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«Shopping: a whole new meaning Martha Peyton, Ph.D., Managing Director TIAA-CREF Global Real Estate, Strategy & Research Savvy investors in the retail ...»

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Summer 2012

TIAA-CREF Asset Management

Shopping: a whole new meaning

Martha Peyton, Ph.D., Managing Director

TIAA-CREF Global Real Estate, Strategy & Research

Savvy investors in the retail sector are well aware of the necessity of keeping

up with change... in fashion, in customer behavior, in geography... and so on.

Every decade since the era of the general store on Main Street has seen the

retail sector rattled by new products and new ways to sell them. Focusing

just on the latter, the introduction of department stores, supermarkets, mail order catalogues, regional malls and big boxes were all revolutionary in their day. Changes in the products sold through those venues have been even more constant to describe in words. In the roughly three years since the bottom of the last recession, retail sector change has been focused on the new smartphone and tablet devices that are facilitating a whole new way of shopping and buying.

These changes are affecting how retailers use space, how much space is needed, and how it is valued. In the body of this report, we describe these forces and advise investors to pay attention.

Ecommerce update is only the beginning In recent years, change related to technology has taken center stage. It started slowly as merchants and consumers discovered the Internet. The U.S. Census Bureau began collecting data on retail sales transacted on the Internet for calendar year 1999. For that year, “ecommerce” totaled $4.6 billion out of total retail sales of $724 billion, or 0.6% of the total. The most recent data for the first quarter of 2012 shows the proportion has grown at a fairly steady upward pace to 4.9%. The more startling measures are the comparative annual growth rates of retail sales overall versus ecommerce sales separately; as shown in the Exhibit 1, the former has grown just over 3% per year on average since 1999 while the latter has grown in excess of 20% per year on average over that period.

Exhibit 1 Retail sales and ecommerce – quarterly growth rates Retail sales Ecommerce sales 80 60 % change 40 20 0

-20 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: U.S. Bureau of Census Shopping: a whole new meaning As a retail property investor, TIAA-CREF has monitored the growth in ecommerce carefully over this entire time frame. We have dissected not only the overall growth path of ecommerce but also its composition across product categories, its impact on consumer behavior, its relationship to traditional retailers, and its impact on retail real estate investment prospects. Initially, ecommerce was largely focused on “pure play” web retailers who accounted for 80% of the $15 billion in ecommerce retail sales in 1999. These pure play web retailers include Amazon which pioneered web retailing beginning in 1995. Exhibit 2 shows that 1999 ecommerce sales were concentrated in computer hardware, books and magazines. Among traditional “bricks and mortar” retailers, some had online capabilities in 1999, but only auto and parts dealers (not shown in the exhibit) had significant ecommerce sales, amounting to only 0.2% of their total sales.

Since 1999, both pure play retailers and traditional retailers have grown their online sales at roughly the same 20%+ annual rate. The more striking development is the increasing diversity in the types of products that are sold online, in particular, the increasing popularity of online sales of clothing and accessories along with electronics and appliances. In 2010, clothing and accessories accounted for 18% of the sales of ecommerce retailers, up from 8% in 1999; electronics and appliances accounted for 13%, up from 4% in 1999.

Exhibit 2 Web retailers sales – 1999 ($ millions)

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Traditional retailers responded to the growth of web retailers by building up their own ecommerce efforts over the last decade. Clothing and accessory retailers boosted their online sales from almost nil (0.1%) in 1999 to 1.6% of their total sales in 2010. Electronics and appliance retailers rose from 0.3% of 1999 sales to 1.1% in 2010. Capacity to accept in-store returns is an advantage for the online offshoots of traditional retailers. Additionally, online sites can encourage store visits by customers who want to see, touch and try on before buying.

The surge in ecommerce sales of clothing & accessories and electronics & appliances represents a sea change in the conventional wisdom that grew up in the early years of ecommerce. That alleged wisdom focused on the relative invulnerability of some product categories to ecommerce incursion. In particular, clothing and shoes were defined as difficult to sell online because of consumer preferences for seeing, touching and trying on. The strength of these preferences was vividly demonstrated in the absolute low level of such sales online; in 1999 it amounted to less than 1% of total clothing and accessory sales. By 2010, the absolute level of online clothing and accessory sales amounted to 10.6% of the total. The sea change is not entirely the tenfold growth in sales but rather the recent enhancements in technology and consumer preferences that point to further erosion ahead in the role of traditional retailing.

New devices and new activities The most significant shift in technology affecting the retail sector is the recent explosion in smartphones. Smartphones are cell phones enhanced by fast and powerful “3G” (third-generation) and “4G” (fourth-generation) technologies. These devices offer all the functionality of older mobile phones along with new functionality and access to a mushrooming array of special applications (“apps”). Official government data on these devices and their uses is not available, leaving our analysis to depend on myriad private sector surveys. These data sources cannot be merged together as seamlessly as more comprehensive government survey data but, nonetheless, the consistent and vivid story that they tell supports the conclusions that we develop in this report.

According to a Pew Research Center Survey conducted in early 2011, 83% of Americans owned a cell phone of some type, little changed from 2010. However, between 2010 and 2011, cell phone equipment was quickly transitioning toward smartphones. A survey from media consultant ComScore covering the last quarter of 2011 shows that 42% of Americans with cell phones had smartphones at that point in time, up from 27% one year earlier. That 50% one-year surge in adoption of smartphones is nothing short of phenomenal! It probably reflects both the short user life of cell phones along with the coming of age of the tech-hungry Gen-Y population cohort.

Within that cohort, various surveys show smartphone ownership of more than 50% and among college students separately as high as 80%. The phenomenon is global according to ComScore, with the U.K., Spain and Italy showing even deeper penetration of smartphones than the U.S.; France and Germany are slightly behind the U.S.

Shopping: a whole new meaning | June 2012 3 Shopping: a whole new meaning

The surge in smartphone adoption has been accompanied by a broadening in how consumers use their phones. Most important to this discussion, smartphones were used to access online retail content by 28.5 million consumers in 2011, an increase of 87% from the prior year. This followed on top of a 53% increase in 2010. The range of retail-related activities is enormous; it includes scanning product codes and comparison shopping, finding store locations and maps, downloading coupons, accessing product information, sending product pictures and text to friends to gather opinions, checking product availability, and connecting with “flash” or loyalty sites. As shown in Exhibit 4, these activities are becoming pervasive among smartphone owners.

Exhibit 4 Use of smartphone/tablet shopping features

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Source: Alix Partners Consumers can perform these activities anywhere and anytime; many of them do so while physically inside stores or in faraway countries. In sum, smartphones are creating what ComScore calls “Internet use on-the go” and thereby changing what it means “to shop.” Further complications are brewing as tablet devices such as the iconic Apple iPad offer another venue for “Internet use on-the-go.” According to ComScore, 14% of U.S. mobile owners also owned a tablet device at the end of 2011; that represents a 40% surge in two years.

The incursion of smartphones and tablets into ecommerce has been enormous over the last year. ComScore reports that in the fourth quarter of 2011, 9% of ecommerce sales were conducted through smartphones or tablets. This is triple the portion for the fourth quarter of 2010. The explosive growth in use of these devices for purchases is a clear signal to retailers of the need to pay attention.

Shopping: a whole new meaning | June 2012 4 Shopping: a whole new meaning

Retailers in the new age Some retailers are indeed paying attention. In 2011, 33% of U.S. retailers surveyed by Boston Retail Partners had mobile-enabled websites, up from 12% in 2010. Cutting-edge traditional retailers are recognizing the increasing difficulty in distinguishing in-store from online sales activity as customers use their smartphones and tablets to do both simultaneously. Of the 400+ publicly traded retail companies, 65 are now blending their in-store and online sales reports, and many are integrating their in-store and online relationships with customers. The integration includes creating a consistent brand identity across venues, offering mobile apps and websites with in-store connections, designing targeted and personalized emarketing and web-connected loyalty programs, using in-store events and experiences to draw shoppers, constructing self-checkouts and ereceipts using mobile devices, equipping sales staff with mobile devices to check inventory, place orders, and facilitate checkouts. Such integration has been dubbed “omni-channel” retailing by the trade publication Retail Maxim which defines it as “one seamless vertical channel that fully integrates the entire supply chain and point-of-sale (consumer).” The retailers adopting these omni-channel initiatives are reported to have had stronger sales gains; the Max-SI publication shows a 6.0% increase in sales of omni-channel retailers in 2011 compared with a 2.8% gain for retailers as a whole.

A further innovation is integration across separate businesses and channels as exemplified by WRAPP, a “social gift-giving service.” WRAPP operates through Facebook accounts and allows users to give a variety of gift cards from merchants such as The Gap, Sephora, and H&M. Gift cards can be redeemed via smartphones for either online or in-store purchases.

These results demonstrate the benefit that traditional retailers can obtain from innovation, but the relatively small portion of the retailer universe embracing these innovations is noteworthy. While shortsightedness might seem to be a good explanation, it is probably less important than the difficulty in financing the high cost of innovation. As a whole, retailers do not have abundant resources as demonstrated by the sector’s 2011 operating margin holding at roughly half of the S&P 500 average. Moreover, omni-channel initiatives can be costly both in terms of capital expenditures as well as specific operating expenses. An example of the latter is the hit to department store operating margins in the first quarter of 2012 that Citigroup equity analysts attribute to free shipping associated with promoting online sales.

Citigroup equity analysts also report that U.S. retailers are on average allocating 11% of their capital expenditures to information technology (IT) in 2012 and that this represents a 3.5% increase from 2011. Targeted investments include mobile and social media technologies along with improved ecommerce capabilities. Macy’s, Nordstrom, and Saks all announced new initiatives in May 2012. Citigroup further reports that among retailers 53% are increasing their 2012 IT spending, 30% are making no changes and 17% are cutting their IT budgets. This disparate behavior points in part to the varying degrees of resources available to retailers.

Omni-channel retailing is also emerging among online retailers who are opening physical stores to provide service and enhance brand identity. Amazon is said to be planning a physical store in Seattle that could become a national chain. Ebay has spawned a 12-state network of franchise stores under the name “iSoldit” that provides services to Ebay sellers.

Microsoft has 22 physical stores so far according to its website which offers a coupon for in-store use and touts the service and “experience” available in its stores. Google is experimenting with a physical store in London. Apple is the leader in these efforts; Apple stores are increasingly eschewing actual merchandise in favor of personal interactions at the “genius bar” and product showcasing.

Shopping: a whole new meaning | June 2012 5 Shopping: a whole new meaning

Merging social media and shopping Beyond this, a whole new form of retailing is taking shape around “daily deal” and flash sales models. The poster child in this category is Gilt, an “invitation” site that has acquired 5 million users over four years and an estimated company valuation of $1 billion. From its cutting-edge perch, Gilt is reaching into omni-channel world with a planned men’s clothing store. A more recent and equally phenomenal example of this genre is Fab.com, a membership site that sells home design items in daily flash sales. Fab.com has amassed

4.5 million users and $400,000 per day in sales over the twelve months since going live in June 2011. From the other direction, several more traditional retailers are establishing or buying daily deal and flash sites including Nordstrom (bought HauteLook), Saks, NeimanMarcus, and Amazon. ComScore reports that nearly 25% of consumers purchased a holiday gift on one of these sites in 2011.

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