Global Market Commentary

October 13, 2016

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Global e-Commerce Adoption Isn’t Slowing — It’s Accelerating, and Has Massive Tailwinds

U.S. e-Commerce Share Gains (vs Retail)

Source:  Bank of America/Merrill Lynch

Most investors probably have the impression that e-commerce has moved beyond its initial stages of rapid growth and into a slower and more “mature” growth pattern.  However, this is not the case – in fact, e-commerce seems to have entered an inflection point of more rapid growth over the past two years.

E-commerce likely has a decade more of double-digit growth as measured in gross merchandise value (GMV), and seems to have recently passed an inflection point.

Several macro factors are driving this acceleration.

First, infrastructure is expanding, both upstream of sellers (logistics) and downstream (delivery networks).  Here, one of the driving trends is local delivery.  Although Amazon [NASDAQ:  AMZN] is spearheading rapid, two-day, one-day, or same-day delivery through its Prime, Now, and Fresh programs, many other companies are implementing novel solutions in this space.  These innovations have the potential to expand e-commerce into verticals where until now it has had limited penetration, including especially on-demand areas such as groceries, prepared food, and health and beauty.  Fierce competition is developing lean, efficient, and inexpensive on-demand delivery networks, which will enable further acceleration of e-commerce share gains over retail: companies here include Instacart, Deliv, DoorDash, GrubHub, and UberEats among many others.  Instacart, for example, is partnering with major retailers such as Target [NYSE:  TGT], Costco [NASDAQ: COST], and Whole Foods Market [NYSE:  WFM].

Besides the improvement in on-demand delivery times, upstream logistics are also improving.  Again, although AMZN is in the lead, Walmart [NYSE:  WMT] is leveraging its enormous brick-and-mortar footprint with its acquisition of Jet.com and its rollout of ShippingPass.  AMZN has built out a huge network of fulfillment centers, but WMT is incorporating its existing stores into a system for on-demand delivery to challenge AMZN.  The point is that this battle is far from over; it is still in its early stages, and many highly competitive challengers will seek to usurp AMZN’s dominance.  The result will be accelerated e-commerce penetration.

Second, global e-commerce penetration is low in most markets.  Global penetration is about 8%; China and South Korea lead with about 17%; the U.S. is at 11%; many countries remain below 5%.  Most notable among the laggards is India, which could be about to see a huge inflection due to accelerated smartphone adoption and wireless infrastructure build-out, as detailed in our newsletter on September 22.  In that piece, we noted a confluence of public and private efforts: aggressive marketing of inexpensive wireless data plans and private-sector wireless capacity buildout, coupled with a reforming drive from government for universal internet access to enable more efficient and less corrupt provision of government services.  Analysts expect Indian e-commerce to expand seventeen-fold in the next decade.

India’s retail market has so far been highly fragmented and dominated by small mom-and-pop shops.  Organized retail represents only 10% of total retail sales.  We believe that similar to the leapfrogging seen in emerging-market internet telecom technology – skipping the developmental stage of land-lines and moving straight to wireless – a leapfrog effect could be seen in India retail, where the stage of dominance by large organized retail enterprises is overshadowed by the immediate arrival of e-commerce.

Currently, per capita e-commerce expenditure in India is less than 2% of China’s, while per capita GDP is about 20% that of China’s.  This implies that a rapid inflection in smartphone adoption and wireless internet could lead to a powerful growth in e-commerce market share gains.  Global e-commerce leaders such as AMZN and Alibaba [NYSE:  BABA] are already leaders in Indian e-commerce in spite of the obstacles posed by Indian logistics: AMZN, for example, is partnering with mom-and-pop operations for local delivery.  Local Indian companies such as Flipkart and Snapdeal are also major players; Flipkart leads in GMV in India.  WMT has entered the Chinese e-commerce market through a partnership with JD.com [NYSE:  JD], and recent reports suggest that it may also be preparing to partner with Flipkart.

Third, technological change is afoot, specifically the arrival of virtual and augmented reality devices.  “Virtual reality” (VR) immerses the user in a complete digital world; Microsoft’s Hololens [NASDAQ:  MSFT] and Facebook’s Oculus [NASDAQ:  FB] are two of the current offerings.  “Augmented reality” (AR) adds digital elements to our perceptual field without blocking it out entirely; Alphabet’s short-lived Glass project [NASDAQ:  GOOG] fell into this category.  (GOOG has also invested in secretive startup Magic Leap, which is preparing a much-anticipated AR technology that early reports suggest will be game-changing; we covered Magic Leap in our letter on January 29, 2015.)  Gaming and other entertainment applications are the first thing most investors think of when AR and VR are mentioned, but e-commerce will be just as significant an application of the technology.  AR/VR will enable the expansion of e-commerce into some of the segments where penetration is currently the lowest, such as furniture and home goods.  Through these technologies, the e-commerce experience will begin to combine the convenience of online shopping with the experiential fullness of physical presence in a brick-and-mortar store.  Simulation and visualization will be key, and are already in early stages with applications from companies like Wayfair [NYSE:  W] and Lowe’s [NYSE: LOW].  W’s WayfairView allows users to place furniture items in pictures of rooms of their house, while LOW is partnering with MSFT in an immersive Hololens VR experience with the same end.  (That app will also pull from your Pinterest page to create virtual rooms decorated in your style with LOW’s items.) BABA is leading the way here with a lab set up to assist businesses in creating VR stores.  As AR/VR hardware adoption accelerates, we believe that this technology will become an integral part of the e-commerce experience.  Eventually, it will be unthinkable to shop online without VR.

Other technological advances are also driving accelerating e-commerce penetration, among which artificial intelligence (AI) is key.

Our regular readers know that we are somewhat skeptical of the larger claims of AI to be able to replicate human intelligence, but that “strong” conception of AI is not what we are discussing here.  The AI we’re discussing here is operating silently behind all the e-commerce websites you visit, mining and structuring data so that your searches provide compelling and relevant results, and building advertising algorithm engines that will present products to you that you actually want to buy. 35% of AMZN’s sales are generated by its recommendation engine.  AMZN CEO Jeff Bezos has said that he views AI as one of the pillars of AMZN’s long-term strategy; the company’s Alexa AI initiative has a thousand employees and according to the AMZN site, currently has openings for 400 more.  AMZN is also integrating AI and automation into its warehouse and logistics, and providing outsourced AI through its Web Services platform.

(We have noted in previous letters that the depth of user data possessed by FB is so profound that if it were fully deployed, many users would probably think it verged on being creepy.)  E-commerce AI being developed by companies like AMZN and Ebay [NASDAQ:  EBAY] will make the e-commerce experience more satisfying and compelling for customers, making the question “Why not just get it on AMZN?” (or EBAY) ever more compelling.

Finally, we note that offline retailers will accelerate the process by acquiring e-commerce companies so that they can “get in the game” – and this will contribute to a critical-mass effect that will also inflect e-commerce penetration.  We mentioned WMT’s e-commerce ambitions in the U.S., China, and possibly India, but many other brick-and-mortar retailers, including Nordstrom [NYSE:  JWN] and Bed Bath & Beyond [NASDAQ: BBBY] have made strategic e-commerce acquisitions so that they won’t be left behind.

As always, we offer the caveat that the strength of the theme does not mean that investors should be willing to pay any price for it.  However, e-commerce leaders should certainly be on investors’ short lists when market-wide corrections offer attractive valuations.  In the near term, we like the large-cap tech leaders of the U.S. stock market.

Investment implications: E-commerce is far from being a mature theme.  Rather, e-commerce penetration is undergoing an acceleration, driven by a number of macro trends, and double-digit growth is likely to continue for many more years.  These trends include the buildout of logistics for ever-leaner and ever-quicker on-demand delivery and the arrival of infrastructure-driven inflections in emerging markets, especially India.  Other supportive trends include technological advances such as artificial-intelligence driven product search and ad serving, as well as augmented and virtual reality applications.  The competitive field is growing as more established brick-and-mortar retailers make acquisitions to strengthen their game as e-commerce penetration accelerates.

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