Less than 50% of retail sales could ultimately go through stores

In one of our most recent Nordea On Your Mind reports (E-commerce: The show must go on) Johan Trocmé interviewed e-commerce and digital business analyst Daniel Ovin from Nordea Equity Research. He shares his views on retail sales migrating online, the technological and consumer behavioural drivers behind this and how far it could penetrate in different product categories. Daniel also discusses how the Nordic region stands out internationally with its tech-savvy and affluent consumers and numerous successful digital and e-commerce startups that have become global leaders in their businesses. 

Daniel, as an online analyst, you have quite a unique job description. Could you quickly describe your role at Nordea Equity Research?

DO: My role at Nordea Research is to cover and analyse both listed and unlisted companies, focusing on e-commerce and digital businesses across sectors. As almost everyone is by now aware, there is an explosive development in this area globally, not only in e-commerce but also in fintech, digital health and online media. My job is to follow these trends, cover the companies we have listed in this sector today, and write sector-wide reports. I also aim to contribute to ensuring Nordea is a relevant partner for businesses in these areas that want to come to the capital markets, and I work across different functions in the bank to share knowledge about trends in this space that could impact other areas within Nordea in different ways.

Many industries worldwide are now facing major disruption as their business models are becoming digitalised – these disruptions are often driven by nimble new players without legacy platforms and structures. Could you give a few examples of industries where you think we will see the most drastic changes from this, and highlight why they will be among those disrupted the most?

DO: I think online food retail is ripe for disruption. It is an area where online penetration is still currently relatively low – around 2% versus around 15% on average for other retail categories. The reason for this is that online grocery is very difficult from a logistics perspective, with some products requiring a chilled or frozen environment, in addition to a typical grocery basket containing on average 40-50 items, all with a relatively low average selling price. This makes the picking and delivery activity as a percentage of sales very expensive. But now automated warehouse solutions that allow online operators to make a positive margin after picking and delivery are starting to emerge.

Another factor that works in favour of online food retailers is the rapidly increasing number of customers shopping for groceries online. This improves the density of delivery. Meanwhile, the incumbent grocery retailers are sticking to their store-based operations, hoping that their store networks will enable them to handle the online operations efficiently by reducing the last mile delivery distance. I believe that potential gains from cutting the last mile delivery distance will be by far outweighed by the higher cost of picking in store, however. This makes the grocery industry a perfect target for pure online operators that seek to disrupt this retail segment.

Another area in which I think we will see a lot of online disruption is the broadcasting of sports and sports advertising. Many linear cable companies rely on broadcasting live sports, as much of our movie consumption has already migrated online, as streaming players such as Netflix have taken market share. Meanwhile, the viewership of some of the largest sports broadcasting events such as the National Football League (NFL) in the US or the Football World Cup have started to decline, as the younger generation is more interested in watching e-sports on platforms such as Twitch. I believe it is still early days for this trend, but I expect a lot to happen in this area over the next ten years.

The online share of sales in the retail industry is continuing to grow sharply. What do you think the key drivers will be for further increases in online penetration, and how far do you think it could ultimately go?

DO: I think it will differ from area to area. For non-physical products such as travel bookings, console games or music, I believe the digital penetration could go to 100%. For some of these categories, we are actually almost there already. For physical products, we are likely to see large differences between categories. For consumer electronics, which is a pretty easy category to sell online given its relatively high average selling price (ASP) and standardised features, online penetration seems to be plateauing in the US at 50-60%. For apparel, the average penetration is currently 15-20% globally, but according to companies such as Asos and Boohoo, the younger customers are already at 40-50% of their apparel purchased online. I see no reason why we should not be able to reach this level for the totality of consumers over time.

For groceries, overall global online penetration is only around 1%. But in South Korea, it is already at 20%. In the UK as a whole, it is around 8%, and the London area is already around 15%, according to Ocado. A few weeks ago, I met with Kroger in the US, which is currently investing in growing its online grocery business, and I believe online penetration for US food retail could reach 15-25%. This would be from a starting point of around 2% today in just ten years' time, but I see no reason why the longer-term online penetration of groceries could not be even higher than this.

Are there categories or certain types of retailers for which online business models are not suitable?

DO: I would say there are very few areas where online business is not suitable at all, but some areas have more challenges to overcome when going online than others. At both extreme ends of the price spectrum, online penetration is lower than the average. For very expensive products, such as luxury goods, consumers seem less willing to purchase online, not having seen or felt the product beforehand. However, I think this could change over time, as the younger generation feels more comfortable with online shopping and we have also seen luxury online penetration growing very fast from only around 5% a few years ago to around 10% today.

For products with a very low ASP, the delivery and picking activity becomes very expensive as a percentage of sales. For example, the UK-based value-focused apparel retailer Primark, with an average order value of below GBP 20, has tried to sell online but could not make ends meet and is now only selling in stores. With advances in warehouse automation and delivery, and as online apparel shopping continues to grow, lower costs and higher density in delivery could make apparel with a relatively low ASP also feasible for online selling.

And lastly, products that need more thorough consulting or an examination, such as spectacles, also have lower online penetration of around 5% globally. As technology develops and as consumers become increasingly comfortable with online shopping, this could also change over time, however.

What do you think today's incumbent retailers should do about consumers migrating online? Is omni-channel a real option for them? What will they need to stay relevant in the future?

DO: If we gave a group of retail entrepreneurs a mission to set up a new retail business from scratch today, I think very few would start by building a massive store base. This is not to say that stores will disappear altogether, or that stores do not have any value any longer. But the key question is, what is the right balance of stores versus online business? Perhaps less than 50% of sales will ultimately go through stores.

Store-based retailers seeking to build an omni-channel business, in my view, often try to use most of their old infrastructure and follow their old procedures when it comes to marketing and pricing. But I think this will have to change drastically in order to build a successful omni-channel business. Brick-and-mortar retailers must also be willing to fully cannibalise their store-based business, and this often meets some internal resistance.

Another problem for brick-and-mortar retailers is that it is very challenging to manage a declining offline business while at the same time overseeing a growing online business, which requires a different skill set. As of now, there are few retailers that have managed to do this successfully.

What could be potential threats to growth for online retail? Capital market funding drying up? Regulation? Antitrust issues? Trade wars? Other factors?

DO: It is very difficult to see how a younger generation, which has become used to online shopping, will stop this habit and go back to store-based shopping. Having said that, issues such as funding, regulation, antitrust or trade wars could all contribute to at least temporarily holding back online growth.

An economic downturn could temporarily make funding scarce, but I think we are in a different environment now, compared with the bursting of the dotcom bubble at the end of the 1990s. Today, most investors have invested in some online operators and made a decent return on this. Also, many online businesses are currently profitable and have strong balance sheets, and there is a large and growing underlying market, so funding should come back after any economic downturn.

When it comes to regulation and antitrust, the online or digital spaces are very young in many respects where regulation may be needed to prevent a negative impact on society. This is an apparent risk, and the severity and likelihood of any setbacks for digital businesses is also difficult to assess. But I am certain that the younger generation would still prefer to continue to conduct much of their shopping and other activities online. They want to communicate and interact on social media, and they want to listen to and watch music digitally, in a non-linear fashion. Even in the event of increased regulation, I believe that big operators such as the FANG (Facebook, Apple, Netflix and Google) companies will still be in a very good position to run these businesses also going forward.

Antitrust measures are also an apparent risk that cannot be ignored. But as of now, the growth of global e-commerce giants such as Amazon or Alibaba is actually making goods and services cheaper for the consumer. For online businesses, scale allows cheaper and faster delivery, for example, as well as a broader assortment. If we start to see a situation where the consumer becomes negatively impacted, and large online operators start to exploit monopoly-like positions to make outsized returns at the expense of the consumer, this could change.

How do the Nordic countries compare to the rest of the world in the digital business arena? Strengths and weaknesses? Are there any Nordic digital players that you think could be major global players in their industries in the future?

DO: The Nordic area stands out well in an international comparison of overall digital savviness and e-commerce penetration. The average online penetration for physical retail products in the Nordic region is around 15%, which is in line with most developed countries. The Nordic region benefits from a relatively tech-savvy population with virtually everyone having access to the internet. The average income is also high, and the region has managed to build a strong position in many digital areas such as gaming, music and fintech. Regarding disadvantages, the fact that the countries are relatively sparsely populated countries and their small overall populations are not ideal factors for e-commerce.

When it comes to Nordic companies, Spotify has already managed to become the largest music streaming company globally, and iZettle (sold to PayPal for USD 2.2bn in 2018) and Klarna are already among the world’s largest digital payment solution providers. The Nordic region has become a leading hub globally in the field of online gaming. Two examples are Swedish DICE, which was acquired by global gaming giant EA for USD 24m in 2006 and makes up most of EA's income today, and King. The latter was acquired by Activision Blizzard for USD 5.9bn in 2015, and has now become the world’s biggest mobile gaming company.

Another example is Mojang, a Swedish company that created the game Minecraft and has become one of the world’s biggest mobile gaming companies after being acquired by Microsoft for USD 2.5bn in 2014. In the future, I believe some of the Nordic gaming companies such as THQ could become major global players in their fields. THQ has a strong track record of producing critically acclaimed games and has close to 100 games due for release in the coming years. It is starting to become one of the leading global gaming companies. Being platform independent, THQ could along with one other peer also be the relative winner in a future game streaming environment.