close to 125K diamonds on aneCommerce at 15% of the same time period. We expect this exclusive basis from various merchants around the world.eCommerce outperformance to continue as long as Any direct competitor would have to start by curating a better selection at lower prices. Blue Nile’s push into non- 99
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailengagement does not benefit from the same barriers to branded jewelry may result in lower gross margins, but thedirect competition. The company will have to constantly long-term benefits will greatly outweigh the near-terminnovate by offering fresh, relevant merchandise at a wide expense.range of price points. Exhibit 172Blue Nile’s centralized fulfillment model is likely to Blue Nile’s cost advantage is reinvested into lowerprovide an efficient platform to disrupt offline pricing or marketingcompetitors. Blue Nile, essentially has one store to buy for, SG&A (ex-advertising & marketing) as % of salesit’s Seattle-based fulfillment center. Offline competitors must 33%carry stock in each retail store or else risk losing the sale.The largest hurdle Blue Nile has is providing astraightforward value proposition for brands to distribute their 23%jewelry through Blue Nile’s platform.Investment Risks 11%Blue Nile’s CEO has joined in March 2012 and has nodirect experience in jewelry. He is undertaking a verysubstantial transition from Blue Nile’s engagementjewelry roots to non-engagement jewelry. Execution risk Tiffany Signet Blue Nileis high, but Harvey Kanter is not trying to single-handedly Source: Company Data, Morgan Stanley Researchalter the company’s focus. He has made key hires in buying,merchandising and marketing. His background in both offline Exhibit 173retail and online eCommerce give us confidence that he has Blue Nile may begin to close the gap betweenthe requisite experience to succeed in his new role. jewelry eCommerce growth with non-engagement Indexed jewelry sales growthBlue Nile’s marketing strategy toward non-engagement 400% US Retail Salesconsumers will be very different from its historical TTM eCommercedemographic. Historically, Blue Nile’s customers were TTM Blue Nile US Sales 300%predominantly men, because historically, engagementjewelry has been the largest mix of the company’s sales.With Blue Nile’s focus now on building its non-engagement 200%business, the company will now direct its larger marketingbudget toward the female consumer demographic. 100%Blue Nile does not have broad brand recognition amongits targeted demographic. We believe Blue Nile will need to 0%leverage other jewelry designers’ brands in order to gain Dec-03 Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11 Sep-12traction with its targeted demographic. Sell-through of Source: US Census Bureau, comScore, Morgan Stanley Research 100
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetaileBay Inc. (EBAY) North America(covered by Scott Devitt)Thesis: We are long-term buyers of eBay because we believe in the future prospects for both of the company’s main segments:Marketplaces and Payments. Marketplaces’ (ebay.com) growth is accelerating out of a several year turnaround, and Payments(paypal.com) continues to gain share within the stores where it is offered, and increase penetration of top online retailers.Exhibit 174eBay accelerated fixed price growth to 20% in 3Q12 Key Takeaways $18B 100%  Marketplaces: For the past two quarters, eBay $16B 90% grew Gross Merchandise Value (GMV) about $14B 80% 15%, as compared to the prior year. During the $12B 70% same period, the company grew active users 60% $10B about 10% and items sold about 20%, both 5-year 50% $8B highs. 40% $6B 30% $4B  Although the stock has recently re-rated, we see 20% $2B 10% another potential re-rating if GMV growth can $0B 0% accelerate from current levels (about 15%) to about 20%, which we see as plausible given 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 recent active user growth. Fixed Price GMV Auction GMV FP as % of GMV FP Y/Y Growth  Payments: PayPal operates a leading online /Source: Company data, Morgan Stanley Research alternative payments platform, and is well positioned to leverage its experience to offline point-of-sale / mobile initiatives.Investment Highlights that now show more accurate results to the customer. Because of these initiatives, eBay has experiencedMarketplaces – ebay.com accelerating active user and items sold growth over the pastTransitioning to fixed price GMV is driving overall growth. several quarters.Taking a cue from other successful eCommerce sites (such Exhibit 175as Amazon and MercadoLibre), eBay management has Top 3 GMV growth categories drove 60% of YTDtransitioned the marketplace to focus on offering more fixed GMV growthprice items. Therefore, as shown in Exhibit 174, fixed price 2010 2011 YTD 9/30/12GMV growth has been accelerating on a relatively consistent Top 3 GMV growth $18,556 $21,595 $18,442basis, from 13% in 3Q08 to 20% in 3Q12. This is due to a Y/Y growth 16% 18%shift in incentives for merchants (i.e. slightly lower fixed pricefees), as well as changing consumer behavior. It is also due % of total GMV growth 45% 58%to growth in new items sold from large offline retailers, such Other growth GMV $22,592 $25,372 $20,687as Coach. Y/Y growth 12% 13% % of total GMV growth 41% 48%Three key categories are driving 60% of GMV growth, and Other GMV $12,384 $13,365 $9,528accelerating active user and items sold growth. Y/Y growth 8% -3%Marketplaces growth has primarily been driven by three main % of total GMV growth 14% -6%categories: Parts & Accessories, Clothing & Accessories, and Total GMV $53,532 $60,332 $48,657Home & Garden. As shown in Exhibit 175, these categories % Y/Y growth 13% 11%represented 58% of the YTD GMV ex-auto growth. We Source: Company data, Morgan Stanley Researchbelieve some of the fundamental drivers of these categories’growth is due to eBay improving its search/best fit algorithms 101
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailPayments – paypal.com Exhibit 176 eBay acquired 15 companies in the last two yearsPayPal, acquired in 2002 for $1.5B, is now worth more Recent transactionsthan 20x that, based on our sum-of-the-parts analysis. Date Target Date TargetPayPal has grown from a facilitator of online auction Sep-12 Svpply Jun-11 alaMualapayments to a global payment platform. The majority of this Jul-12 card.io Jun-11 Magentogrowth is due to its Merchant Services business, which offers Feb-12 WHI Solutions Apr-11 FigCardthe ability for customers to use PayPal to complete purchases Dec-11 BILLSAFE Apr-11 Whereon 3rd party sites. In the US, PayPal’s penetration of the top Dec-11 Zvents Apr-11 Gitti Gidiyor100 eCommerce sites has grown from 30 in 3Q08 to 63 in Nov-11 Hunch Mar-11 GSI Commerce Sep-11 Appchee Mar-11 PeaceSoft1Q12. During this time period, PayPal’s Merchant Services Jul-11 ZongTPV has grown 37% Y/Y, on average. While we expect this Other noteable transactionsgrowth to slow in the next several years as penetration of Date Target Date Targetthese top merchants reaches a plateau, we note the Dec-10 Milo Sep-05 Skypepenetration of top 100 sites in Europe and Asia were 35 and Apr-09 Gmarket Jun-05 Shopping.com17, respectively, as of 1Q12. This would imply there is still Oct-08 Bill Me Later Aug-04 Craigslistplenty of room for international growth. Jan-07 StubHub Jul-02 Paypal Source: Company dataShifting TPV mix to Bill Me Later (BML) is one clear wayPayPal can improve transaction margins and overall eBay’s ROIC is at a decade-low. As a result of theseprofitability. BML was acquired by PayPal in 2008. It offers a acquisitions, and internally-focused investments in itsservice that extends credit to a consumer for a specific business, eBay’s FCF has not grown at the same rate as itstransaction, (unlike a typical credit card that provides credit assets. eBay’s 2Q12 ROIC declined to an all time low. Inthat can be used for any purchase). BML entices customer 3Q12, eBay achieved the highest LTM FCF in two years,adoption in three distinct ways. 1) It offers delayed interest primarily due to improvements in PayPal margins.payments (i.e., no interest payments for 6 months on Exhibit 177transactions over $150). 2) It can also gain adoption by eBay’s ROIC has been on a consistent decline sinceoffering credit to customers early in the purchase funnel, on 2008the product description page. 3) Finally, it can offer LTM FCF ($bn) ROICtransaction-based awards, such as 2x rewards, free shipping $3.0 25%etc. BML improves transaction margin by shifting paymentprocessing from high cost credit cards to low cost bank $2.5 20%transfers. $2.0 15%Investment Risks $1.5 10%eBay may face integration risk after the 15 acquisitions $1.0since the beginning of 2011. While obtaining talent was the $0.5 5%purpose of several of these acquisitions (all but one do not $0.0 0%generate significant revenue – GSI being the exception), Mar-02 Sep-03 Mar-05 Sep-06 Mar-08 Sep-09 Mar-11 Sep-12effectively integrating these new companies both financially,and culturally, could take significant time and resources from Source: Company data, Morgan Stanley Researchmanagement. Several of these acquisitions have beenfocused on hyperlocal eCommerce, which may turn out to not There are several other long-term business risks. Forbe a prudent business strategy. We note, however, eBay has Marketplaces, slowing GMV growth due to comping fastera relatively successful history of integrating its major growing years is the most prevalent. PayPal also faces manyacquisitions (PayPal, Bill Me Later, Gmarket), which is slightly risks, including, competition from emerging payment startups,offset by eBay’s inability to integrate Skype. banks increasing ACH fees, and networks. 102
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce: Key Stock Calls: US RetailBed Bath & Beyond (BBBY) North America(covered by David Gober)Thesis: We see increasing industry competition pressuring both comps and margins at core Bed Bath stores. Near-term we seecontinued pressure from increased couponing, as well as negative product and concept mix shift pressures. Longer-term webelieve BBBY is exposed to greater pressure from online competition given its decentralized distribution structure andunderdevelopment of online models to date. At about 12.5x ‘13E EPS, BBBY trades at a slight discount to the hardlines sectoraverage, but well above other players facing competitive threats.Exhibit 178MS Pillow Talk survey point to Amazon gaining Key Takeawaysshare in BBBY’s key home furnishings demo of 35+  Categories like Consumer Electronics and Books AMZN share of HF age group started to meaningfully decline once Amazon reached 10% 5% share. While there are clear differences between Housewares and CE, we believe growth deteriorates 8% as Amazon grows. 6%  AMZN has broadly missed the BBBY demo so far, but beginning to make strides amongst older shoppers 4% (See Exhibit 78). 2%  BBBY currently generates less than a few percent of its revenues online. 0%  BBBY’s decentralized distribution network for its 18-34 35-54 55+ namesake Bed Bath Beyond concept could put the May 12 Aug 12 retailer at a disadvantage in efficiently scaling itsSource: AlphaWise, Morgan Stanley Research online business.Investment Highlights Investment RisksBBBY at greatest risk from AMZN. Based on our AlphaWise Home furnishings is a fragmented industry andPillow Talk Tracker, and our home furnishings model, we consolidation could spare BBBY. BBBY has gainedbelieve Amazon has about 5% share in Housewares. As it significant share from smaller players, many of which nogrows, an already promotional sub-industry would go into longer exist, as well as department stores. We believe thatoverdrive. share within its product set has consolidated significantly, but further share gains from department stores or massAMZN making progress in BBBY demos. BBBY over merchants could cause performance to be better than weindexes with 35+ women while online skews younger. Our currently expect. While we believe the store opportunity forsurvey suggests a willingness for older demos to migrate core Bed Bath stores may be lower than traditionallyonline and based on our AlphaWise Pillow Talk Tracker, expected, we could see accelerated growth from BBBY’sAMZN does seem to be gaining traction with 35+ consumers. buybuy Baby concept.BBBY’s decentralized distribution and underpenetration Capital structure changes could provide liquidity upside.online puts revenue at risk. Only 9% of BBBY purchasers Currently BBBY has no debt and $900MM in cash / short termcited “good website” as a consideration in choosing BBBY. securities. While we believe mgmt will remain conservative inFurther, BBBY’s decentralized distribution structure makes its its use of leverage and will likely use excess firepower fordelivery capabilities particularly challenging to scale should tuck-in acquisitions, BBBY has more leeway to become moreBBBY want to rapidly grow its online channel. aggressive on its leverage and repurchase pace. 103
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailCostco (COST) North America(covered by Mark Wiltamuth)Thesis: Though Costco is arguably behind in eCommerce, we believe the company’s low prices and loyal membership base willenable it to thrive, even in an Internet enabled world. In our view, low prices always win. Costco’s narrow SKU base enables it tosource in bulk and pass savings on to its members. We believe the company enjoys some buffer against online attacks as manyof its core products (large volume packages, low value products, fresh food) face shipping challenges in the online channel. Soempty out the back of your SUV; we’ll see you at Costco this weekend, and for many years to come.Exhibit 179Stable membership income and customer loyalty Key Takeaways 3,000 100%  Rather than needing to transform itself to fit a digital world, Costco’s membership warehouse 2,500 90% model can continue to thrive in an eCommerce 2,000 world. 80%  Low prices always win; our price surveys show 1,500 Costco 30% below grocery prices, 10% below 70% 1,000 Walmart, and comparable to Amazon and other 60% online competitors. 500  Low value, bulky and perishable items are the 0 50% sweet spot for warehouse clubs, but these 2005 2006 2007 2008 2009 2010 2011 2012 products face shipping challenges in the online Membership Income Total Income Renewal Rates channel.Source: Company Data, Morgan Stanley Research  Membership fees are 80% of earnings and renew at 90%. This growth annuity is a key investment attribute for COST.  Costco has a long runway of unit growth ahead of it, particularly in international markets, which are slated to be 2/3 of store growth in the next 5 years.Investment Highlights affords it some protection from online competitors. With 55% of its sales in consumables, including fresh food and manyLow prices always win – Costco will thrive even in an bulky and low value items (paper towels, toilet paper, bottledeCommerce economy: Our price surveys show Costco 30% water,) that are difficult to mail/ship to a consumer, thebelow grocery pricing and 10% below Walmart. Looking warehouse club arguably is a more efficient channel to deliveracross at Amazon, we find pricing similar on like items, but many of these items.some large volume packages and bulky items carried inCostco are not available at Amazon. High turns + low margins = industry leading ROIC: While Costco’s low prices also translate to low margins, theWhile many in the online world offer a plethora of products, company’s low margin, high asset turn business model hasCostco keeps its focus narrow (SKU count of about 4,000 vs. consistently translated into one of the stronger ROIC businessabout 5,000 at Sam’s and about 7,000 at BJ’s Wholesale models in retail. We calculate a 16% ROIC based on aClub). This focus enables the company to concentrate its NOPAT margin of only 1.8% and asset turns of 9x. To put thisbuying power and pass on the savings to its members. in perspective, this is a Kroger-level margin and an asset turn that is 3-5x higher than other retailers in our coverageTraditional retailer’s delight: Low value, bulky and universe.perishable items: We believe Costco’s product focus also 104
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMembership fees – Costco’s key investment attribute: We believe that Costco should be able to generate a flat toCostco derives about 80% of earnings from membership fees. rising operating margin progression over time as theMember fees range from $55 for a basic membership (Gold company’s same store sales growth in the 5% range drivesStar or Business) to $110 for a premium Executive leverage on occupancy and SG&A. The company has amembership (which provides 2% cash back for customers). stated policy of not posting gross margins higher than 15% onAs the membership fee tends to be raised every 5 years, and private label and 14% on branded products (so company-widethe company enjoys new member sign-ups each time it opens gross margins are only in the 10% range). As managementa new store, Costco has built a growth annuity that investors shows no signs of deviating from this gross margin policy, thehave saluted with a premium stock valuation. We believe the drivers for margins are largely limited to operating leverage,predictability of this incoming cash flow (memberships have a cost control, and private label mix gains.90% renewal rate) is one of the key attributes to the Costcoinvestment case. At our November Global Consumer Conference, CFO Richard Galanti indicated that Costco should be able to deliver 50-Costco still has significant expansion ahead, particularly 100bps of retail margin expansion over 10 years, with thein international markets: We see many years of store hope that this could be achieved over a 5 year period. Fromgrowth ahead for Costco. The company has been growing our analysis, if Costco can keep up its 5% core US comps itsquare footage 3-4% and recently laid out targets for 5% should deliver operating leverage sufficient to drive retailgrowth for F14. We estimate that the US club store market margin expansion.has at least seven more years of growth before it approachessaturation, and international market opportunities are just Exhibit 181starting to blossom. At the 2012 Morgan Stanley Global Costco retail operating margin vs. P/E P/E Retail operating marginConsumer conference, CFO Richard Galanti outlined a 5 yeargrowth story that featured 2/3 of expansions coming from 35x 1.8% 1.6%international markets. Of note, Asian markets (which average 30x 1.4%double the memberships per store vs. the US) are expected 1.2%to double over the next 5 years. 25x 1.0% 0.8%Exhibit 180 20x 0.6%Costco stores 15x 0.4% 2012 New Total 0.2%US 431 55 486 10x 0.0% 1998 2000 2002 2004 2006 2008 2010 2012Canada 82 18 100 COST Retail Op Margin COST PEUK 22 7 29 Source: Morgan Stanley ResearchAsia 30 32 62Australia 3 9 12 Investment RisksEurope 0 8 8 Premium valuation: Costco shares trade at a premiumMexico 32 10 42 valuation of 20x 2013 P/E. While we believe Costco’s doubleBusiness centers 8 10 18 digit EPS growth story should keep COST shares moving, ifTotal 608 149 757 high valuation stocks should suffer a market correction or ifSource: Morgan Stanley Research any of Costco’s key growth attributes should slow (same store sales, rate of store expansion, membership renewal rates),Retail margin gains correlate with Costco valuation: While Costco’s valuation could decline and COST shares could failmembership fees provide 80% of Costco earnings, we believe to reach our price target.it is the swing in retail operating margins that tends to drivethe stock. We found a 0.86 correlation between Costco’s retail Costco is far behind offline retailers and even furthermargins (ex membership fees) and Costco’s P/E. With retail behind online retailers when it comes to eCommerce:margins of under 1%, the market believes Costco has the Costco has recently put some focus on eCommerce; it ispotential to earn far more – if it could just put more margin currently retooling its website to allow external searches, andthrough. it just launched its first apps for mobile devices. Previously, if consumers searched for a 50” flat screen TV, Costco would 105
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailnot even show up as a retailer of these products. But while barriers, inventory shrink challenges and other factors, ifthis is a step in the right direction, it is only a small step. discretionary sales (TVs, electronics, home categories, etc)eCommerce is not the focus at Costco, and we do not see erode significantly due to Internet competition, overall samethat changing any time soon. store sales for Costco could fade, and our thesis of Costco winning in an Internet economy could prove incorrect.Discretionary sales still vulnerable: While consumablessales are protected from eCommerce incursions by shipping 106
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMacy’s Inc. (M) North America(covered by Kimberly Greenberger)Thesis: We have conviction M’s sales momentum and margin improvement are sustainable. Key initiatives still have significantrunway and newer strategies are in nascent stages. Also, recent organizational changes enable faster decision-making,increased collaboration, and better execution, positioning M for future growth. With Macy’s trading at 9.6x P/E (2013 MSe), abouta 15% discount to its 5-year average 11.5x multiple, we believe the market is underappreciating Macy’s continued market sharegain potential, as well as the retailer’s best-in-class free cash flow yield and share buyback capacity.Exhibit 182M eCommerce sales will grow rapidly Key Takeaways $3,500 14%  We forecast eCommerce sales will grow at a 19% $3,000 12% CAGR over the next 4 years, reaching $3.6Bn or $2,500 10% about 12% of total sales. $2,000 8%  Management continues to reaffirm its view that its omni-channel strategy is still in early innings of $1,500 6% driving sales and margins. $1,000 4%  M believes it can grow omni-channel and increase $500 2% overall company profitability. $0 0% 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e M eComm sales (Left) eComm sales as % of total retail sales (Right)Source: Company Data, Morgan Stanley Research estimatesInvestment Highlights M’s eCommerce business began with gift and bridal registries, resulting in a significant skew towards homeWe view M as a softlines eCommerce leader given its assortment. Over time, the business shifted towardscomprehensive and innovative multi-channel strategies. centercore categories, which compliments online selling as fitM’s eCommerce sales grew at about 34% 2006 to 2011 is far less relevant in handbags, cosmetics and jewelry thanCAGR to $1.8Bn+, or about 7% of total sales. We forecast apparel. Since 2008/2009, apparel online selling haseCommerce sales will grow at a 19% CAGR over the next accelerated and become a significant total online salesfour years, reaching $3.6Bn or about 12% of total sales. M contributor. Today, M’s website offers a broad assortment,believes it can grow omni-channel and also increase overall however online SKUs do not overlap 100% with stores. Still,company profitability. M offers free shipping on orders $99+, key omni-channel initiatives enable greater inventory sharinga gross margin headwind as sales growth continues. across channels.However, higher online merchandise margin help offset they/y delivery cost increases. 107
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 183Macy’s fulfillment initiatives: Evolution of Search & Send 2Q10 3Q10 4Q10 4Q11 1Q12 CurrentCustomer shopping stores…Inventory from stores     4-store test 23 stores 80 stores 292 storesInventory from online DCs ─  Search & Send     Began rolling out rolled out Search & Send nationallyCustomer shopping online…Inventory from stores     4-store test 23 stores 80 stores 292 storesInventory from online DCs      Source: Company Data, Morgan Stanley ResearchOmni-channel – a key Macy’s initiative: As the store and M’s fleet and, when also including online, represent aboutonline channels blend more and more (e.g. customers 70% of the company’s sales. Store-to-door is significantlyresearch products online and purchase at stores, customers helping to increase several categories’ fulfillment rates,buy online and return to stores, etc.), M’s is especially including women’s fashion.focused on its omni-channel (store and online combined)strategy. In connection with the store-to-door fulfillment strategy, M is adopting technology, which helps stores optimize how ordersManagement continues to reaffirm its omni-channel are fulfilled by identifying where an item’s sell-through is low,strategy is still in early innings of driving performance. M while also considering shipping costs and split shipments (anis leveraging omni-channel to capture sales today that it order with multiple items coming from different stores). Thiswould have missed historically. Going forward, management should help increase full price selling and raise gross margin,also sees significant opportunity in maximizing inventory in our view.efficiency, which should reduce markdowns, thereby boostingcompany gross margin. Enhancing online fulfillment: Until very recently, if an item offered online sold out, M could not meet additional onlineSearch and Send - phase 1: Rolled out Holiday 2010, demand. In 3Q11, the company started testing site-to-store-Search and Send order fulfillment helps M satisfy store to-door fulfillment and began rolling out the initiative acrossdemand with eCommerce inventory when an item is out of merchandise categories in 1Q12. This initiative satisfiesstock. Categories where store-assortments overlap online demand with store inventories (specifically the 292considerably with online merchandise are seeing the greatest stores currently providing store-to-door fulfillment).benefit (e.g. home has about 100% in-store and onlineoverlap). Categories where overlap is lower are experiencing Digitizing store inventory: Online fulfillment’s seconda smaller fulfillment benefit (e.g. women’s apparel has about component will enable M to offer merchandise online20% in-store and online overlap). Store fulfillment is narrowing traditionally sold only at stores, including fashion apparel.this gap (see more below). Customer can browse and purchase these items online, but stores rather than distribution centers will pick, pack and shipStore fulfillment (or Search and Send - phase 2): With the merchandise.store-to-door fulfillment, M satisfies store demand with storeinventory when an item sells out at another store. Testing Omni-channel facilitates enhanced square footagebegan Holiday 2010 with a few stores, and now 292 stores efficiency. In 2013, management plans to start rolling-out aare fulfilling orders. These 292 stores are the largest stores in “show-rooming” strategy. M will display merchandise in store, 108
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailwhich typically sells well online, but only carry the inventory at year. Currently, the associates take physical inventory once aits distribution centers. The company is already featuring year. On average, testing indicates inventory accuracy canlamps and window treatment displays in stores. In addition, reach a steady 97% or better with RFID. In addition, RFIDthe company will also roll-out in-store pick-up in 2013. compliments M’s omni-channel strategy, enabling M to get theThrough strategies like “show-rooming” and in-store pick-up, right inventory to the right place and find inventory quicklyM’s store base becomes a competitive advantage vs. online within its channels to satisfy demand.only retailers. Using eCommerce to expand internationally: ManagementMacy’s is making significant investments in expanding stresses that any potential international Macy’s strategy mustonline distribution, including building a $150MM, 1.3MM be in a region where the retailer could have a headquarterssquare foot distribution center in Martinsburg, West Virginia, presence and scale, making China a logical market. Inwhich opened June 2012 to fulfill Eastern US orders. In addition, international tourism and Thanksgiving Day paradeaddition, M announced plans in January 2011 to add 725 new broadcasts have familiarized many Chinese customers witheCommerce positions over two years, expanding its the Macy’s brand. However, management believes there isMacys.com and Bloomingdales.com marketing, still a “great deal” to learn about Chinese shopping patternsmerchandising and operations organizations as well as and merchandise preferences.Macy’s Systems & Technology organization. Further, thecompany indicated it would add nearly 3,500 full-time, part- In May 2012, M announced plans to sell private brandedtime and seasonal holiday associates to bolster online goods (e.g. M’s I.N.C. brand) on Chinese eCommerce siteexpansion. omei.com beginning Spring 2013 and invest $15M in its parent company, VIPStore Co. This agreement provides M anOnline selling insights are supporting the My Macy’s opportunity to “test the waters” in China without puttingstrategy: My Macy’s helps the department store grow sales significant capital at risk. In addition, management indicatedby tailoring in-store merchandise assortments and sizes, eCommerce would likely play key a role in its China strategymarketing, and overall shopping experience to local longer-term given how quickly the business is growing.preferences. Online selling is particularly useful in providinginsights to help M re-assort each store’s inventory. For Investment Risksinstance, management found that wide-calf, tall boots soldexceptionally well online (representing about 20% of online As a softlines retail eCommerce trailblazer, M faces futuretall boot sales vs. 3% of stores’ tall boot sales). The company ROIC uncertainty. Ongoing technology advancements andwas able to use shipping data to determine where the boots quickly changing customer preferences produce a shiftingsold best, and added more inventory to stores in those eCommerce competitive landscape. To remain ahead of theparticular markets. curve, M needs to make significant annual eCommerce and IT investments, in our view. However, the eCommerce sellingMargin opportunities are ongoing -- RFID could be the channel is new and recent innovations’ potential returns arenext leg: M is currently testing radio-frequency identification relatively unknown (e.g. cross channel fulfillment, RFID(RFID) technology, anticipating a Spring 2013 storewide roll- implementation, etc.). In addition, we think relative to specialtyout. With RFID, Macy’s store associates can count inventory retailers M’s business complexity and high SKU count makesignificantly faster, enabling multiple counts throughout the each initiative harder to implement. 109
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailNordstrom Inc. (JWN) North America(covered by Kimberly Greenberger)Thesis: We think JWN’s ongoing eCommerce spend helps ensure future cash flow visibility. We believe investors are too focusedon the near-term impact and are overlooking the long-term benefits. We view JWN as a best-in-class operator and its growthinitiatives as longer-term advantages. Still, shares look fairly valued at 14.1x P/E (2013 Mse) vs. its 14x 5-year average.Exhibit 184We forecast JWN eCommerce sales will grow at a Key Takeaways25% 2011-2015e CAGR  JWN’s ability to keep pace with changing $2,500 15% technology establishes the company as an online retail leader, and has driven eCommerce $2,000 12% penetration to about 11% of 2012E sales (MSe). $1,500  30% of the JWN’s current $3.3B 5-year capital 9% plan will go toward eCommerce Investments. $1,000 6%  We think investors misunderstand ongoing $500 eCommerce investments’ importance and value. As technology and customer online/mobile $0 3% expectations evolve, JWN must evolve its direct 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e business to keep pace with online competitors JWN eComm sales (Left) eComm sales as % of total retail sales (Right) and retain its leadership position.Source: Company Data, Morgan Stanley Research estimatesExhibit 185eCommerce: JWN aggressively investing to improve speed, convenience and experience 2003 2005 2008 2009 2010 2011 Today & Beyond Website Access at POS Enhanced Mobile Website Direct to Customer Free Shipping & Returns Buy Online, Pickup In Store Private Sales Improved Fulfillment One Inventory Platform Process Social Community Mobile POS Devices International Shipping iPhone & iPad Apps Continual Website Website Revamp EnhancementsMulti-Channel Foundation WiFi In All Stores Personalization 40%+ Growth YTDSource: Nordstrom Data, Morgan Stanley ResearchInvestment Highlights adopter of multi-channel fulfillment, pooling inventory systems beginning in 2005 and implementing cross channel fulfillmentOngoing eCommerce investment presents significant in 2009 (See Exhibit 185). JWN’s ability to keep pace withROIC and shareholder return opportunities, despite near changing technology establishes the company as an onlineto mid-term margin uncertainty. JWN has been building itseCommerce business since 2003. The company was an early 110
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailretail leader, and has driven eCommerce penetration to about slowly. This helps drive inventory turns, thereby allowing JWN11% of 2012E sales (MS estimate). to increase merchandise freshness and lift full price selling.Online penetration increasing annually: We forecast JWN’s eCommerce represents 30% of JWN’s current $3.3Bn 5-2012 online sales will reach $1.25B, or about 11% of total year capital plan. Thirty percent of the JWN’s current $3.3Bnretail sales – 2x+ 2007’s 5.2% sales penetration. Longer-term, 5-year capital plan will go toward eCommerce Investmentswe also are model a +25% 2011-2015 direct sales growth over the next few years include: i) website updates; ii) privacyCAGR, with sales penetration reaching 14% in 2015. and security upgrades; iii) personalization – providing systemseCommerce’s outsized sales growth and high merchandise with greater flexibility to customize each shopper’s onlinemargins help generate high value creation and high EBIT experience (e.g. some customers like a brand and want todollar growth. From a balance sheet perspective, fast capital see the entire offering, while others like a brand but want theturns, short asset lives and low, although recurring, capital assortment edited down to looks they might actuallyrequirements help propel ROIC (see Exhibit 186). purchase); iv) enhanced website navigation and graphics; v) expanded online assortment; vi) faster checkout; vii) reducedExhibit 186 fulfillment and delivery times; viii) improved quality of delivery;We forecast JWN eCommerce sales will grow at a and ix) easier return processes.25% 2011-2015e CAGR $2,500 15% Exhibit 187 JWN plans to spend about $990M on eCommerce $2,000 12% through 2016, or 30% of total Capex 1,200 35% $1,500 IT Capex spending (Left) 9% IT spend as % of total Capex (Right) 30% 1,000 $1,000 25% 6% 800 $500 20% 600 $0 3% 15% 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 400 10% JWN eComm sales (Left) eComm sales as % of total retail sales (Right) 200 5%Source: Company Data, Morgan Stanley Research 0 0%Customer feedback spurs and influences most JWN 2005 2006 2007 2008 2009 2010 2011 2012e 5-Yr Planinitiatives, allowing JWN to adapt its business to how its Source: Company Data, Morgan Stanley Researchcustomers want to shop. JWN’s current eCommerceinvestments are focused on expanding selection (currently Mobile POS opportunity: Last year, the company rolled out75% of stores assortment is available online and growing), 6,000 mobile POS devices throughout its full line fleet. Theincreasing convenience (e.g. free shipping/returns, expedited initiative is still in early stages and management is learning asdelivery, etc.) and enhancing customer service (e.g. improved it goes. For instance, sales associates expressed frustrationcheckout, online order fulfillment in the high 90% range). In that the early devices did not have the same functionality asaddition, the company hired 400 new eCommerce and IT registers. Management already addressed this issue. By year-employees in 1H12. Many new employees came from the end mobile POS devices will be 100% on par with registers,leading technology / retail companies in Seattle, including by 2013 mobile POS will have even greater functionality thanMFST and AMZN, introducing skill sets that JWN was lacking. the registers and by 2013 year-end, in-store checkout will be entirely mobile.JWN seeks to engage customers across channelsrelatively seamlessly. In 2009, JWN was the first department The company also rolled out about 1,500 POS devices tostore to adopt multi-channel fulfillment. Today, the company is Rack stores in 3Q12. While the devices are still new to thestill a cross-channel fulfillment leader, several steps ahead of stores, management’s early reads indicate the devices areMacy’s. The current system enables JWN to first look for elevating the stores’ service experience by reducing lines andinventory where a store might be ready to take a markdown. improving speed at checkout. In addition, management canThe system can also fulfill from stores where an item is selling now reduce fixed registers, freeing up incremental selling 111
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailspace. As a result, over time management believes the Rack JWN is acting offensively – investments should enable JWNmobile POS implementation should help drive incremental to retain and attract new customers – and defensively – ifsales volume. JWN doesn’t embrace the latest technology, another retailer will. For instance, while 15 years ago 7-10-day catalog orderHauteLook acquisition opens market opportunity and delivery times were acceptable, today 3-5 day delivery isbolsters e-comm talent: JWN acquired HauteLook, a flash standard. Meanwhile AMZN raised the bar with 2-daysale website, in early 2011. Management identified the on-line delivery, and even same day in select markets. JWN beganoff-price market opportunity. However, the economics of testing same day delivery in a few markets this year.developing an online off-price business were not particularly Meanwhile, other retailers, such as M and URBN, arecompelling. HauteLook filled that gap by providing the pursuing more rapid fulfillment, but are several steps behindcompany with a profitable way to enter the category. Through JWN, in our view.this acquisition, management continues to discover new waysto do business and innovate. In addition, the HauteLook We think JWN faces two key eCommerce risks: failing to 1)business provides JWN exposure to a slightly younger and a deliver on its anticipated returns and 2) offset increasedbit less affluent consumer. expenses in the future.While HauteLook remains an independent entity, as part of Exhibit 188JWN, the business can now participate in some the Rack’s Accelerating eCommerce should create significantbuys to secure product. This is a win-win, as it also provides long-term value DirectJWN with even larger scale to coordinate and leverage Aggressive growthorders. Sales Mix (Current) ~10%Investment Risks Sales Growth High Gross Profit % HighOnline sales growth should drive EBIT dollar growth, Full-priceROIC and shareholder returns, but SG&A rate varies with Costs High Variable Fulfillment/delivery; Evolving technologyinvestments. We think investors misunderstand ongoingeCommerce investments’ importance and value. As EBIT High EBIT $ Growth EBIT margin declining due to ongoing investmentstechnology and customer online/mobile expectations evolve, Capital Low But OngoingJWN must evolve its direct business to keep pace with online Short asset lives; High capital turnscompetitors and retain its leadership position. This investment Value Creation High High sales growth; High EBIT $ growthdoes generate incremental SG&A expense, and potentially Productive capital baselower operating margins, but we think the longer-term value Source: US Census Bureau, comScore, Morgan Stanley Researchcreation trumps the shorter-term expense. 112
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailRadioShack (RSH) North America(covered by David Gober)Thesis: RadioShack faces challenges as 1) pressure from carriers and handset makers intensifies, 2) online competitionincreases, and 3) better capitalized peers Best Buy and Walmart grow their mobile share. We expect further margin erosion andrevenue headwinds to continue for the foreseeable future. We see online as a threat to RadioShack as opposed to anopportunity, as RadioShack likely generates about 1% of revenue online and relies more on convenience of its store base thanonline experience. We expect its consumer electronics and signature segments (54% of revs by 2013) to be under most pressurefrom price transparency with online competitors, with Mobility facing only marginal incremental competition from AmazonWireless.Exhibit 189Survey shows CE online penetration likely to grow Key Takaways Online growth for hardlines retailers Current Online Penetration  The migration of Consumer Electronics online Future Buyers 80% appears likely to continue. According to the 70% CE expected to continue migration survey, 53% of CE buyers plan to buy online, 60% online compared with 47% of current buyers. 53% 50% 47%  In mobile phones, traditional retailers have 40% dominated the market given the complexity of the 30% sale (credit checks, contracts), with BBY and 20% WMT showing the strongest growth in the 10% category. 0%  While online has yet to make inroads in mobile, Books Cons. Sport. Athletic Home Office Home Pet Auto Elec. goods wear furn supp imprv supp parts Amazon.com has been gaining about 70bp ofSource: AlphaWise, Morgan Stanley Research share YoY, taking its mobile share to about 2%. eBay has 1-2% of the market.Investment Highlights cycles and implement upgrade fees to restrict subsidies payouts, reducing retail opportunities for RSH. We expectCompetition heating up in mobile, online & in-store. Given these factors to continue to hamper RSH earnings power, andstrong momentum behind mobile devices (tablets, eReaders, believe the competition will only get worse.smartphones), retailers have pushed aggressively into thecategory. Data from TraQline suggests that Best Buy and Investment RisksWalmart have been the biggest winners, gaining about 100bpof share YoY for the last four quarters. BBY’s share has Verizon awareness within RSH begins to accelerate. RSHincreased from about 5% in 2011 to about 6% in 2012 and replaced T-Mobile with Verizon in its carrier offerings inWMT’s from 3.5% to 4.5%. Amazon.com has also gained September 2011, and believe customers are still not awareshare, and now captures about 2% of the mobile market. that Verizon is offered in the store. By advertising the VerizonRadioShack, on the other hand, has seen its share stagnate, brand, and mobile in general, RSH could stem traffic declines.and remains below these fast growing peers with just 1-3% ofthe mobile market in the US. Changes to Target mobile deal. RSH currently operates mobile Kiosks in Target stores, only selling low-marginMargins eroding at a rapid pace. RSH’s gross margins have postpaid devices. The deal is currently EBITDA negative foreroded meaningfully from 45% in 2010 to 35-36% in 2012, RSH, and shares could get a boost if RSH either exits thedue to a multitude of factors, the biggest being the shift to deal completely or gets concessions from Target to sell morehigh price, low margin smartphones like the iPhone. Also, top high margin accessories and prepaid phones.line trends have declined as carriers shift to longer upgrade 113
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailUnder Armour (UA) North America(covered by Joseph Parkhill)Thesis: We see a clear path to 20%+ revenue growth over the next several years coupled with operating margin expansion asthe company focuses on controlling inventories, improving sourcing, and focusing on more profitable sales. Success in footwearand international market opens up very long-term growth opportunities.Exhibit 190Larger percentage of international online users than Key Takeawaysinternational revenues  Under Armour has the largest percentage of International revenues vs. international views 70% online sales out of all brands that we cover. This 60% is partially due to a more US centric business but 50% also due to the company’s focus on the area. 40%  According to comScore, 18% of online traffic 30% comes from international users, while only 10% of 20% 15% revenues come from international. We believe 10% 10% expansion of online capabilities internationally will 0% enable the company to improve its presence Vans Ralph Finish Under Nike Timber- The Foot Guess Lauren Line Armour land North Locker internationally. The international footwear and Face apparel market (non-US) is a $120B market. International revenue (%) International unique views (%)Source: comScore, Morgan Stanley Research  Under Armour manages its brand well and insists on premium pricing. The company is one of the only brands that has a store on Amazon, but the store does not compete on price. The company has found that being on Amazon has opened its brands to new consumers.Investment Highlights Footwear gaining traction. In our consumer survey, Under Armour was the only brand where consumers also planned toUnder Armour has the potential to grow revenues 20%+ increase purchases relative to the brands they had purchasedover the next several years, driven primarily by new product last year. While success should depend on execution, ourinnovations, new retail programs, and factory outlets survey results indicate UA is gaining mindshare in footwear, and we believe UA’s new lightweight running shoe launch inPerformance apparel still early cycle in the US, earlier 2H12 continues to be well received.internationally. According to our February 2012 AlphaWiseconsumer study, only 40% of consumers that have bought Investment Risksathletic shoes or apparel have bought performance apparel.25% of those that have bought performance apparel only As a high beta and high multiple stock, UA risks multiplebegan buying it in the past year. The typical replacement contraction, should the market correct. If sales growth shouldcycle is 18 months. These dynamics make us comfortable slow below 20%, we also believe the multiple could pressurewith 10%+ industry growth over the next several years. the shares. Finally, if operating improvements do not materialize, UA may not reach our EPS estimates or priceGross / operating margins set to expand. We believe target. Footwear and international success is not guaranteedsourcing initiatives set in place last year will allow gross as Under Armour has formidable competitors (Nike, Adidas)margins to expand in 2H2012 and continue in 2013. who have larger marketing budgets. 114
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailUrban Outfitters Inc. (URBN) North America(covered by Kimberly Greenberger)Thesis: We believe the Street underestimates the magnitude and pace of URBN’s margin rebound. We forecast EPS will doubleover 3 years and find URBN’s 0.8x PEG ratio compelling. URBN is a self-help story, in contrast to peers who depend on highersales to recover lost margin. After reorganizing management and decisively clearing excess product, URBN is poised to regainmuch of the 660 bps operating margin lost in 2011.Exhibit 191Online currently represents 22% of URBN’s retail Key Takeawayssales  URBN leads the pack by proactively leveraging $1,000 30% new mobile and online technology. $800 25%  The company targets eCommerce sales will comprise 50% of total sales in 5-years. Recent $600 20% and upcoming systems, talent, marketing, and $400 15% fulfillment capacity investments should drive growth. $200 10%  URBN’s strategy emphasizes increasing $0 5% distribution options, reducing ship times and improving customer convenience. 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e URBN eComm sales (Left) eComm sales as % of total retail sales (Right)Source: Company data, Morgan Stanley ResearchInvestment Highlights SG&A expenses due to higher marketing spend, but the operating profit margin is above the stores division.URBN leads the sector in online sales penetration withonline representing about 24% of 2012e total retail sales. Store fulfillment: URBN’s strategy emphasizes increasingURBN is proactively leveraging new mobile and online distribution, reducing ship times and improving overalltechnology to drive outsized ecommerce sales growth. A customer convenience. Management recently implementedbroadened product assortment, technology improvement, and “pick, pack, and ship”, which enables eCommerce and storestrategic online marketing investments utilizing paid search, order fulfillment from both its US store and distribution centeraffiliate marketing, search engine optimization and social inventories based on product availability, proximity andmedia, have helped successfully increase online traffic. 3Q12 several other factors.website traffic across brands grew 32%. With this functionality, URBN can 1) ship and fulfill orders withThe company’s online channel growth outpaces total store inventories if distribution center inventory is out of stocksales growth. URBN’s eCommerce business grew 27% and 2) sell web-exclusive merchandise returned to storesannually from 2006-2011 vs. the 15% company average. directly from the store rather than first returning it to a3Q12 eCommerce sales grew 36%. The company targets distribution center.eCommerce sales will comprise 50% of retail sales in 5 years.Recent and upcoming systems, talent, marketing, and The company believes this program will not only reducefulfillment capacity investments should drive growth. eCommerce order cancellations and back orders but also will likely improve inventory efficiency, increase inventory turns,Furthermore, URBN’s eCommerce channel has achieves a and reduce markdowns. The company successfully testedhigher EBIT margin than its stores. eCommerce gross margin “pick, pack, and ship” in 2Q12, and began utilizing in 3Q12.is above the traditional retail average because it does notincur rent expense. eCommerce does have slightly higher 115
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailDuring 3Q12, $23 million of direct-to-consumer initiated Developing a global eCommerce strategy: The company isdemand (14%) was filled from stores. Without “pick, pack, and growing its global online presence. Both Urban Outfitters andship”, URBN estimates half of this demand would have been Anthropologie European eCommerce online sales growthlost due to out-of-stock inventory positions. In addition, “pick, continues to outpace US sales growth. We see anpack, and ship” helped URBN lower markdowns and enabled incremental revenue growth opportunity now that Free Peopleits brands to buy less inventory. has launched its own European website.URBN believes “pick, pack, and ship’s” 4Q12 impact will be In Europe, the company has localized country-specific onlinemore meaningful Q/Q given recent learnings. 3Q12 staffing content and opened a new fulfillment center last year. Thislevel adjustments should allow more accurate, efficient and new center should support growing EU demand for at leasttimely fulfillment. the next 3-5 years. In Asia, management indicated it might enter the region by first building an eCommerce businessExpanded online assortment garnering high returns: followed by stores.URBN 2Q12 web-exclusive product offerings grew 75% y/yand almost doubled in 3Q12. Web-exclusive products now Mobile technology – a strategic cornerstone: iPad tabletrepresent 37% of URBN’s eCommerce sales mix. For technology remains a cornerstone of URBN’s eCommerce /example, management increased its 2Q12 online dress styles technology strategy. Two years ago URBN rolled-out iPad50% y/y to 1,500 and reaped “excellent” returns. Online sales POS devices in all stores to serve as registers. The iPadsare accelerating faster than inventory growth and web- reduce expenses, costing $1,000 fully installed instead ofexclusive product is higher margin than the average. $5,000 for a register, and enable greater customer interaction.Enhanced distribution: URBN’s $55M Reno, Nevada Beyond utilizing iPads as registers, the company is using theeCommerce fulfillment center opened in September. The technology to (among other things):center contains 500k square feet of capacity and isexpandable to 1M square feet, enabling processing of up to i) download content to the stores, including training videos,about 100k orders per day. The center is currently fulfilling product information, gift registry data, etc.;half of West Coast eCommerce orders (30% of total) andmanagement expects to ramp to 100% over the next few ii) aid returns and restocking – including an online app whichmonths. allows associates to deliver items bought online and returned to the stores back into the inventory system; andIn addition, beginning Spring 2012, the company’s SouthCarolina facility is now expediting shipments overnight to the iii) enable store associates to “save the sale” by searching theWest Coast. enterprise (e.g. other stores or online) for an item if a store is sold out or does not have the right color or size.With the Reno and South Carolina facilities, URBN can nowoffer 2-day or less delivery to 80% of its customers. Embracing showrooming: URBN is also piloting a programFurthermore, since all of URBN’s stores can serve as where it uses traditional retail stores to showcase online-onlydistribution points, merchandise can now get to West Coast product (the current push is shoes). Stores display thecustomers in under 2 days 20% of the time. product but do not stock the merchandise. Instead, an associate checks customers out via a mobile POS device andManagement intends to offer 2-day ground shipping across items purchased are shipped from distribution centerthe US within 3 years. Ground shipping is significantly more inventory. This strategy enables URBN to leverage its storecost effective than air shipping. Longer-term, the company base to boost sales volumes without taking significanthopes to roll-out same day delivery. URBN is also deploying inventory risk.same day order online and pick-up at store and expects toimplement this company-wide within the next few months. 116
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 192 Investment RisksRecent West Coast delivery improvement 20% As a softlines retail eCommerce pioneer, URBN faces future ROIC uncertainty. Ongoing technology advancements and quickly changing customer preferences produce a shifting eCommerce competitive landscape. To stay ahead of the 13% curve, URBN needs to make significant annual eCommerce 1-2 day delivery and IT investments, in our view. However, the eCommerce grows from selling channel is new and recent innovations’ potential 0% to 20% returns are relatively unknown (e.g. pick pack and ship, mobile technology, etc.). 1% 0% May June July AugustSource: Company Data, Morgan Stanley Research 117
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWalmart (WMT) North America(covered by Mark Wiltamuth)Thesis: We believe Walmart’s low price model will continue to thrive even as eCommerce trends continue to grow. Further, webelieve Walmart could be the one traditional retailers that have the potential to become a global leader in eCommerce sales.While currently eCommerce is only 2% of sales for Walmart and its core offline business is arguably under attack from Internetcompetitors, as the world’s largest retailer, Walmart can use its buying power to ensure it will not be beaten on price, and webelieve the company will either buy or build its way into a stronger competitive position in eCommerce.Exhibit 193Walmart’s cash flow can be put towards growing its Key TakeawayseCommerce and international operations  Walmart’s core business should continue to thrive Free cash flow as it pursues a strategy of sacrificing gross margin (US$ mn) in order to drive sales. We see a long runway of 20,000 store growth both domestically and internationally and a new push into smaller store formats will 15,000 only increase the Walmart low price brand ubiquity. 10,000  CEO Mike Duke has made becoming a global leader in eCommerce a top strategic priority for 5,000 Walmart. It has started building its talent base in search, social media, and mobile technologies 0 and it is experimenting with using its store base to 2010 2011 2012e 2013e 2014e 2015e help speed fulfillment of Internet orders.Source: Company Data, Morgan Stanley Research  The “no state sales tax” advantage Internet-only companies have enjoyed to date is beginning to fall. With a more level playing field, Walmart can use its scale to compete effectively on price.Investment Highlights Kosmix (presumably for social media talent) and Vudu (a movie streaming platform) show that Walmart is comfortableWalmart CEO has set a goal of becoming a Global doing acquisitions in the eCommerce area.eCommerce Leader: We believe Walmart is investing heavilyin eCommerce and mobile technologies to transform itself into The shift has already begun: The company is working toa multi-channel retailer that owns their customers regardless leverage its 4,000 stores in transitioning into becoming aof channel. The company has guided to about $9B in multi-channel retailer. “Site to store” deliveries alreadyeCommerce revenue in the next year. While this represents account for 50% of online transactions and the company isjust 2% of sales, CEO Mike Duke has laid out a strategic goal testing same day delivery, using its stores to shorten the tripof becoming a global eCommerce leader. We believe the to the consumer. IT work has been focused on improvingcompany could start to make major progress within five years, search capabilities on its website, and the company recentlyand within 10 years, the company could become a significant development of an online price monitoring system that checksforce in eCommerce sales. prices every 20 minutes.Walmart’s cashflow engine will fuel eCommerce A more level playing field should benefit Walmart: Tospending: With $26 billion in cash flow from operations and date, Internet-only retailers have enjoyed a pricing advantage$14 billion in free cash flow, Walmart has significant over traditional retailers because most Internet operators doresources to put towards buying or building its way into a not collect sales tax in states where they have no physicalstronger eCommerce position. The company’s acquisition of presence. This is set to change as state legislatures are 118
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retailworking to close the gap and as leaders like Amazon have projects and 11-12% square footage growth (likely instarted collecting sales tax in more states. With a level sales anticipation of Target’s entry), Mexico is still growing its storetax playing field, Walmart is in a position to use its scale to be base, and even the UK, which is a more mature market, hasa low-price leader for both traditional stores and in online grown with the acquisition of Netto. International is alsochannels. In the end, we believe Walmart’s reputation for low making major investments in China (370 stores), Africaprices will be the driver for a growing share of eCommerce (MassMart acquisition, 347 stores) and it has a significanttransactions. business in Brazil (512 stores) and Japan (419 stores).Core consumables business is defensible: Walmart’s core Investment Risksbusiness should continue to thrive even in an Interneteconomy. Food and consumables represent 55% of Walmart stock will be more driven by its core US retailWalmart’s sales. As many of these items are lower value and business (71% of earnings): Should Walmart’s US sameperishable, they are not well suited for eCommerce. store sales falter or if its Internet spending crimps profitability, WMT shares could come under pressure. We believe theWe expect Walmart to continue its strategy of sacrificing stock has become a safe-haven trade for investors in 2012,gross margin in order to maintain price leadership and drive with forward P/E being driven from 12x to 15x. As same storesales. Our price surveys show Walmart 12-20% below sales growth was a little softer than expected in the recentconventional grocery store pricing. quarter, valuation has now cooled to 13x. We view WMT shares as fully valued given its 8-10% growth rate. We believeWhile electronics, home, entertainment and other hardlines WMT will need to show upward sales momentum in order tocategories in its stores (or roughly 27% of the store) could be keep WMT shares moving in the near-term.vulnerable to Internet incursions, we expect Walmart to use itsscale to ensure that it is at least reasonably priced vs. online For eCommerce, the risk is becoming an also-ran: Whilecompetitors and in its Walmart.com sites, we expect the we expect Walmart to focus its considerable cash flow andcompany to be highly competitive on price. buying power on building its eCommerce effort into a global leader, the risk for the company lies in mediocrity. If it fails toStore expansion marches on: We see a long runway of marry its low price image and solid execution to its Internetstore growth ahead for Walmart in both domestic and business, the company could become an also-ran and fallinternational markets. The company has been adding about short of becoming an eCommerce leader.2% square footage domestically, adding 135 supercenters peryear, and we expect a greater push into smaller stores. Size poses a challenge for Walmart: While Walmart’s sizeNeighborhood Market grocery stores could reach $10B in gives it scale advantages that it can put towards maintainingsales by F2016 (or roughly 1/3 the size of Safeway), and the low prices, having $470B in sales can make it difficult tonew 15,000 square foot Walmart Express stores also look change quickly. Further, the law of large numbers alsopromising. Over time, this proliferation of store formats will dictates that Walmart’s growth will be more gradual. Foronly increase the Walmart low price brand ubiquity. example, we estimate that even if its small store initiative is successful, the company will have to roll out about 150International (22% of EBIT) is a significant growth area for Neighborhood Markets a year to move EPS by $0.01/share.Walmart and we expect the company to continue to devote Over the long-term, we view Walmart as an 8-10% EPSsignificant cash flow towards expanding internationally. Over grower.the last 5 years, international has delivered a sales CAGR of11% vs. Walmart US and Sam’s at 2-5%, and EBIT hasgrown at a 5 year CAGR of 10%.The company’s three primary earnings bases (Canada,Mexico and the UK) are still posting solid growth. Canada iscurrently executing on a record store growth year with 73 119
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailWilliams-Sonoma (WSM) North America(covered by David Gober)Thesis: We see significant potential from eCommerce as Williams-Sonoma’s furnishings brands (Pottery Barn, West Elm)continue to benefit from online targeting and improving online conversion of retail locations, which serve as branded showrooms.WSM already generates about 46% of revenues from its Direct-to-Consumer (DTC) business and about 1/3 of total revenuesonline. It continues to utilize its scale advantage to lower production costs and target consumers including targeted concepts likePottery Barn Kids and pbteen.Exhibit 194Home furnishings online penetration at about 30%, Key Takeawaysin the middle of the pack in hardlines  Consumers already shop for home, at home. In Online growth for hardlines retailers Current Online Penetration this survey, about 30% of home furnishings Future Buyers buyers had shopped online recently. 80% 70%  While “Future Buyers” showed no increase from 60% current online penetration in home furnishings, our 50% HF online growth appears November 2011 eCommerce survey showed modest; Amazon.com growth tells different story Amazon share gains are likely to accelerate. 40% 30% 28% 28%  Online growth a positive for WSM, not a negative. 20% Given 80-90% private brand mix as a percentage 10% of sales, the threat from Amazon is less direct, 0% and online sales are higher margin than in store. Books Cons. Sport. Athletic Home Office Home Pet Auto Elec. goods wear furn supp imprv supp parts  WSM has 33% of sales online, vs. 0-3% for homeSource: AlphaWise, Morgan Stanley Research furnishings peer BBBYInvestment Highlights Investment RisksTargeting improves online. WSM has always coupled Online competition in housewares could continue tooffline with direct to consumer catalogs as a leader in pressure the namesake brand. While the Williams-Sonomatargeted marketing. eCommerce allows the company to take brand is only about 25% of total WSM revenues, we expectthis a step further with less cost as seen through its ability to pressure from online competition to remain intense given thereduce square footage. Given an about 800 bps higher high level of branded, higher ticket, relatively transportablemargin for DTC relative to retail, ROIC should improve over products. WSM noted that offline competition has intensifiedtime as well. over the past year and our survey work suggests that AMZN will put increasing pressure on the category over the nextBranded products make “showrooming” a positive. few years.WSM has been able to reduce its number of retail locationswhile driving sales online as it finds consumers will go to Further investments possible. While we see revenuestores and then order at home. Given the vast majority of growth beginning to benefit from investments in the WestPottery Barn and West Elm products are private label, Elm brand, new brand launches, international, andconsumers cannot price match the exact same item as with eCommerce enhancements, it is possible that investment willbranded products. continue without significant profitable payback. 120
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce Key Stock Calls:Western Europe RetailASOS PLC (ASOS.L) Western Europe(covered by Anisha Singhal)We believe that ASOS is structurally positioned to benefit from the changing trend of how consumers shop. Surveys suggest thatmore than 20% of UK consumers are now buying more clothing online than in store. The global online apparel market remainsvery fragmented but we believe ASOS can continue to gain share. Not only is ASOS’ customer base growing very rapidly, but itscustomers are also making more repeat purchases. We believe that is it ASOS’ superior customer proposition relative tocompetitors which has been the key to success thus far, and we expect ASOS to remain one step ahead of peers, as store-basedretailers make a more aggressive move online.Exhibit 195ASOS is now the most visited apparel website in the Key Takeawaysworld  The global online apparel market is very Average daily visitors 000s (August 2012) fragmented, but ASOS is already the most visited apparel website in the world ASOS 625  Launches of local language websites in China and KOUDAI.com 471 Russia should be usefully helpful in boosting sales HM.com 465 in these fast growing markets Nike 453  Free delivery is extremely important to consumers, who do not want to pay for shipping. Moonbasa.com 355 ASOS has offered free global shipping since January 2011, but many of its competitors still do Inditex 334 not. Forever 21 321 MYNTRA.com 286 360buy.com 275Source: comScore, Company Data, Morgan Stanley ResearchInvestment Highlights … but the China and Russian launches should allow ASOS to gain local market share. Russia and China areThe global online market remains very fragmented… The already ASOS’ 6th and 7th most important marketsglobal online apparel market is predicted (by Euromonitor) to respectively (by sales) despite no tailored efforts to servebe worth £45B. However, this market remains extremely these markets. These are simply customers ordering from thefragmented, with even the most visited apparel websites in UK website, in English, and waiting up to 11 days for standardthe world only commanding about 1% market share each. We delivery. However, the potential for growth in these markets isbelieve, however, that ASOS is on its way to building itself significant, and as Exhibit 195 shows, the Chinese onlineinto a global player, and expect the launch of own-country apparel is predicted to grow by 43% CAGR over the next 5websites in China and Russia will dramatically boost demand years and reach nearly $20B by 2016.from these key regions. 121
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailExhibit 196 Exhibit 198Online apparel sales in China are predicted to total The majority of consumers globally are choosingnearly $20B by 2016 the cheapest delivery options… Agreement with statement "When buying products online, I would choose the cheapest shipping option" 6% 25 Strongly/Somewhat agree Neither agree nor disagree Strongly/Somewhat disagree Online apparel sales - $mn (RHS) 100% 5% % of total apparel sales online (LHS) 90% 20 80% 4% 70% 15 60% 50% 3% 40% 10 30% 2% 20% 10% 5 0% 1% Japan US Brazil Germany UK China Russia Australia Source: AlphaWise, Morgan Stanley Research 0% 0 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 2016e ASOS additionally offers its UK customers both ‘Click andSource: Company Data, Morgan Stanley Research Collect’ services, despite not having a store network, and a ‘delivery pass’ (ASOS premier) which allows free next dayWe believe ASOS’ strategy of high customer service is delivery and home collection for returns for only £9.95 a year,correct. As we said our in our recent initiation note (Staying a service we are unaware of any other clothing retailerOne Step Ahead – Initiate at Overweight, October 15, 2012), offering.we believe that ASOS currently has a far superior customerproposition than its peers. We firmly believe that ASOS’ Aside from a better delivery offer, ASOS has a compellingsuccess thus far has come about because ASOS’ product offer through both its competitively priced, yet verymanagement has identified what consumers want when fashionable own brand range, and through a wide selection ofshopping online. ‘Free shipping’ is such a requirement, as our branded merchandise. Offering a ‘broad selection’ is therecent AlphaWise survey shows, consumers all around the second most important reason (after low prices) whenworld do not want to pay for delivery (see Exhibit 197 and consumers consider their favorite retailer. By creating a high-Exhibit 198). Indeed, ASOS offers free shipping to all 190 service, fashion ‘destination’, ASOS has attracted top brandscountries it delivers to. to sell through its website, despite many of them having their own store estates and own eCommerce platforms.Exhibit 197… and claim that they would buy more online ifmore retailers offered free delivery Investment Risks Agreement with statement "I would buy online more often if retailers offer free shipping" Distribution costs are ASOS’ most significant cost and Strongly/Somewhat agree Neither agree nor disagree Strongly/Somewhat disagree 100% are continuing to rise as a percentage of sales. Obviously, 90% offering free global shipping, free returns from its major 80% markets and ASOS Premier all come at a price, and 70% distribution costs are ASOS’ single largest operating cost at 60% 50% roughly 4% of sales. We expect this to rise in the medium 40% term, as the company continues to ship everything from the 30% UK warehouse free for customers. However, we should see 20% some efficiency gains in the longer run, as the company can 10% 0% make better use of its returns hubs (e.g. fulfillment from China Brazil US Japan Russia UK Australia Germany returns) and eventually opens warehouses outside the UK.Source: AlphaWise, Morgan Stanley Research Loss of brands… With about 50% of sales coming from third-party brands, and these important to its customer proposition, the potential loss of key brands poses a risk. However, with no one brand accounting for more than roughly 122
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail3% of sales, we see the risk of this materially having an brands trend upwards to represent the majority of sales.impact on sales as very low. However, as ASOS continues to grow in scale, it should be able to negotiate both better terms with the brands and with…or conversely, increased importance of third-party its own suppliers, potentially offsetting any downwardbrands. With the company constantly continuing to add more pressure on gross margins.brands to its website, there is a risk of gross margin dilution if 123
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce Key Stock Calls: Latin AmericaMercadoLibre (MELI) North America(covered by Scott Devitt)Thesis: We are long-term believers in MercadoLibre’s continued eCommerce success and share gain in Latin America.MercadoLibre has also successfully diversified its revenue base by growing its adjacent revenue verticals to be 31% of totalrevenue, which has, in turn, helped improve operating margins by about 500bps since 2009. However, the company’s GrossMerchandise Volume (GMV) growth is slowing, considerably, and the company faces several quarters of extremely difficultcomps. Additionally, the company faces competition from local eCommerce companies and Amazon, and macro-related issuesinclude currency and geopolitical risk.Exhibit 199Although MercadoLibre’s GMV growth has slowed to Key Takeawaysa 4-year low, we see opportunity for reacceleration  MercadoLibre is the largest pure-play eCommerce GMV ($USD MM) Y/Y Local Currency Growth company is Brazil, which is the sixth largest 1,600 70% economy by GDP. Brazil’s eCommerce 1,400 60% penetration is 3.4%, below the worldwide average 1,200 of 6.5%. 50% 1,000 40%  MercadoLibre’s main customer base in Brazil is 800 the middle class, a demographic that has 30% relatively low internet penetration of 23%. 600 20% 400  Although GMV growth has decelerated for the 200 10% past several quarters, we believe this is temporary in nature and mostly due to the immense growth 0 0% 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11 4Q11 2Q12 the company achieved in the comparable y/ySource: Company data, Morgan Stanley Research periods.  MercadoPago, its payments subsidiary, facilitates payments for on- and off-platform transactions.Investment Highlights Exhibit 200 MercadoLibre generates 2x as many unique visitorsFocused on long-term growth. MercadoLibre is the largest as the next largest website, Americanas.comonline retailer in Brazil, and we expect the company can Averagecontinue to gain share over the next several years. Key millions YTD 2011 YTD 2012 Y/Y growthreasons for GMV growth include: broad product selection, 1. MercadoLibre 13,019 13,941 7%increasing focus on customer service, bundled payment 2. Americanas (B2W) 5,676 6,042 6% 3. Submarino (B2W) 4,670 4,499 (4%)processing (through subsidiary MercadoPago) and 4. Magazineluiza 2,942 3,621 23%increasingly integrated shipping options. 5. Casabahia (CBD) 2,806 3,289 17% 6. Pontofrio (CBD) 2,664 3,130 18%MercadoLibre generates the most internet traffic in Brazil. 7. Dafiti 1,212 3,062 153%This eCommerce marketplace generated, on average, about 8. Walmart 1,964 2,936 50%14M unique visitors per month, more than 2x the next largest 9. Extra (CBD) 2,425 2,767 14% 10. Livrariasaraiva 2,207 2,508 14%eCommerce website, Americanas.com, which is one of B2W’s 11. Ricardoeletro 1,424 1,866 31%three online brands. MercadoLibre also generates more total 12. Carrefour 1,813 1,850 2%visits than the sum of all six of B2W and CBD properties. 13. Comprafacil 2,315 1,820 (21%)Further, MercadoLibre’s unique visitors and total visits are 14. Shoptime (B2W) 1,441 1,556 8% Source: comScore, Morgan Stanley Researchgrowing faster than both B2W and CBD properties. 124
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMercadoLibre offers a lower take rate, relative to eBay increased conversion and accelerated GMV growth to a peakand Amazon. We estimate MercadoLibre’s take rate to have of 54% y/y (local currency) in 4Q11. MercadoLibre is nowremained in the about 5% range for the past six years, comping this growth – without a platform improvement of thealthough the company has improved its value to sellers by same scale.adding many additional features, including bundling itsMercadoPago payment solution as part of seller fees. At 5%, Increasing credit card fees hindering margins. While TPVMercadoLibre’s all-in average take rate is about 25% of growth is a long-term benefit if MercadoPago gains off-Amazon, and about 38% of eBay. If MercadoLibre’s take rate platform adoption, the margins could degrade over the nextincreased to about 6%, it could drive about 20% revenue several quarters because TPV is growing faster than revenue.growth, at about 100% incremental gross margin. The reason for this margin compression is due to MercadoLibre’s bundling of its payments solution with itsExhibit 201 marketplace listings fee, effectively offering free paymentMercadoLibre’s take rate is significantly lower than processing. Therefore, we expect credit card fees and fraudeBay and Amazon charge backs to grow, without generating corresponding Take rates revenue (see Exhibit 202). MELI hopes its users adopt 20% MercadoPago as a permanent payment solution, similar to AMZN estimated 3P take rate PayPal’s Merchant Services business, and is thus sacrificing (including CC fees) its near term margins for this long-term goal. We are 15% EBAY intl take supporters of this long-term initiative, but believe it could rate (including PayPal fee) challenge the stock in the meantime. 10% EBAY intl take Exhibit 202 rate (excluding PayPal fees) We estimate MercadoLibre pays about 10% of 5% revenue as credit card fees MELI take rate (including Fees as % of revenue Estimated credit card fees ($mn) 0% MercadoPago fee) $60 2006 2006 2007 2008 2009 2009 2010 2011 2012 14% 12% $50Source: Company Data, Morgan Stanley Research 10% $40Non-GMV based revenue growth. An increasing portion of 8% $30MercadoLibre’s revenue is generated from non-GMV (gross 6% $20merchandise volume) sources, such as MercadoPago off- 4%platform Total Payment Volume (TPV), financing receivables, 2% $10MercadoClics (advertising) and MercadoShops (3rd party 0% $--online stores). In 3Q12, approximately 31% of MercadoLibre’s 2006 2007 2008 2009 2010 2011 2012e 2013erevenue was generated from these four sources, with the Est credit card fees Fees as % of revenuemajority coming from MercadoPago and financing (versus Source: Company Data, Morgan Stanley Research27% in 3Q11). Further, similar to eBay’s investments in aplethora of new initiatives such as local inventory monitoring, Macro related risks. MercadoLibre’s mantra on the regions itgeo-targeting, smartphone barcode scanning, etc., to become serves is to “live through down periods, and take share duringa ‘commerce enabler,’ we see similar upside and potential for up periods”. That being said, MercadoLibre generates 15% /MercadoLibre. 25% of revenue, and 21% / 27% of operating income from Venezuela and Argentina, respectively. AlthoughInvestment Risks MercadoLibre’s Venezuela operations are self-sustaining (the company does not invest cash into the country), there is riskTougher comps hurt near-term GMV growth. In 2H11 the currency may be devalued. The Argentina operations areMercadoLibre migrated its website to an entirely new slightly more complex, as the company is headquartered intechnological platform, and immediately made several the country. The company’s solution to Argentina politicalimprovements to the website. One of the improvements issues is to slowly migrate headcount into a neighboringinvolved improving the registration process to allow customers country, Uruguay, which is more politically stable.to complete purchases more easily. This dramatically 125
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce: Key Stock Calls: Japan InternetRakuten (4755.OS) Japan(covered by Tetsuro Tsusaka)Largest eCommerce player in Japan: Track record of above market growth domestically in both eCommerce and financialservices, but expansion to overseas eCommerce businesses and eBooks (Kobo) creates uncertainty to group-wide profit growthExhibit 203Growth in transaction value exceeds the market. Key TakeawaysNegative earnings contributions from overseas &  By far the most dominant player in eCommercenew businesses are a concern business, with total transactions value outstripping 40,000 25% growth in the overall eCommerce market. We 35,000 estimate total eCommerce transactions value at 30,000 20% 25,000 more than 2x Amazon Japan. 20,000 15%  Reward points for using the marketplace can be 15,000 used for settlement credit cards and bank loans. 10,000 10% Growth in transaction value cycles through to 5,000 growth in settlement value. 0 5% (5,000)  Losses are increasing overseas and in new e-(10,000) 0% book business. When these losses will start Jun-10 Jun-11 Jun-12 Jun-13 Mar-10 Mar-11 Mar-12 Mar-13 Sep-10 Dec-10 Sep-11 Dec-11 Sep-12 Dec-12 Sep-13 Dec-13 shrinking, or be profitable, is unclear. These high- risk, high-return businesses are in contrast to Financial services Market place Travel Global, eBook, etc YoY%Source: Company Data, Morgan Stanley Research estimates domestic operations.Investment Highlights Value of eCommerce transactions is Rakuten Ichiba’s growth driver: The firm secures a margin of just under 3% onOperates Japan’s leading eCommerce shopping mall: the total value of transactions in the marketplace. In the pastDomestic gross merchandise sales growing at mid-to-high three years, transaction value has grown at an 18% CAGR.teens, faster than the eCommerce market growth. As eCommerce usage is still not as high in Japan as in othereCommerce business grows, finance business expands due developed countries. With penetration of smartphones/tabletsto synergetic effects on settlements. The firm is successfully still in early stages, we anticipate further growth in shoppingmonetizing the overall eCommerce ecosystem in both opportunities in the mobile environment. Hence, we foreseeeCommerce and finance. earnings contributions from transaction value CAGR of 10- 15% for the next three years. The eCommerce market as aIn the eCommerce site category, Rakuten is 3x larger whole is growing at a high single-digit rate, which Rakutenthan Amazon Japan in site visitor traffic: By nature of its has consistently outperformed.business as a marketplace (Rakuten Ichiba), Rakuten is ableto offer a greater number of items than Amazon, which has a Investment Riskshybrid marketplace / market maker model. A virtuous cycleoperates whereby increased outlet openings feed through to Overseas business & new eBook business: Apart from itsexpansion of the site’s item lineup, increasing the number of leading affiliate, Rakuten LinkShare, that is already profitable,shoppers, and adding to settlement value. Further, a Rakuten’s overseas business makes a limited contribution tomarketplace business relieves Rakuten of the need to earnings. Rakuten’s mid-term strategy is to build overseasshoulder inventory risk and distinguishes it as a provider of an marketplaces that replicate the fundamental principles of itsenjoyable shopping experience for users. Japanese marketplace. Rakuten has eCommerce operations in Taiwan, US, France, Indonesia, Brazil, Germany and the 126
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailUK. Currently, Rakuten is combining local direct sales with a presence in North America after Amazon’s Kindle and Barnesmarketplace, but this model will evolve as it applies the tenets & Noble’s Nook. Rakuten is in process of rolling out Koboof Rakuten Ichiba to overseas eCommerce operations. globally, including in Japan. Recent earnings results show losses swelling in both overseas operations and the newIn its eBook business, Rakuten purchased Canadian eBook business, to the detriment of overall earnings.company Kobo in 2011, which gave it the third largest 127
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailMorgan Stanley Global eCommerce: Key Stock Calls:Australia RetailDavid Jones (DJS.AX) Australia(covered by Thomas Kierath)Thesis: DJS is highly exposed to online sales leakage given its prices are significantly higher than offshore peers and itscustomer base is very active online. Additionally, DJS was late to develop an online platform, so has given its competitors aconsiderable head start. We think earnings will remain pressured over the coming years and that consensus expectations for acyclical earnings rebound are unfounded.Exhibit 204Consensus EPS revisions: A very poor earnings Key Takeawaystrajectory  DJS products are skewed towards global brands, David Jones Ltd. which are far cheaper when purchased online. As 50 online growth continues, we expect this to pressure revenue growth. 45 2007 2008  DJS only recently established an online platform; 40 2009 it has given competitors a considerable head- 2010 35 start. 2011 30 2012  Stated company plans are to continue to roll out 2013e 2014e new stores – we argue that online growth will 25 diminish the need for new stores. 20  DJS’ customers tend to earn above average May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- 07 07 08 08 09 09 10 10 11 11 incomes – these consumers spend moreSource: Company Data, Morgan Stanley Research proportionately online, so DJS is more exposed compared to peers.Investment HighlightsDepartment store categories are exposed to online Exhibit 205competition…. Our survey shows that key department store 47% of shopper bought clothing online in the pastcategories like clothing, consumer electronics, jewelry, home 12 months – apparel is 50% of DJS sales Books 59%furnishings and shoes all sell well online. Clothing 47% Consumer electronics 46% Jewelry 38% Sporting goods 33% Home furnishings & accessories 28% Office & school supplies for home use 27% Shoes 26% Athletic apparel & athletic shoes 25% Personal care & household products 25% Pet food & pet supplies 22% Home improvement items & tools 19% Auto parts & accessories 19% Groceries 17% Large home appliances 14% Source: AlphaWise, Morgan Stanley Research 128
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional Retail…especially from overseas. Within the key department evident in DJS’ own price promise that it will only price matchstore categories, consumers are purchasing these products domestic store based retailers and no international or purefrom offshore. This does not surprise us given the large price online retailers.differentials. Investment in online seems light. Despite being a laggardExhibit 206 in eCommerce, we are yet to be convinced of DJS’38%-62% online shoppers purchased jewelry, commitment to building an accretive online platform. Theclothing, accessories or shoes from offshore management has made it clear that the investment in onlinewebsites will come from the existing capex budget of A$80m, which Books 67% seems very light compared to Nordstrom’s US$1B Jewelry 52% eCommerce capex plan for the next five years. Clothing 49% Athletic apparel & athletic shoes 48% Store roll out to further pressure long-term earnings and Auto parts & accessories 43% returns. DJS remains committed to rolling out new stores. Shoes 38% We would argue that as sales shift online it should be Consumer electronics 38% shrinking the store footprint rather than expanding it. None of these categories 35% Sporting goods 32% Investment Risks Personal care & household products 26% A$ depreciation should ease the price differentials and Home improvement items & tools 22% online leakage. The rapid A$ appreciation in the past couple Office & school supplies 21% of years has accelerated the growth in online. Not only did it Home furnishings 18% magnify the domestic price premium over offshore, it also Groceries 13% sent more Australians and their shopping overseas. So a Large home appliances 11% (gradual) reversal of this trend should ease the topline Pet food & supplies 10% pressure for DJS.Source: AlphaWise, Morgan Stanley Research Cyclical improvements: DJS is leveraged to improvementsDJS ‘House of Brands’ strategy leaves it more exposed in general consumer spend. In addition, given DJS’ customerto online leakage. DJS has repeatedly emphasized its base tends to be higher income earners with investments in‘house of brands’ product strategy and market position. property and / or stock markets, an improvement in theseMoreover, we estimate that about 50% of DJS sales are markets should also lift its customers’ propensity to spend.generated from global brands. While this provides a point ofdifference to competitors, it also exposes DJS to global price Exhibit 207benchmarking. As Australian prices reduce DJS is likely to Online retailers used in the past 12 months –be impacted by price deflation leading to a reduction in sales. online purchasers who used the retailerBy comparison, Myer has consistently focused on the eBay.com 57%  The Iconic 3%  Amazon.com 28%  Myer 3% development and growth of its private labels, now close to JB Hi-Fi 15%  The Good Guys 2% 20% of Myer’s revenues. We think that Myer is less exposed Apple 12%  Kmart 2% to price deflation given that it owns a higher proportion of the Big W 11%  EB Games 2%  Grays Online 8%  Bing Lee 1% brands it sells. Dick Smith 7%  Bonds 1%  Officeworks 7%  Surfstitch 1%   Global pricing harmonization: a double-edged sword. We Coles 6% David Jones 1% Woolworth 6%  Peter Alexander 1% see this as a material headwind for DJS. If prices are Target 5%  Sheridan 1% lowered, revenues are likely to be pressured as volume uplift Cellarmasters 4%  Oroton 1%  Aussie Farmers Direct 4%  Just Jeans 1% is unlikely to provide a complete offset; if prices remain high, Dan Murphys 3%  First Choice 1% then we’d expect leakage to online to continue. To date, DJS Harvey Norman 3%  Dotti 1%  ASOS 3% has managed to drop prices on a small number of selected Source: AlphaWise, Morgan Stanley Researchproducts. We don’t expect DJS will be able to achievecomparable pricing to global retailers across productcategories, given a higher cost base and higher wholesalebuy prices compared with offshore peers. We believe this is 129
  • MORGAN STANLEY RESEARCHJanuary 6, 2013eCommerce Disruption: A Global Theme – Transforming Traditional RetailJB Hi-Fi (JBH.AX) Australia(covered by Thomas Kierath)Thesis: JBH operates in a very difficult consumer electronics industry. Despite an industry leading cost base, we think thatstructural factors (i) a slowing technology cycle, (ii) an over-stored industry, (iii) products moving digital and (iv) Apple takingshare, will lead to lower earnings ahead. JBH is also greatly exposed to eCommerce disruption given that many of the categoriesit operates in are increasingly sold online.Exhibit 208We expect JBH earnings per store to decline further Key Takeaways EBIT per store (A$ mn)  JBH operates in a challenged industry facing 1.4 multiple headwinds, including competition from 1.2 online, products going digital, an over-supply 1 imbalance and the growth of Apple compression 0.8 industry profit 0.6  Despite operating with an industry leading cost 0.4 base and expanding market, we don’t think JBH 0.2 can offset the structural issues facing the industry. 0  Within our coverage universe JBH is most FY13E FY14E FY15E FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 impacted by growth in eCommerce given theSource: Company Data, Morgan Stanley Research product categories that it operates in.Investment Highlights Exhibit 209 Consumer electronics is the third popular onlineJBH: A good retailer in a challenged industry. JBH has product categoryestablished excellent retail credentials over the years. Percentage of online purchases in past 12 months (by category)However, the consumer electronics industry is facing serious Books 59%challenges. Industry consolidation has accelerated in the past Clothing 47% Consumer electronics 46%couple of years, as difficult trading weighs on the weaker Jewelry 38%retailers. While JBH’s low cost base should assist with market Sporting goods 33%share gains, it does not necessarily guarantee dollar profit Home furnishings & accessories 28%growth, as evident in the UK and the US. For details please Office & school supplies for home use 27% Shoes 26%refer to our note Australia Retail: Asia Insight: Consumer Athletic apparel & athletic shoes 25%Electronics – The Fast Lane Is Slowing Down. Personal care & household products 25%