Ecommerce -- the most happening part of the retail industry -- doesn’t operate exactly like its brick-and-mortar counterpart. While goods and services do change hands, there’s a completely different infrastructure involved, whether it’s the marketplace, logistics or payment systems. That’s because each of these things is necessarily driven by technology.

The recent past has, however, seen traditional retailers like Wal-Mart (WMT Quick QuoteWMT - Free Report) investing increasing amounts into building this technological infrastructure, even as Amazon (AMZN Quick QuoteAMZN - Free Report) takes an increasing interest in brick-and-mortar operations to drive efficiencies in its delivery system.

Retail ecommerce is also unique because a single company (Amazon) accounts for most of it, is the major trend-setter and the greatest influencer on the entire industry, at least in the U.S. While new players are emerging, it won’t be easy to unseat Amazon simply because of its size, experience, prices and loyalty program. So it’s only a company like Wal-Mart, which has similar resources and huge experience that can hope to truly challenge the ecommerce leader. And that’s still a few years off.

The other major point of difference is the fact that, unlike traditional retail, it’s relatively easy for an advertiser or other Internet service provider to also get involved in the retail process, and thereby siphon off some of the profits.

The following diagrams seek to define the broad spectrum of companies primarily dependent on the Internet for the distribution of their goods and services.

 

As evident, the Internet-supported buying and selling process mainly includes three Zacks categorized sectors, i.e. Internet - Commerce, Internet - Services and Internet - Delivery Services.

Over the past year, the Internet - Commerce segment outperformed the S&P 500 by a wide margin. The sector appreciated 48.8% during the period, compared to the S&P 500’s 14.9%. It is also up 38.8% year to date compared to just 8.3% for the S&P 500.

This segment is obviously in the growth phase because revenues are surging (up 54.4% in the last two years ending 2016). EPS before non-recurring items was up 25.9% on a share count that declined about 2.0%. Forward earnings estimates are trending down, however, indicating that the industry is currently in investment mode.

The Internet - Services segment hasn’t done quite as well, having grown 21.0% in the past year. The sector broke away from the S&P 500 after quarterly results started coming out in mid-April. The revenue growth rate of around 47% was slightly slower than Internet - Commerce in the last two years.

The business has a stronger-margin profile, with EPS growth at around 36% on a share count that is being gradually lowered. Estimates for the segment are trending up since the June quarter of 2016.

The Internet - Delivery Services segment has been the most sluggish, trailing the services segment with a growth rate of 19.9%.

Revenue has grown 83.2% between 2014 and 2016, with the gross margin remaining relatively consistent. Opex and interest expense have risen steadily, impacting the EPS before non-recurring items. The debt-to-total-capital ratio dropped in 2015 and remained steady in 2016 with both debt and equity increasing.

Market Trends

The ecommerce marketplace is influenced by both buyers and sellers. Moreover, there are multiple trends -- big and small, old and emerging -- that are always in play. So it helps to take a quick look at what’s going on-

Buyer Trends & Preferences

Ø  Mobile, Wearables: These remain as important as ever, as users are increasingly accustomed to “anytime, anywhere” shopping. The online store never closes, nor does the online payments machinery. Even brick-and-mortar sales are supported by mobile apps that increase awareness of products and push promos at opportune moments. Payments tech from Apple (AAPL Quick QuoteAAPL - Free Report) , Alphabet GOOGL, Samsung, Alibaba BABA, PayPal PYPL and others help the electronic transfer of funds to stores. eMarketer estimates that smartphones will remain a huge driver, growing to 50% of mobile commerce in 2017 and 53.5% by 2020. Larger mobile screen sizes, new categories (cars, grocery, luxury that were earlier restricted to offline purchase) and greater comfort in using online payment systems are the main drivers.

Ø  Social Networking: The traditional buying experience often involves friends or family getting together to look through merchandise and select after much discussion. The online experience has been more restrictive in this respect. Despite the fact that personal recommendations and comparison shopping have been around for a while, these are helpful in making a selection, but don’t make buying a collaborative exercise. So the shopping experience has been more of a chore than fun. Once the novelty of doing things online wears off or for those who have been doing it online from the get-go, there will be a natural tendency to start looking for more, so this is where social networks like Facebook and Twitter , for example, will start playing a bigger role. Others like Pinterest are already travelling this path.

Ø  Voice Search: Merkle’s Digital Marketing Report for the first quarter indicates that Google AdWords increased 19% sequentially and 21% year over year in the first quarter of 2017, with product-listing ads being one of the hottest trends. Product-listing ads (PLAs) accounted for more than half of retail search ad clicks, growing 48% sequentially. Spending on Google Shopping increased 32% year over year. The continued popularity of mobile search helped Google. Google has said that 20% of searches through its mobile app and Android devices are voice searches. Therefore, it’s clear that voice search is no longer a novelty but an emerging trend for shoppers. 

Ø  Geography No Barrier Anymore: These days, if people want to buy something they don’t get at the retail store, the first thing they do is check online (or they might check online first and decide their point of pickup accordingly). So the world is getting ever smaller as shoppers see local, state, national and international barriers melt away. Satisfaction, of course, leads to higher expectations.

According to Frost & Sullivan, Southeast Asia (only Indonesia, Malaysia, the Philippines, Singapore, Thailand and Vietnam) is poised to become one of the world's fastest-growing regions for ecommerce revenues, growing from around $11 billion in 2015 to more than $25 billion by 2020.

According to Forrester research, the five key Asia/Pacific markets of China, Japan, South Korea, India and Australia will almost double from $733 billion last year to $1.4 trillion in 2020. Size and population density in China and India make them very important markets. So let’s just touch upon prospects in the Chinese and Indian markets since they are on a very strong growth trajectory.

China

According to Forrester, China will remain the biggest ecommerce market in the next few years generating 9X the size of the Japanese market and 17X the size of the South Korean market by 2020.

With the digital revolution in China, many Chinese have multiple devices they use to research a product or shop. Devices will take a new turn this year as virtual reality (VR) starts playing a bigger role taking consumers from the “VR café” experience they enjoyed in 2016 to devices enabling the experience. eMarketer quotes a GfK forecast that retail sales through VR devices in China will grow from RMB 650 million in 2016 to RMB 1.6 billion in 2017. Moreover, all the big ecommerce companies like Alibaba, Tencent (TCEHY Quick QuoteTCEHY - Free Report) and LeEco will continue to invest heavily in VR this year.

Cross-border trade is another driver, as young Chinese are extremely brand-conscious and like to buy foreign goods, especially if they’re from the U.S., South Korea or Japan, and especially in categories like food, dairy, personal care and beauty. But local brands are increasingly capturing “mind share,” especially in electronics and mobile phones. The Chinese Ministry of Commerce says that cross-border transaction value will make up 20% of total Chinese foreign business and continue to grow at over 30% a year.

The Ministry also sees a growing number of Tier 2 and Tier 3 cities coming online, with only 10.6 million of the estimated 159.9 million new users between 2015 and 2018 coming from Tier 1 cities.

India

According to the ASSOCHAM-Resurgent India study, the number of people shopping online will grow from an estimated 69 million in 2016 to 100 million in 2017, driven by a growing number of digital natives (including people in their early teens and from Tier 2 and Tier 3 cities), better logistics, broadband and Internet-enabled devices.

Mobile commerce will be 45-50% of total retail sales this year compared to 30-35% in 2016. Popular categories in 2016 were apparel, which grew 85%, mobile phones 68%, cosmetics 25%, watches 75% and artificial jewelry 65%.

Seller Trends, Strategies

Ø  Focus Shifts from Device to Consumer: This is a direct offshoot to the phenomenon that many people currently use multiple devices so that the device on which a product is researched is not necessarily the one where the purchase is completed. Also, the purchase may finally even be completed in the physical store, leading to what is being called the online to offline (O2O) trend. Therefore, it has become important to follow the customer on the various devices rather than follow the device. This understanding is still relatively nascent, but it’s a trend that is catching on.

Ø  App Versus Mobile Web: As the ecommerce market matures, it’s becoming very clear that smaller players can’t compete with what companies like Amazon offer. Also, their customers don’t already know them, which means that they aren’t eager to download their apps. These players need a platform to be able to display their wares and promote their brands. This is where Google plays an extremely useful role, as the search engine can now pick out and display relevant information not just from across the web but also from individual apps that have been indexed. As smaller players are more dependent on the mobile web, its importance versus apps is increasing by the day.

Ø  Omnichannel Approach: Logistics is one of the most important considerations for ecommerce retailers. Whether building their own warehouses like Amazon does or relying on specialists like Alibaba does, ecommerce companies are required to act nimbly because customers want quick delivery and quick return options. For smaller etailers, it doesn’t make sense to go it alone as customers are hard to serve and the business is hard to scale. So they usually prefer to join an online marketplace to leverage their capabilities.

The challenge is more complex for the big players because the number of buyers and sellers is growing as is the volume of transactions. Amazon deals with this through its warehouses and encourages sellers to store with it through the Fulfillment by Amazon (FBA) initiative. FBA requires sellers to store inventory in Amazon warehouses with Amazon taking care of sales and support. This helps to cover cost of the warehouses that Amazon needs to invest in anyway. In some cases, Amazon ties with retailers to use their brick-and-mortar locations as pickup points for customers with those requirements.

Amazon has also leased 21 aircraft to support its logistics operations. It is has also taken the lead with respect to drone deliveries, having secured necessary patents and having tested the technology in countries where drones aren’t effectively banned. So just about as soon as the FAA approves the concept, Amazon drones will take to the skies.

For big traditional retailers, omnichannel is a stepping stone to the online world. They already have the logistics and physical stores in place, though of course they are adjusting locations in line with expansion plans. So while they continue to invest in the physical store experience they are supplementing this with online channels to expand their reach. Book online and pick up at store is a popular model for them.

Ø  Technology Investment: Traditional retailers like Wal-Mart and Target (TGT Quick QuoteTGT - Free Report) want to build their online apps/websites/storefronts in a way that they can preserve their brand value while expanding their reach. Therefore, they are in competition with the big online players rather than in partnership with them. Online players are faster to adopt new technologies that help them improve navigation and customer experience, which in turn improve reviews and thus draw more traffic to them. But traditional players are getting involved, too. For instance, beacon technology that enables retailers to track customers in the store and push promos and offers to them is expected to increase in importance. New payment technologies such as near field communication (NFC), quick response (QR) code, Soundwave and Bluetooth low energy (BLE) are facilitating the process. Innovative new technology is influencing every aspect of the buying experience spanning gadgets like TVs and game consoles that are increasingly getting connected to digital versions of books, music, video and games that are becoming available for online purchase and consumption.

Ø  Advent of Chatbots: Social networking platforms like Facebook Messenger, Twitter, WhatsApp and Google Allo are warming up to the idea of chatbots. Businesses are increasingly operating globally, across time zones and catering to customers that expect immediate availability. But it’s not always possible to have customer service people on the job at all hours because of a dearth of resources and other constraints. But with chatbots, people can get personal queries answered, as and when they require. Some platforms like Facebook Messenger already have a large number of chatbots on them, so users are getting used to the idea. And companies that can’t get people to download and/or use their apps (though Google is making this easier by crawling apps for indexing and Android Instant Apps), have the option of getting their chatbots on a social networking platform to interact with consumers.

Ø  Discounting Remains Important: The market is more competitive than ever before, so retailers compete very hard on the number and percentage of discounts. One format that Groupon (GRPN Quick QuoteGRPN - Free Report) pioneered didn’t do so well, however, because of the low barriers to entry. The company has since launched a marketplace to increase scale.

Emerging New Format

Alphabet has launched “Purchases on Google,” which is a variation of its usual product listing ads (PLAs) for Android and iOS devices. The objective is to speed up the purchasing process for customers. There are no additional charges/CPCs for these ads. The Google carousel displays the products in the usual way, but if they qualify, a “Buy on Google” message appears that leads the user to a seller-branded page. Either fresh payment information or the details stored with Google allows immediate checkout from this page. Google only processes the sale but order fulfillment, customer interaction and customer data remain available to the retailer.

The Zacks Industry Rank

We rank the 264 industries across the 16 Zacks sectors based on the earnings outlook and fundamental strength of the companies in each industry. As shown in the diagram above, two (Retail/Wholesale and Computer & Technology) of the 16 broad Zacks sectors are related to the ecommerce industry. The outlook for industries positioned at #88 or lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Internet - Commerce, Internet - Services and Internet - Delivery Services have ranks of #51, #58 and #217, respectively, meaning that the first two have ‘Positive’ ranks while the last one is ‘Negative.’

Earnings Trends

The broader Retail sector, of which Internet Commerce is a part, is doing better than the S&P 500 so far this quarter. However, revenue growth of 4.9% fell short of the S&P 500 average of 6.6% with earnings growth of 9.0% also below the S&P 500 average of 10.8%.

The beat ratios were also disappointing, which is kind of understandable since the bulk of the retail sector comprises more mature companies, so estimates are more accurate than other sectors (like technology, for example). This quarter, the sector is expected to report revenue and earnings growth of -0.4% and 3.9%, respectively. For comparison purposes, the S&P 500 will grow 4.6% on revenue and 5.9% on earnings.

The other companies we are discussing in the e-commerce outlook fall under the broader Computer & Technology sector. The sector hasn’t done as well as retail so far in the second quarter, posting revenue and earnings growth of 6.6% and 11.6%, respectively. The revenue and earnings beat ratios are both 100%. This quarter, it’s expected that revenue and earnings growth will average at 6.0% and 9.9%, respectively. 

Take Your Pick

While we generally prefer stocks operating in strong industries at any point of time, a negative sector outlook doesn’t mean that there aren’t any good picks at all.

Zacks methodology helps us find the stocks that have upside potential despite the hiccups.

So at the moment, we can recommend Internet-Commerce stocks like Alibaba, PetMed Express (PETS Quick QuotePETS - Free Report) and Autobytel . They are leading players in their served markets, carrying a Zacks Rank #1 (Strong Buy). You can now see the complete list of today’s Zacks #1 Rank stocks here.

As far as Internet - Services stocks are concerned, we like Autohome ATHM, which has a Zacks Rank #2, as well as TiVo , Yirendai YRD, Bridgeline Digital (BLIN Quick QuoteBLIN - Free Report) and HealthStream HSTM, which also have Buy ranks.

The stocks in the Internet - Delivery Services segment aren’t recommended at this time; MakeMyTrip, with a Zacks Rank #2, is an exception.

Background/Description

Ecommerce remains a fairly small part of total retail at just 7.1% of U.S. retail sales, but eMarketer is optimistic that the share will grow to 9.8% by 2019. Note that the share of ecommerce sales in total retail sales is relatively lower in the U.S./North America with Western Europe and Asia/Pacific already doing 7.5% and 10.2% of their purchases online.

The U.S. Census Bureau says that the manufacturing sector is relatively more reliant on e-commerce (60.9% of their total shipments), followed by merchant wholesalers (27.7% of their total sales). These two segments make up the business-to-business (B2B) category.

Retailers and service providers generated just 6.4% and 3.8%, respectively of their revenues online, with retailers growing faster than service providers. The Bureau categorizes these two segments as business-to-consumer (B2C).

Manufacturers and retailers grew their business double-digits, while wholesale and services saw single-digit growth. [All the above data from the U.S. Census Bureau relate to 2014, as published in June 2016.]