The U.S. retail marketplace is in the midst of a revolution, with technology accelerating changes in the way consumers shop and the ensuing fallout ripping through the capital markets. Through the years, Amazon has been at the forefront of these changes, wreaking havoc and taking market share across spending categories. Most recently, the company has taken another step forward with its offer for Whole Foods Market. Perhaps the largest untapped opportunity for e-commerce, groceries have officially joined the ranks of the disrupted consumer-spending categories.
So what are the implications for fixed income markets? As distortions within the apparel category have revealed so dramatically, the value at risk is significant, literally destroying business models that have been in place for decades. We believe the Whole Foods deal represents a game changer in that same sense, albeit with varying degrees of value at risk across fixed income markets. While the disruption will likely take years to play out and new dynamics will continue to emerge, the current perspectives of Voya fixed income team are highlighted below.
Real Estate Finance and CMBS
Retail has gone through many transformations over the last 50 years. Decades ago retailers were local, and most were in downtown locations. Wal-Mart decimated these urban local retailers, making many of these cities ghost towns. The world moved to suburban areas; the basic layout was multiple large boxes with regional and local retailers in between. Many of these developments were vast asphalt deserts with little or no vegetation. The first signs of competition from technology became evident in the late 1990’s: Amazon was taking hold, and there was a proliferation of grocery delivery companies. The demise of traditional brick and mortar retail as we knew it was in the mainstream media, but quickly evaporated as the technology bubble burst in 2000. The next major challenge to retail was the global financial crisis, when many retailers weakened by the likes of Amazon ultimately failed. Retailers such as Borders (the examples are many) left large retail centers. In most cases, this space was backfilled by stronger retailers and spaces were reconfigured to accommodate fresh concepts. Lessons learned over these twenty years are clear: well-located retail will survive when owners are innovative and adapt to changing technology and consumer preferences.
While the dominant distributor of retail is now Amazon, the retail experience of the 2000s suggests this is not the end of retailers but a new beginning. The purchase of Whole Foods should have real estate owners and developers that are more willing than ever to adapt – and excited by the prospects for sustainably higher rents. Amazon’s presence in brick and mortar has been limited to distribution centers until now. Whole Foods has approximately 450 stores in what are considered attractive demographic areas and represent the first step in solving Amazon’s “last mile” problem. In blazing this path, Amazon will lead the way and be an example of how grocers (and other retail concepts) can successfully balance physical locations with an on-line presence.
The large grocery chains have anywhere from 2,000 to 3,000 locations; this new dynamic will create massive opportunities for landlords with well-located properties. Even if Amazon and others seek to grow modestly, that could mean a 4 to 5-time increase in physical locations for Amazon.
Now, this won’t be without complications. While it is still early to definitively see what Amazon will transform these stores into, some will need extreme retrofitting. One can expect that these sites will at least partially serve as pick up locations and act as showrooms if consumers want to see or touch before the purchase. For that prototype, stores will have to be in easily accessible locations with ample open parking areas that allow for quick ingress and egress across the property. Many Whole Foods are located in crowded centers – while an opportunity at the highest level, it does create challenges.
And empty big box stores may be just what Amazon may need to expand into. While these stores are hard to reconfigure, many of these assets have sat vacant and garner lower sale and rent prices. They have great ‘clear heights’ for warehousing and deep floor plates allowing for a showroom in the front and storage in the back. Taking this a step further, and of particular relevance to the CMBS market, think what Amazon could do to the prospects of a well-located B mall that is currently struggling to survive given existing retail dynamics.
There will be winners and losers as retail transforms; the most innovative and nimble owners will be well rewarded, as is already becoming evident in the apparel category. As always, poorly located or configured properties will continue to struggle, with these dynamics much more acute in the retail sector. While it is easy to predict the outright demise of retail, this acquisition is a signal that online retailers – even the most successful disruptor - still need a brick and mortar presence. This particular transaction has the potential to solve the puzzle of properly balancing an online presence with being located close to the consumer and to solving the “last mile problem.”
Investment Grade Credit
Amazon’s proposed acquisition of Whole Foods Market would be the largest in the company’s history and create the 7th largest grocer in the United States. This acquisition will provide Amazon with several competitive benefits in a segment which represents about 17% of all U.S. retail sales. First, Amazon will be able to leverage Whole Foods Market’s 460 physical stores to increase the penetration of its private label brands and sell Whole Foods Market brands to Amazon customers. This will likely provide greater Amazon Prime adoption and program usage. Similarly, Amazon may utilize the physical stores to facilitate fresh food delivery and speed delivery times to the grocer’s upscale customer base. Amazon will also gain access to vital store-based customer data on shopping habits of high-frequency grocery shoppers. Given its technological expertise, Amazon will likely utilize this data to refine its product offerings and streamline the grocery-shopping experience. Amazon will be able to combine its logistical expertise with Whole Foods Market’s fresh/frozen food distribution knowledge. Eventually, we would expect the company to roll out its cashier-less store prototype to Whole Foods Market locations.
The proposed acquisition has significant ramifications for consumer-oriented sectors of the corporate market. For retailers, this acquisition validates the value of omni-channel retailing, where physical stores and online channels complement each other. However, Amazon’s presence will significantly increase industry competitiveness. We expect Amazon to significantly lower prices, further depressing industry pricing and margins for food retailers. This comes at an inopportune time for the industry, given that the industry has already been dealing with food deflation over the past several quarters. The Whole Foods Market acquisition will likely spur additional industry consolidation amongst the other large grocery players. With Amazon signaling that it is open to buying brick and mortar retailers, other non-grocery retailers may need to defend against a potential entry of Amazon as a formidable omni-channel competitor. Finally, there are likely negative ramifications for consumer sectors beyond retailers. Given the fact that natural and organic goods will likely be more reasonably priced and more broadly available, this will be a negative headwind for large consumer packaged goods companies that are largely underpenetrated in the natural and organics space. In addition, restaurants may face stiffer competition if eating at home becomes less expensive and the delivery of fully-prepared meals becomes more readily available.
High Yield Credit
We expect further consolidation within the supermarket sector. Expectations are for ongoing margin pressure following a) the Whole Foods/Amazon deal and b) the earlier announced U.S. expansion plans from German deep discounters ALDI ($3.4bn to open 900 additional locations by 2022) and LIDL (inaugural 100 locations over the next year). Growing size and scale within the fragmented food retailing segment is becoming crucial against the backdrop of heavy promotional spending, increased competition from new entrants, and tight margins. With the exception of Albertsons, the High Yield supermarket sector is comprised of regional and specialty players that could become acquisition targets for larger, better capitalized companies looking to expand into new geographies. Going forward, we expect regional supermarkets will need to further invest in e-commerce and click-and-collect capabilities to maintain market share. In addition to regional supermarkets, we also expect wholesale distributors will experience headwinds as supermarket consolidation will lead to pricing pressure.
As can be gathered from the above, the Amazon Whole Foods deal is indeed a game changer. From a corporate credit perspective, competitive pressures, already intense, are set to ratchet even higher. Most immediately, grocers’ hands will collectively be forced to adjust their strategies. Implications clearly extend beyond, moving up the food chain (pun intended) to food wholesalers and laterally to restaurants.
From a commercial real estate perspective, the transaction – at the highest level – should be viewed positively by lenders and CMBS investors. It is a fresh, new expression by the largest disruptor in retail of the need for commercial real estate and a more traditional brick and mortar presence in execution of their strategy. While there will be fallout for commercial real estate space occupied by grocers that don’t adapt, the positives of this move outweigh the negatives. This should ultimately translate into value appreciation for owners of properly located commercial real estate, clear positives for loan products and certain CMBS.
Voya’s investment team endeavors to stay in front of the disruption in retail. Expect Voya’s fixed income platform to continue avoiding risks stemming from stale business models while capturing new, diversifying sources of value as investment opportunities emerge.
Past performance does not guarantee future results.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.