THE U.S. ONLINE RETAIL FORECAST

Omni-channel Retailing Challenged by its Success

THE U.S. ONLINE RETAIL FORECAST

Just consider how many times this year you’ve read or heard the phrase “declining mall traffic” in the business media. This increasingly common refrain is backed by evidence; Prodco Analytics has consistently reported traffic declines at shopping centers in the mid-single digits year over year ("YOY") for the better part of the last two years, with the trend worsening in 2016. Quite simply, Americans are making fewer trips to shopping centers, particularly malls, as online shopping continues to get more convenient and popular. The transition of store-based retail chains into omni-channel merchants over the last decade has contributed greatly to this phenomenon. Omni-channel retailers collectively account for most online sales today, with many regional and national retailers today generating at least 10 percent of their sales online. (Total online sales account for nearly 12 percent of U.S. retail sales, excluding auto and gas.)

The success of the online channel has likely contributed to slackening store traffic. Omni-channel retailers will all say they view and operate their two (or three) selling channels as one interconnected business, and that may be so, but it’s hard to ignore the reality that many retailers have merely maintained their market share and have little else to show for these herculean efforts except a vastly more complex entity to operate in a hypercompetitive marketplace.

The announcement this summer that Macy’s will be closing 100 stores by 2017 — or 15 percent of its full-line department store base — is a significant event in several respects.

Most noteworthy is the scale of these store closings — such a large reduction in footprint in one swoop by a financially sound national retailer is virtually unprecedented. (These announced closings come after nearly 40 Macy’s store closures

were completed in the first half of 2016.) To the extent these designated stores serve as mall anchors, their shuttering will have a larger ripple effect on those shopping venues, as mall owners will be challenged to timely reconfigure and re-let these very large boxes to multiple new tenants in those spaces.

That is starting to change as store closing programs become more aggressive. Last year Gap Stores announced it would close nearly 25 percent

THE U.S. ONLINE RETAIL FORECAST

Omni-Channel Retailing Challenged By Its Success

After years of premature and wildly errant predictions about the “death of stores”

caused by online sales, we’ve come to a point where even a mild version of this

scenario is dismissed as hyperbole. That’s unfortunate because we are now

witnessing a shift to online sales that is impacting the physical retail landscape on a

scale that can no longer be considered immaterial. These changes are gradual and

cumulative, which tends to obscure their corrosive effect.

2

Until recently, store closing

initiatives by healthy retail

chains could best be

described as nibbling around

the edges. Underperforming

stores were closed, usually

as their leases expired, but

rarely have these cumulative

closings accounted for more

than a very small percentage

of a chain’s store base.

THE U.S. ONLINE RETAIL FORECASTTHe U.S. ONLINE RETAIL FORECAST

of its namesake stores in response to years of persistent underperformance. This past year many other non-distressed specialty chains, including Barnes & Noble, Children’s Place, A&F, American Eagle Outfitters, Pier One, Ralph Lauren and Chico’s have announced planned store closings that are more aggressive than those in years past. None of these other planned closings is on the scale of Macy’s or Gap Stores, but cumulatively they, along with store closings by retailers in Chapter 11 (the recent liquidation of The Sports Authority and partial liquidation of Aeropostale alone will shutter nearly 1,000 stores), inevitably take a toll on vulnerable shopping centers in less desirable locales — potentially setting off a spiral of vacancies as some shoppers avoid venues with too many dark storefronts.

Furthermore, it’s certainly possible that Macy’s decision to go big with store closings, and particularly Wall Street’s immediately favorable response to this decision, could encourage other major retailers to likewise consider bolder moves as investors’ increasingly view robust store closings as a laudable strategic decision to drive returns rather than evidence of weakness or a reactionary response. Macy’s bold decision is also an acknowledgment that the success of the online channel is changing the equation that omni-channel retailers use to evaluate store performance. Macy’s indicated that its stores to be closed were profitable—they were not money losers but smaller, marginal performers whose low return on investment (“ROI”) couldn’t justify an ongoing

commitment and investment when much of their underlying real estate could be sold or otherwise monetized. Especially noteworthy, Macy’s expects to retain nearly 25 percent of its sales from these stores to be closed, primarily through its online site. Such a high sales retention rate, combined with the store expense savings of these closings, lowers the threshold for these decisions or, conversely, raises the bar for marginal stores to justify their existence. If Macy’s were not so successful with its online business, it likely would have been less aggressive in closing stores, as it expects $300 million of sales will stay in its coffers despite these closings.

Earlier this year we wrote (see Omni Channel for Retailers: It’s a Rocky Road to ROI) that without such drastic measures, omni-channel retailers risked seeing their sizeable investments in online become just an added cost of doing business rather than a legitimate driver of enterprise ROI. Return on investment has been declining for most large retailers since 2014 due at least partially to hefty omni-channel investments, all-consuming integration efforts and related gross margin compression. Macy’s apparently sees it that way too given its decision to go with a smaller footprint. Others might follow as they become convinced that their online shop will mitigate the business impact of a smaller store presence. We expect that other large chains will study their move closely and consider its relevance to their own business. Going forward, store closings of 10 percent or more of a chain’s physical

store base by major omni-channel retailers wouldn’t strike us as excessive or surprising. Get used to it.

U.S. Online Sales: How Large is the Pie and Who is Getting the Slices?Online retail sales will approach $400 billion this year and continue to grow at a low double-digit rate (YOY) compared to approximately two to three percent for store-based sales. In fact, online retail sales growth has accelerated slightly in the past year to just over 14 percent, defying an expectation that its growth trajectory would soon slow. That’s the good news. The bad news is that Amazon.com continues to take a disproportionate and growing share of these sales despite the success that omni-channel retailers have achieved to date.

Amazon’s dominance of online retailing shows no sign of letting up as it expands and extends its product reach in apparel, grocery and other consumer staples. Millions continue to sign-up each year for its Prime program, whose members are now conservatively estimated to top 50 million globally. Amazon’s second Prime 3

In short, this means that

for each marginal sales

dollar that migrates away

from stores to the online

channel today, only about

68 cents stays within the

traditional retail

ecosystem.

THE U.S. ONLINE RETAIL FORECAST

$400AMZN's share of annual online sales growth

AMZN's share of total annual online sales

0%

5%

10%

15%

20%

25%

30%

35%

$150

$0

$50

$100

$200

$250

$300

$350

in billions

EXHIBIT 1

U.S. Online Retail Sales vs. Amazon

20

05

20

06

200

7

20

08

20

09

2010

20

11

20

12

20

13

20

14

20

15

2016

Source: U.S. Census Bureau and SEC filings, last twelve month (“LTM”) basis.

Day came and went in July without the same fanfare of its inaugural event a year earlier, but it was wildly more successful, with U.S. orders up 50 percent over 2015 according to the company, which called it “the biggest day ever for Amazon.” Analysts estimate its Prime Day sales rivaled those of Black Friday, but, more important, it added legions of new Prime members who, in short time, will become faithful Amazon shoppers.

Our estimate of Amazon’s domestic market share of U.S. online sales is 20 percent (Exhibit 1), excluding third party sales it fulfills, which by some estimates are nearly as large as

its own retail sales. (Amazon doesn’t book third party sales as revenue nor does it disclose their dollar value.) This merits repeating: Amazon’s share of U.S. online sales when third party sales are also included is probably close to 40 percent. More impressively — and more alarming for omni-channel retailers — Amazon’s domestic sales growth has accelerated since late 2014, and at 26 percent (YOY), is more than twice the growth rate of total online sales, excluding Amazon (Exhibit 2).

Arguably, it alone is responsible for the acceleration of total online sales growth in the last year since online sales growth,

excluding Amazon has leveled off near 13 percent (Exhibit 2). Collectively, online sales by omni-channel retailers are growing at a healthy rate, but aren’t accelerating and, therefore, they continue to lose market share. That means Amazon is taking 32 cents of every additional sales dollar that leaves stores and shifts to an online channel (again, this excludes third party sales.) There’s little reason to expect any reversal of these established trends despite the best efforts of traditional retailers to tame the beast.

4

AMZN North America Sales ($)

Rest of U.S. E-commerce Sales ($)

AMZN Share of Online Sales Growth (%)

AMZN Share of Online Sales (%)

THE U.S. ONLINE RETAIL FORECAST

5

EXHIBIT 2

U.S. Online Retail Sales Growth

YOY Growth percent AMZN North America Sales

-6%

0%

6%

12%

18%

24%

30%

36%

42%

48%

1Q2005

3Q2005

1Q2006

3Q2006

1Q2007

3Q2007

1Q2008

3Q2008

1Q2009

3Q2009

1Q2010

3Q2010

1Q2011

3Q2011

1Q2012

3Q2012

1Q2013

3Q2013

1Q2014

3Q2014

1Q2015

3Q2015

1Q2016

20

05

20

06

20

07

20

08

20

09

2010

20

11

20

12

2013

20

14

20

15

2016

YOY Growth percent U.S. E-commerce Sales Excl. AMZN

FTI Consulting’s U.S. Online Sales ForecastWe expect U.S. online sales to reach $395 billion this year, $436 billion in 2017 and $562 billion by 2020 (Exhibit 3). Our model anticipates that online market share will eventually top out at nearly 25 percent if the low penetration category of grocery is excluded (or 20 percent including grocery). This represents a near doubling of online market share over the next decade or a compound annual growth rate ("CAGR") of eight percent.

Online market share varies greatly by product category and always will. The early mover categories, such as books, music and computers, are mature and enjoy huge online market share, but are not large product categories. The bulk of online sales dollars today come from what we call the medium penetration categories, consisting of apparel and accessories, consumer electronics, home furnishings, sporting goods and toy and hobby. Each of these categories already enjoys online market share in the mid teen to low 20 percent range. Their ultimate ceilings are higher than the overall ceiling and are closer to 30 to 35 percent in our model.

Perhaps the most surprising category of the last year or two is home goods and furnishings, which have achieved a near 20 percent online market share by our estimates.

Like apparel, home furnishings are a “high touch” category that might have been expected to be a hard sell online, but have instead defied early skepticism.

The tremendous success of Wayfair, an online-only seller of furniture and home furnishings that has scaled up to $3 billion of sales in just five years, has lit a fire under all large competitors in the sector that were slow to ramp up their online businesses and are now scrambling fast to do so.

Yes, online sales growth

will slow — it must — as

online shopping eventually

approaches its maximum

potential audience and

more consumers reach

saturation levels for their

online shopping needs.

Source: U.S. Census Bureau and SEC filings, LTM basis.

Indeed, if online retailing

has provided us with one

genuine surprise over the

last decade, it is

consumers’ acceptance

and use of the channel for

products that seemed to

be ill suited for it.

THE U.S. ONLINE RETAIL FORECAST

6

0%

5%

10%

15%

20%

25%

30%

$0

$100

$200

$300

$400

$500

$600

$700

$800

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

in billions

EXHIBIT 3

U.S. Online Retail Sales Forecast

Online Retail Sales ($)

Beware a Pyrrhic VictoryOnline retailing has been an unambiguous boon for consumers over the last decade, providing many shopping benefits at little or no cost to them as retailers continue to pick up that tab — which has become sizeable. Whether it’s lower online prices, mobile shopping apps and coupons, free shipping, generous return policies or last mile coverage, consumers have been wooed and spoiled by technology-enabled conveniences that they have been conditioned to expect for free and forever — much to the chagrin of retailers who likely never imagined all these “giveaways” would continue

indefinitely at their expense. Retailers — omni-channel and online-only — have been hugely successful at building a 21st century shopping channel that consumers have embraced with few reservations. There’s every reason to expect this migration to the online channel will continue at a healthy clip. The ongoing challenge for large retailers is to meet the many demands of the omni-channel imperative without eroding the profitability of the enterprise. Otherwise, it is a hollow and costly victory.

Source: U.S. Census Bureau and SEC filings.

Online Market Share ex. Grocery (%)

Online Market Share (%)

THE U.S. ONLINE RETAIL FORECAST

7

Appendix: Our Forecast Model of U.S. Online Sales and Market Share The general model that best describes consumer adoption of the internet for shopping is the logistic growth curve, commonly known as the S-curve due to its resemblance to the shape of that letter, which is used to depict many natural and social phenomena. The S-curve inherently recognizes that unbounded growth cannot persist indefinitely because resource limitations, saturation or other inhibiting factors will inevitability cause growth to slow and finally taper off. The S-curve plots this progression over time. It is a generalized model that can take on many forms, and can be as varied as the shape of the letter S itself; stretched and elongated (slow adoption) or sharp and upright (fast adoption). Regardless of its particular shape, every S-curve exhibits two distinct growth phases that are symmetrical about the curve’s inflection point, that is, the middle of the S where its concavity changes.

Our online forecast model is derived from imposing the best fitting logistic curve on actual online sales figures by product category. The U.S. Census Bureau has published online retail sales estimates in about a dozen product categories since 1999. From these time series data, we estimate online market share for these categories since inception. We then derive an appropriate S-curve equation for each of these market share and use these equations to project online sales and market share in the years ahead. These online sales forecasts by product category are then aggregated to derive our bottom-up forecast.

THE U.S. ONLINE RETAIL FORECAST

About FTI ConsultingFTI Consulting, Inc., is a global business advisory firm dedicated to helping organizations protect and enhance enterprise value in an increasingly complex legal, regulatory and economic environment. FTI Consulting professionals, who are located in all major business centers throughout the world, work closely with clients to anticipate, illuminate and overcome complex business challenges in areas such as investigations, litigation, mergers and acquisitions, regulatory issues, reputation management and restructuring.

www.fticonsulting.com ©2016 FTI Consulting, Inc. All rights reserved.

Authors

Christa Hart Senior Managing Director Retail & Consumer Products +1 212 499 3619 christa.hart@fticonsulting.com

John Yozzo Managing DirectorCorporate Finance & Restructuring +1 212 499 3624 john.yozzo@fticonsulting.com

fticonsulting.com/retail

The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.