This is the final article in our series exploring five areas that have been experiencing tremendous growth through strong technological innovation or by leveraging advances in the internet. We refer to these five areas as SCODI, which stands for:

  • Software as a Service (SaaS)
  • Cloud
  • Online retail
  • Digital payments
  • Internet of Things (IoT)


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Online retail and digital payments: Hand in hand

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Online retail and digital payments are inextricably linked, because shopping online requires paying online—and both areas continue to grow rapidly, boosted partly by the proliferation of smartphones and other mobile devices that make it extremely quick and easy to buy online, anytime.

Online retail has been expanding at a rate roughly three times faster than the retail industry overall, and recent data suggest future retail growth will be primarily online. In fact, online retail has been growing much faster than the overall retail industry for a number of years, as seen in Chart 1.

 

 

Chart 1

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Online retail’s rapid growth has been driving impressive sales numbers. According to the U.S. Census Bureau, U.S. e-commerce sales hit $127 billion in the second quarter of 2018—a 15.2% year-over-year increase

What have consumers been buying online? ComScore, Inc., provides insightful data on online retail, which reveals several interesting trends. During the fourth quarter of 2017, one of the fastest-growing online shopping categories was apparel and accessories, where sales were up 27% year over year. Another top category for online purchases was home furnishings: Sales jumped 21% year over year during those three months.

It’s also important to recognize the breadth of product categories that have experienced robust growth in digital sales; a majority of retail categories covered by comScore—including apparel/accessories and consumer electronics—generated over 15% growth in digital sales in 2017. Clearly, the reach of online retail has been expanding, which reinforces both its magnitude of growth and its longevity.

Even though online shopping has been growing faster than the overall retail industry, it still has a long runway for future growth. Despite its popularity, online sales currently account for less than 10% of retail sales overall. Increasingly, mobile commerce is becoming a key driver of total online sales given the widespread use of smartphones and as consumers have become more comfortable using payment apps. Chart 2 illustrates the rapid growth in mobile commerce, which still represented only about 24% of total online sales at the end of 2017, according to comScore.

Chart 2

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Consumers’ rapid shift toward online retail has been driving the transition from cash-based to digital transactions. According to the World Payments Report 2017 from Capgemini SE and BNP Paribas, electronic payments and mobile payments are forecast to grow at a compounded annual growth rate of 17.6% and 21.8%, respectively, from 2015–2019. The acceleration in digital payments presents a large opportunity for payment-network and payment-processing companies.

With the rapid shift toward paying online, payments companies have needed to evolve—they’ve had to develop payments technology that works well in a world increasingly driven by electronic transactions. It may seem simple: The consumer enters a credit card number, and three to four seconds later, the purchase is completed. But behind the scenes, there are entire payment systems that enable digital-payment transactions to take place. It takes five types of companies to make every digital payment happen:

  1. Retailer acquirers: Companies that provide retailers with the ability to accept electronic payments
  2. Retailer processors: Specialized companies that handle the front- and back-end processing of payments transactions on the behalf of retailers
  3. Card networks: Credit card companies that connect the two key parties in transactions—retailers and consumers
  4. Issuer processors: Companies that represent cardholders in transactions
  5. Card issuers: Companies (typically, banks) that provide credit and credit cards to consumers

Every time a consumer makes an online purchase, the retailer the consumer is buying from pays a payment-processing fee, and each company involved in the payment system for that payment transaction receives a portion of the fee. So, companies involved in different facets of online payment systems stand to benefit from growth in online purchases.

What might investors underappreciate about online retail/digital payments trends?

  • The e-commerce market might grow much bigger than expected. Consumers keep increasing not just the quantity but also the variety of products—like groceries and auto parts—that they’re willing to buy online, leading to annual e-commerce growth rates in the mid-teens over the past few years. This trend shows no signs of slowing over the near term.
  • As e-commerce grows, so do digital payments. By necessity, growth in online shopping boosts the volume of digital transactions that consumers expect to be instantaneously processed. This expectation, in turn, drives up demand for the services provided by payment network and payment processing companies. Digital payment demand has been further aided by the rapid shift toward mobile e-commerce.
  • Mobile transactions likely may be growing faster than investors realize. In recent quarters, mobile commerce has been growing more than 30% year over year, a robust pace that might continue for several more years. As consumers become more comfortable shopping via their mobile devices, the positive impact on digital payment volumes could be substantial.

 
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Internet of Things: Is there a limit to the possibilities?

Through a variety of wireless solutions and sensors, the IoT takes advantage of systems connected to the cloud to make a wide range of everyday items “smart”—like garage door openers, home security systems, TVs, and kitchen appliances, among thousands of others. But the IoT also has a wide range of business applications, such as in industrial controls. While devices can be independently connected, and many of them are, they also can be set up to share data. This capability provides important benefits for businesses, such as optimizing data by connecting multiple devices together.

Gartner, an information technology (IT) research firm, has projected that the IoT will grow at a 32.9% annual rate through 2020—reaching an installed base of 20.4 billion units—and expects that 6.5 billion “things” will ship In 2020, with 64% of them directed toward consumers. This anticipated level of growth offers a tremendous potential opportunity for semiconductor manufacturers in particular, which sell the key item needed to provide connectivity to “things.”

What might the market be overlooking about the IoT? 

  • It’s likely that many more everyday things than investors can imagine may be made smart. We think the market underappreciates not only the digitization of high-profile products like driverless cars and artificial intelligence but also the electrification of everyday products. For example, roughly 5 to 10 years ago, about 50 semiconductor components went into an automobile; today, there are more than 300.
  • Increasing the electronic content within various things may drive more sustainable growth for well-positioned semiconductor companies. The growing number of electronic functions added to industrial equipment and attempts to make even simple machinery smarter have been driving up demand for semiconductors. The higher demand in turn helps remove much of the cyclicality that had been the norm within the semiconductor industry. We believe this improves the long-term visibility into the earnings power of semiconductor manufacturers.

Companies with meaningful exposure to online retail/digital payments and/or the IoT appear attractive relative to the market The table below shows the valuations and fundamentals of companies in the online retail/digital payments and IoT groupings. The IoT group is composed of companies in the semiconductor industry, and this group appears to be trading at attractive valuations relative to the market and to possess above-market growth potential. The online retail/digital payments group, largely found in the online retail and IT services industries, is trading at a slight premium to the Russell 3000® Growth Index; however, based on this group’s higher three- to five-year projected earnings-per-share (EPS) growth rate relative to the index, online retail/digital payment’s growth potential continues to be compelling.

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Index definitions

Within the online retail/digital payments and IoT groups, we believe the most favorable opportunities often are companies that can successfully innovate their products. This capability enables companies to increase market share as well as expand into new, rapidly growing markets.

SCODI: Five high-growth areas that have been disrupting the marketplace

For investors seeking companies focused on technological innovation or benefiting from advances in the internet, the areas explored in this series—SaaS, the cloud, online retail, digital payments, and the IoT—offer potentially compelling and underappreciated opportunities. In late September, changes to the Global Industry Classification Standard methodology will affect the sectors in which many of these companies are located. Following those changes, broad exposure to SCODI-themed companies may be achieved by allocating within multiple sectors—including consumer discretionary, IT, and communication services.

 

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