E-Commerce in the Time of COVID-19

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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April 27, 2020

E-Commerce in the Time of COVID-19

The COVID-19 pandemic will drive extraordinary top-line growth for most companies in the e-commerce landscape, from merchants, platforms, specialists, and payments. At the same time, many will also see much higher costs due to safety precautions, higher input prices, hiring/training expenses, etc. We believe the experience of this pandemic will yield fundamental changes in consumer behavior, boosting e-commerce growth to an even higher trajectory with new shoppers, new categories, new geographies, innovative services, and greater engagement. This should also hasten the global shift toward electronic payments. However, there will be substantial necessary investment associated with these opportunities. Moreover, the added costs associated with crisis operations may be difficult to fully dial back. Still, we see opportunity across the spectrum –marketplace platforms, online merchants, operations specialists, and payments. Our best picks fall on that spectrum: Platforms – AMZN, EBAY, JD, MELI, ETSY, FVRR; Merchants – W, CHWY; Specialists – SHOP, STMP, GOOGL; and Payments – PYPL, V.

  • You can’t always get what you want … With hundreds of millions of people largely confined to their homes, and most retail stores in big economies shuttered with strict crowd controls yielding long lines for the grocery stores and pharmacies that remain open, the COVID-19 pandemic has sparked a mad rush to the internet. Pure online retailers in the US and Europe are seeing orders up 40-80% YoY with April sales in-line with the past holiday season. E-commerce sales are more than doubling in markets like India, Mexico, Indonesia, and Australia. Against the rush of demand, supply chains and logistics are strained, pushing out delivery intervals and forcing leading platforms to prioritize “essential” goods. Nonetheless, all parts of the e-commerce landscape ought to report extraordinary revenues in 1Q.
  • Blow out sales will be accompanied by extraordinary expenses. Servicing the unexpected rush of orders amidst the pandemic places enormous strain on e-commerce ecosystems. Sourcing product is difficult and more expensive. Capacity shortages across the value chain force facilities expansions, new hiring, accelerated training, and higher wages. Circumstances demand new procedures and equipment to protect workers and customers from infection. Some players may choose to invest in opportunities to serve new geographies and new market categories. All of this will raise costs and investment, dampening margins even as revenues surge.
  • E-commerce will be on a higher trajectory post-pandemic. While e-commerce demand will certainly ebb once the worst of the contagion is behind us, the market will have shifted to a higher, steeper trajectory. We see opportunities from 5 vectors: 1. New shoppers – consumers who had resisted e-commerce learn to embrace it; 2. New categories – customers expand their buying to areas like grocery and pharmacy; 3. New geographies – Crisis lowers entry barriers, increases attractiveness of market entry; 4. Value added services – vendors can bundle additional services like financial products or other services; and 5. Greater engagement – increased site traffic enables advertising, memberships, etc. In addition, the e-commerce boom also hastens the shift to electronic payments.
  • Opportunity means investment. The ascension of global e-commerce demand to a higher plane will require new long-term investment by those seeking to capture it. AMZN, which had reported unexpectedly strong margins in its most recent quarter, can be expected to begin a new cycle of investment, with spending to support grocery and pharmacy deliveries leading the way. Other retailers, behind the pace set by AMZN will spend to shorten delivery intervals. The race to scale in emerging markets will heat up, pitting local brands against international platforms. Moreover, many of measured (e.g. higher pay scales, worker safety procedures, temporary delivery/logistics arrangements, etc.) rushed into place to cope with the pandemic will be difficult to dial back. This spending will temper the earnings upside for several quarters despite extraordinary top line growth.
  • Cash is no longer king. We wrote about the changes happening in payments and POS last year (Digital Payments: Revolution at the Register). The pandemic and resulting rush to online retail will accelerate the shift toward contactless payments and integrated POS/online payment solutions that we forecast, while raising the pressure on credit card fees from e-commerce platforms. In the short-term, payments volumes will be down sharply, with physical POS and cross border commercial transactions hit particularly hard. While payment volumes will undoubtedly recover, we expect the mix will favor solutions that integrate POS with online and payments processing with broader retail business processes (e.g. inventory, finance, etc.) favoring vendors like PYPL, Stripe, SQ, Adyen and others over traditional merchant acquirers. Interest in touchless retail solutions, like that prototyped in AMZN’s Go stores, will rise. We also expect P2P payments platforms, like PYPL’s Venmo and SQ’s Cash, to flourish.
  • More opportunity than AMZN can handle alone. Awash with orders, AMZN delivery intervals have stretched from days to weeks and the company is looking to hire 100K new workers to help alleviate the strain on its operations. Grocery deliveries in many markets are a daily lottery, with some Whole Foods customers unable to grab a slot in weeks of trying. While AMZN has undoubtedly signed on many thousands of new Prime memberships and appears ready to report truly extraordinary YoY sales growth, it is likely that smaller rivals are growing even faster as they feed on AMZN’s overflow. Alternative platforms like EBAY, ETSY, Instacart, and others should thrive, as should international players like MELI, Rakuten, JD and BABA. SHOP and GOOGL Shopping, which enable smaller merchants online, should also see significant sales upside, as should STMP. Large merchants with both physical stores and online presence, like WMT, COST and TGT, will see e-commerce gains offset by declines in brick-and-mortar.
  • Our Picks. Online retail platforms selling goods sourced from 3rd party merchants, sometimes alongside their own brands, are obvious winners. We favor AMZN, MELI, JD, and EBAY. We also like FVRR, which is a marketplace for freelance services. Independent online merchants are also gaining traction – though many are private, we like W and CHWY. Many independent merchants rely on software and services from specialists, like SHOP and GOOGL. Finally, in payments, we prefer PYPL, V and MA. (Note: we believe SQ is exceptionally well positioned for the long-term but faces unusual short-term pressure from its small retail POS heavy business mix)

The Stores are Closed

Around the world, hundreds of millions of people are isolating at home. In the acutely threatened countries, most retail stores are shuttered and even those deemed essential – groceries, pharmacies, gas stations and the ilk – are restricting entry in many cases. Increasingly, consumers are turning to online retailers to deliver goods directly to their homes. E-commerce sites are seeing orders 40-80% higher than a year ago, a scale more typical of the height of the Holiday season than March and April. The CTO of SHOP, which supports thousands of independent merchants online, reports that their platform is now seeing Black Friday levels of traffic every single day. Clearly, e-commerce ecosystems, unburdened by the heavy costs of shuttered brick-and-mortar stores, are thriving.

Still, investors should remember that ramping operations to this scale without benefit of careful planning while also protecting vulnerable employees will be costly. Moreover, many players will invest aggressively to address the myriad long-term opportunities beginning to flower far earlier than most expected. We see these opportunities stemming from five vectors. 1. New Shoppers – Consumers who had eschewed online shopping in the past now have little choice. Many of them will remain customers post-pandemic. 2. New Categories – Certain retail categories – e.g. grocery, pharmacy, etc. – have been resistant to the e-commerce revolution. No longer. 3. New Geographies – Global players may find entry barriers lowered as they contemplate entry into new markets. 4. Value-added Services – With a bigger share of the household wallet, e-commerce platforms can lever the relationship into financial products (e.g. credit cards, demand deposits, loans, etc.) and other services (e.g. membership programs, media streaming, etc.). 5. Greater Engagement – Deep knowledge of a consumer’s buying habits is catnip to advertisers. These opportunities can accrue directly to an online merchant but are more likely to be exploited by e-commerce platforms that often front for thousands of underlying 3rd party sellers.

We also note that a sharp shift toward digital shopping is also a boon for electronic payments platforms, accelerating a shift from physical payment mechanisms – cash, checks and cards – to online credit and debit, P2P transfers, and mobile payments. It also benefits companies that provide infrastructure, software, and services to facilitate independent merchant storefronts – e.g. parcel delivery, shipping specialists, logistics platforms, back office systems, etc.

While AMZN is the obvious beneficiary of most of this, there are others. Amongst platform players, AMZN is joined by EBAY, ETSY, MELI, and JD as recommended names. We are also intrigued by FVRR, a platform for freelance service providers. The list of merchants is shorter, as most public retailers offset their online opportunities with now shuttered physical stores. We like W and CHWY. The top picks amongst e-commerce specialist firms are SHOP and GOOGL (N.B. we believe concerns for GOOGL’s advertising franchise are somewhat overstated). Finally, in payments, we like PYPL, SQ, MA and V. In the immediate term, SQ will obviously suffer for its exposure to small brick and mortar retailers. Still, we believe that it is positioned to take significant share once physical retail begins to recover, particularly from merchants blending stores with online sales.

Every Day is Black Friday

Coronavirus went from an isolated problem to a global pandemic in the blink of an eye. Within the span of a few weeks, over a billion people worldwide found themselves largely confined to their homes, asked not to commute to work or go to school or go to the movies. In most parts of most countries affected by the contagion, all retail stores, save for those selling goods deemed essential – e.g. groceries, medicine, and gasoline – were closed. In this context, homebound shoppers reached for their mouse or their smartphone.

E-commerce platforms are swamped (Exhibit 1, 2, 3, 4). Same day deliveries are out the window. Intervals for many items on Amazon’s marketplace have stretched to weeks as the e-tail giant was forced to prioritize basic supplies and medically necessary items. Pure online retailers have seen orders up 40-80% YoY in most developed markets, while business in countries like India, Indonesia, Mexico, and Australia has more than doubled. Consumers shopping more for delivery availability than price are discovering new online sources for the things that they need boosting the fortunes of smaller platforms and independent virtual storefronts.

The circumstances have not gone unnoticed by investors. Amazon shares are up 30% YTD, Etsy has risen 47%, Shopify is 62% higher and Stamps.com is up a whopping 77% (Exhibit 5). We believe that these names are likely to justify this enthusiasm but note that there are others with a strong position in e-commerce, like EBAY, MELI, JD, and PYPL, that have been relatively quiet. Given the enormous size of the e-commerce pandemic wave and the signs of strain on the operations of the largest players, it seems likely that smaller players may see outsized upside.

Exh 1: Snapshot of YoY eCommerce Sales Growth Globally in Mar-Apr 2020

Exh 2: US & CAN eCommerce sales are up more than +120% YoY in April 2020

Exh 3: ex-US eCommerce sales up too as lockdowns were enforced in each region

Exh 4: Breakdown US retail growth by key categories for first quarter, April 2020

It’s Gonna Cost Ya’

The top line windfall will not come without associated costs. For example, Amazon has announced an across the board wage hike of $2/hour along and double-time pay for overtime alongside plans to hire 150,000 workers. Walmart, Target, Home Depot and Safeway, amongst many others, have also announced wage hikes and big hiring initiatives. Companies are also spending to protect workers – extending paid sick leave, supplying masks and other gear, paying for testing, and redesigning processes to minimize employee contact. Product costs are also up, as international supply chains slow, as domestic manufacturing strains under the pandemic, as logistics and delivery costs rise, and as the availability of many essential items tightens. These costs will not be fully passed on to customers and investors should expect a toll on margins over the next few quarters despite the unprecedented volume of sales. Moreover, the product mix away toward groceries and other staples and away from apparel and other discretionary categories will have

Exh 5: YTD Cumulative Returns of Top Ecommerce Platforms in US, Apr 2020

further negative effect on margins (Exhibit 6, 7, 8). Target has already announced that its operating margins would be down more than 500bp in the first quarter. Given TTM operating margins of just over 6%, Target is operating just above break-even, although we note that the majority of Target depressed margins are likely related to the fixed costs of operating physical stores with lower than anticipated sales volumes.

The Future is Now

As the crisis proceeds into recovery, consumer demand for e-commerce will recede but likely remain well above its previous trajectory. Within this, we see major opportunities deriving from five major change vectors:

  1. New Customers – In the crisis, many consumers who had previously eschewed online shopping were forced to look to the internet for both necessary and discretionary purchases. Many of these people, perhaps surprised by the convenience, selection and price found on the internet, will continue to do some of their shopping online once brick-and-mortar stores reopen. In January, Amazon reported that the number of Prime memberships had topped 150M, a rise of 50M since the 100M milestone was reached in April 2018. We suspect that it will hit the 200M marker before the end of 2020 (Exhibit 9, 10).
  2. New Categories – Many internet shoppers had been comfortable buying books and gifts online but reticent to trust a stranger to pick out produce or fill a prescription. Necessity has groceries and medications being delivered to millions who would never have placed an order pre-crisis. As

Exh 6: TTM YoY Sales Growth and Operating Margins for Top US Retailers

Exh 7: Snapshot of hiring and operations expansion plans for top US Retailers

Exh 8: AMZN Quarterly Shipping Costs as a % of Sales, 2Q16 – 4Q19

Exh 9: Amazon Prime easily beats other US Retail Loyalty Member Base

Exh 10: Summary of Major Vectors of Change in Ecommerce

shutdowns stretch into their second month, a decent portion of these reluctant customers have likely become converts. US grocery sales are about $700B and drug store sales are ~$300B. Even a few percentage points of shift would be a big deal (Exhibit 11, 12, 13, 14).

  1. New Geographies – Big retailers have always looked for opportunities for international expansion. The pandemic may make market entry easier, increasing consumer interest and potentially softening local competition. For example, Amazon has country specific operations in 13 global markets and has prioritized building its presence in markets such as India, Brazil, Mexico, and Turkey. Alibaba has also made geographic expansion a strategic imperative, with major investment in southeast Asia, Russia, India, and Mexico. Expect a lot more of this in the post-pandemic environment.
  2. Value-added Services – As consumer relationships strengthen, e-commerce platforms can lever them to offer additional services. Credit cards are an obvious example, but we believe broader consumer financial products, such as deposit accounts, loans (including mortgages), trading, and financial advisory are likely future steps. Other potential areas are media (e.g. video, music, podcasts, news, etc.), travel, and even telemedicine. Amazon, with its Prime Video, Prime Music and credit card initiatives, has already moved aggressively in this direction, but we expect it to be even more aggressive moving forward.
  3. Greater Engagement – E-commerce players capture valuable data about their customers’ shopping habits and the more often users hit the site and the more they buy, the more valuable that data becomes. Advertising has become a major growth business for Amazon and an underexploited resource for most other online shopping services.

The top e-commerce players are investing against all of these opportunities. We expect that margins, particularly for the distribution platforms, like Amazon, Alibaba, MercadoLibre, eBay and others, will remain tight for several quarters as a result. It is not clear that investors are expecting this, and while temporary, it could yield downward pressure in 2H20 and 2021.

Exh 11: US Pharma Sales and Estimated Digital Penetration, 2014 – 2019

Exh 12: US Annual Grocery Store Sales, 2014 – 2019

Exh 13: US online grocery shopping has more than doubled in the last 9 months

Exh 14: US Households buying grocery online for the first time is up, April 2020

We Don’t Need No Stinkin’ Cards

Barter begat cash. Cash begat checks. Checks begat credit cards. Credit cards begat debit cards. Cards begat digital wallets. Digital wallets begat mobile payments. Merchants and e-commerce platforms began to embed digital payments directly into applications, looking for ways to sidestep the substantial fees collected by issuing banks for their incentive-laden premium cards (Exhibit 15). Payments facilitators began to tie digital and mobile payments into turnkey solutions for merchants managing business across both physical and digital storefronts. A tech revolution at the point-of-sale began.

We wrote about the changes that were afoot in payments in 2019 (Digital Consumer Banking: What Will GAFA Do?). In that piece, we wrote about the opportunity for online merchants to bypass bank-issued credit cards and their substantial transaction fees with private label cards and pre-funded spending accounts. The success of Amazon and Apple’s cards, following the long history of store cards, has spurred Google and others to follow suit. While these payment products are a serious threat to bank-issued cards, Visa and Mastercard, which assure broad acceptance and provide the rails to facilitate settlement, should benefit, particularly in developing markets where cash still predominates.

PayPal’s digital payment products are widely accepted by online merchants and should also benefit greatly from the step-function shift to e-commerce (Exhibit 16, 17). P2P payment products, like PayPal’s Venmo, SQ’s Cash App, and the Zelle App offered by a consortium of banks, were already growing rapidly before the pandemic, and have accelerated since. We also expect an acceleration in cross-border transfers (although accompanied by a decline in cross-border transactions due to supply chain obstacles and import restrictions), which should be a further benefit to PayPal.

Exh 15: Legacy merchant systems are under pressure from Digital native demands

Exh 16: US Mobile Wallet Users and Forecast, 2019 – 2024E

Exh 17: US Digital Wallet Transaction Volume and Growth, Forecast 2019 – 2024E

We also wrote about dramatic changes at the point-of-sale in brick-and-mortar stores (Digital Payments: Revolution at the Register). With most physical retail locations closed, the revolution at the register is on a cease fire of indeterminant length, and the primary arms dealers – Square leads, but PayPal, Intuit and Shopify are also aggressively pressing traditional POS solutions – will see a sharp pull back in transactions that will only recover as consumers head back to the stores. While we believe that the mix shift from stores to e-commerce will be on a permanently higher trajectory post-pandemic, the integrated customer-friendly solutions offered by the POS upstarts may find themselves in a stronger position to take share.

Exh 18: Financial and Valuation Summary of Key Players winning in Ecommerce

Amazon is Not the Only Winner

While few companies are in a better position than Amazon to gain from the social changes catalyzed by the COVID-19 contagion, there are other beneficiaries that have not yet generated as much buzz with investors. We break the winners into 4 categories (Exhibit 18):

  1. Platforms – E-commerce platforms front for 3rd party merchants, providing a critical mass of shoppers and offering logistics, marketing support, and other services. While Amazon began as a pure online merchant, its marketplace for independent sellers has become its largest business, generating highly profitable fees while the merchants bear the costs and risks of inventory. We favor Amazon, JD, MercadoLibre, and eBay, and note that Alibaba and Rakuten are also well positioned for the changes underway. We also note that Israeli company Fiverr, which operates a global platform to match freelancers and small businesses offering services (e.g. design, marketing, writing, etc.) with customers is also well positioned.
  2. Merchants – Most independent online merchants also operate physical stores, so the benefits from a booming e-commerce channel are offset by the dismal realities of social distancing. Many purely e-tail businesses were struggling somewhat before the crisis, burdened by scale disadvantages vs. the big platforms and the global chains that have made e-commerce a priority. Still, companies with tight focus and differentiated products can thrive. There are many private examples – Warby Parker, Casper, Bonobos, etc. – but relatively few public pure plays. Two that stand out are Wayfair (furniture) and Chewy (pet products) (Exhibit 19).
  3. Specialists – Smaller retailers who choose to open their own digital storefront away from the big e-commerce platforms often have need of specialized help in setting up and operating their site. These companies provide software and support to manage operations, handle logistics and market to consumers. Shopify, which provides a wide range of solutions to facilitate e-commerce, was already a big winner before the pandemic but should see material acceleration in its business now. Alphabet also provides marketing, transaction processing and logistics services to merchants under the Google Shopping brand. Alphabet stock has been hit be fears of a recession induced ad slump, but we expect digital ad suppliers to gain significant share from traditional media in recovery.
  4. Payments – As noted above, we see a new generation of payments specialists crowding out traditional merchant acquirers (Fidelity, Fiserv, and Global Payments) and card issuing banks. This transition is being accelerated by the boom in e-commerce. Here we like PayPal, Visa, MasterCard and Square. A note on Square – we are aware that Square’s business has centered on the small-to-medium retailers badly threatened by social distancing. Our recommendation is purely on the company’s long-term opportunities and the belief that its exposure is well understood by investors.

Exh 19: Summary of Winners for Ecommerce in the Pandemic Environment

 

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