More Retail Notes - Identify Your Target
Board: Berkshire Hathaway
Personally, I dislike shopping and avoid stores like the plague (except Costco). If I have to drive someone to a mall I’ll sit in the car and read. On the other hand, I’ve worked a lot with companies ‘in transition’, and this has usually meant ‘distress’. This in turn has meant that I've somehow spent a disproportionate amount of time involved with retailers.
So, continuing on and hopefully addressing some of the subsequent comments to my original post:
With most industries, a five year look is not a bad stretch, and with retailers it happens to be convenient. 2007 happens to be a good ‘benchmark’ year. When we’ve seen retailers reporting earnings reports the past year or two, the first thought is usually to put the results into historical perspective – ‘ok, but how does that compare to 2007?’ (more on that in a minute). In another year or so, that benchmark of historical performance will cycle out, and many retailers’ results will reflect some improved five-year trends. Crappy 2008 or 2009 will be the starting point.
Over the long term, we’ve seen numerous short-term flashes. If we look at any five-year snapshot in memory, we’ve seen some remarkable performances in terms of sales and earnings growth.
We saw old-school Kresge’s recreate themselves to rapidly become the number-two retailer in the country, behind only Sears; we saw the category killers – notably ToysRUs - plus Sports Authority, Circuit City, CompUSA and others, drive general merchandise department stores and main-street retailers out of their segments, supposedly forever. We saw a new category of formidable mall retailers including Gap and the Limited corner a huge market share of the country’s apparel sales – a decade ago Gap accounted for almost 10% of US apparel sales.
We saw flashes from the Sharper Images and Abercrombie’s, with their out-sized mark-ups converting into remarkable gross margins -- for awhile anyway. We saw the rash of off-price merchants, who thrived on traditional retailers’ mistakes and inefficiencies -- until the sloths either solved those problems or folded. The ‘flashes’ are almost endless. The graveyard is enormous: http://en.wikipedia.org/wiki/List_of_defunct_retailers_of_th.... But how do we identify a sustainable model?
From this week’s Barron’s article featuring the Gap:
Dana Telsey, of the retail-stock research firm Telsey Advisory Group, says….she detected "continued improvement in the women's business," with enough freshness in Gap-brand goods that they're showing "an ability to move merchandise." She describes the Gap target, "basics with a flair," as still a work in progress, yet sees Old Navy's value offering as intact.
This might make those of us who look for ‘competitive advantage’ and ‘moats’ a bit apprehensive. Now no offense to anyone reading this, but most of us guys – at least those who weren’t into fashion from an early age – don’t want to be putting wagers here. For anyone who can hold up their end of a conversation with the Telsey’s among us, more power. But anyone with that gift might be better off just consulting for the industry than investing in it. The rest of us might think ‘circle of competence’.
Let’s say that we want to keep pursuing this, though. What are some things we should we look for in retailers that might set them apart?
Succinctly defined customer –
Retailers need to have a concise sense of their ‘target customer’ (aka ‘core’ customer). Back a couple of decades ago – late ‘80’s probably -- when Sears was still ‘number 1’ but fading fast, Crain’s Chicago interviewed the then-new president of the Sears retail group. The interviewer asked that terrific question: who is Sears’ target customer? The guy replied ‘everybody’. With that answer it was stunningly clear that Sears was dead – they just didn’t realize how bad it was. An update on this: Just yesterday Sears announced it was hiring a new CEO, Brookstone’s Boire. From the WSJ: Mr. Boire's expertise is in finding the right products to stock, a perceived weakness at Sears Holdings, which had been operating without a chief merchandising officer. At least that’s a step.
As with Sears, every time we see a wavering vision of ‘core customer,’ we can predict disaster. Witness Talbots. Or Walmart for that brief stretch beginning when they promoted a former Target exec to head of merchandising -- he immediately went for new target customers (plural!). Walmart fired him late last year and they have been coming back on track since.
Contrast that with one gruff old-school retailer – the CEO of a then-successful regional competitor to Sears. He described his customer succinctly as (something like): ‘She’s 55, 38C’. (I may not have this exactly, but one fashion executive in the room audibly choked when he heard the comment.) Now this isn’t to say that all of this retailer’s shoppers were this woman – but whether it was sofas, men’s accessories, juniors, infants, cosmetics, whatever, this shopper would be right at home, comfortable with everything offered – whether for herself, her husband, her daughter or her grandchildren. Unfortunately, the retailer didn’t long survive this CEO – it was gone within a few years of his passing.
Similarly, around the same time Crate & Barrel founder Segal made the comment that he could easily sell $50 million of Mikasa if he elected to carry it (a lot for them back then), but that he wouldn’t because stocking Mikasa would confuse his core customer.
Anyway, if we can’t get a succinct picture of a target customer, we should probably pass. I’d run.
This leads to the next element. Retailing strength is notoriously tied to the strength of the CEO. The more key-man dependency there is, however, the more we should be cautious. This is especially true of narrow-focus fashion-dependent retailers. The key person may not always be the CEO, but it will always be a senior merchandising person. The rest of the organization is important of course, but at the same time they are expendable – perhaps even interchangeable with other strong retail executives. At the best-performing of the narrow-focus retailers there will be a merchandising visionary – someone – without whom the company may have problems. The higher the gross margin rate, the more important this is key person is in establishing some competitive advantage.
As margins decline and operating efficiencies and vendor leverage (arm-twisting) are larger factors as competitive advantages, the merchant-superstar element is probably less vital than disciplines and structure. It’s still pretty important, however. Even with Walmart, we could get glimpse of the impact of a key merchandising individual. [As an aside, Costco founder Jim Sinegal retired this past weekend; we might be confident that Costco won’t miss a step, but it will be worth watching].
Even having a superstar merchant-CEO doesn’t guarantee continuing success. We’ve seen countless examples where once-successful retailers are eventually left behind while a few keep riding the waves, season to season. Former powerhouses like the Gap under Drexler and the Wexler’s Limited (ex-Victoria Secret) can fall off the crest and not get back. Some, like Abercrombie, have had good runs but we have to figure it’s a matter of time before they slip, or before their fickle target customer simply moves on for no predictable reason.
That said, there are always personnel plays – we saw the recent surge at Penneys with ex-Apple Johnson’s arrival. The guy may be a store genius (a cynic might grouse that with Apple capex checkbook and the stores’ near-exclusive preferential supply of Apple’s new products for the past five years, who wouldn’t look smart?) but success will revolve around better merchandising. Penney’s probably needs the Jobs of merchandising more than the Johnson of stores. Maybe he is that person, or maybe he can find that star.
On a slightly related note: As noted in the original post, KKR has populated Dollar General’s executive group with drug store execs. Are a chunk of the country’s 20,000 dollar stores – at least DG’s share – eyeing the country’s 20,000 drug stores for a piece of their enviable $300/sf non-pharmacy business? DG arch-rival Family Dollar recently followed suit, hiring a former CVS executive as COO and President. It may be shaping up to be an interesting battle.
Working capital % to sales
When we look at earnings and earnings trends, we should have a good feel for incremental working capital rates – the amount of working capital (inventory and receivables, net of payables) the company takes on for every dollar of additional sales. We might not be too concerned because it is net assets, after all, but incremental working capital requirements can just kill cash flow.
We can take this to other related businesses as well. We’ll remember awhile back the discussion about returns on book value. The example of McLane came up – discussing likely returns on their ‘book value’ which was loosely calculated here as Berkshire’s purchase price plus net capex. As that business has grown, however, it would have taken on additional working capital – a more subtle addition to ‘book’, both in the form of additional inventory and in McLane’s case, receivables (Walmart, notorious for extracting payment terms, is by far its largest customer). The point is that this often seems to be an under-analyzed area, and it is relevant here.
With retailers, not all working capital ‘models’ are similar. Most of the general retailers originally listed -- including the dollar stores -- employ working capital at a rate of about 5% of sales (adjusted to exclude excess cash, not tied to sales). Nordstrom’s working capital rate is at the high end of the group, at 15%. Walmart’s working capital percentage to sales is a bit less than zero, actually, thanks to good payment terms and high inventory turns. Costco’s rate is zero, excluding excess cash.
Again, the point here is that most retailers have some working capital burden attached to sales growth -- and this cash flow usage is by definition not reflected in the P&L. it’s a plus to book value, which might be a good thing if it were enhancing ROE versus being a cost of business, an ROE anchor. As we consider or compare retailers, we should be mindful of it.
Watch ‘incremental’ rates
This is the rate at which each additional sales dollar flows through to the bottom line – and during sales declines we look at the ‘decremental rate’, the amount of loss incurred with each sales dollar decline. The incremental earnings rate would at least theoretically correspond to: the gross margin rate, less truly sales-variable expenses. We want to see a rate that translates to earnings growing more rapidly than sales. It seems obvious, but it’s often overlooked.
Re-phrasing this, we can divide the change in earnings by the change in sales and see if the rate makes sense. On the upside, we’re looking for a rate that generally approaches the overall gross margin rate, suggesting good internal financial controls and operating disciplines. On the downside, where sales have dropped off, we want to see a (low) rate that reflects good expense controls in a contracting environment. With sales increases, we also want to watch incremental gross margin rates to be sure the retailer isn’t just giving goods away.
In terms of expense correlations, Amazon so far fails the test. They always have plausible-sounding explanations, but if we look at the actual line items, the expense increases don’t seem to match the spiel. Amazon does a lot of things right, and they are clearly strategically superb – formidable-- and they may end up ruling the world or something. But their incremental rates suggest that internally they are managed more like a dot-com-era sort of operation than a Walmart or Costco competitor (places that exhibit adult supervision over the checkbook. Amazon’s real challenge will come when sales growth eventually decelerates -- the quality (or deficiency) of financial disciplines will become apparent.
Looking at the group discussed on this thread: Low-margin Walmart coverts additional sales at about a half-point better than its overall earnings percent-to-sales rates (about 4.3%); Costco maintains its low sub-2% of sales rate, probably by design; Sequoia favorite TJX has been converting sales increases to earnings through the recession at a 12%;rate the dollar stores have been converting at about 10% the past few years, though Dollar General has spiked to a recent 20% conversion rate with some of its recent changes. On the downside, Penney’s has been dropping earnings at 35% of their sales decline, suggesting that they have not been operationally managing the decline well, at all; SHLD is at least doing a better job in that regard, with ‘only’ 14% of their sales decline flowing through to bottom line losses.
In short, retailers’ incremental/decremental rates can help give us some insights into controls and disciplines.
Beware the ‘big bath’
Decades ago Federated Department Stores (since renamed Macy’s) was famous for taking one-time charges – big baths -- followed by some period of steady growth. This got so bad that one influential retail analyst – it may have been Exxstein – refused to cover them until they shaped up. That was quite awhile ago, and we may not have seen too much of that recently.
About three years ago, Macy’s did take a mammoth $5B goodwill write-down – in case we’re wondering what happened to Macy’s equity along the way – but at least the charge was non-cash. Still, over the years struggling retailers have been somewhat prone to taking ‘one-time’ charges, so we just have to be alert to those.
Invert gross margins
High gross margins – as a refresher, the amounts left over after retailers have paid for goods and gotten them to their stores, but before they’ve paid expenses -- have historically be viewed as good things, and most retailers and investors agree. We might say ‘most’ because a handful – Walmart, Tesco, Costco (in other words, the world’s most successful and profitable retailers)—still work to keep gross margin rates low, on the premise that if their cut of the sales dollar is smaller, customers will buy more.
We can use that perspective ourselves – think like customers (and Costco) -- and consider gross margin rates to be the amount the retailer is marking up goods and still (usually) making money. The retailer’s mark-up, on one hand, is a reflection of how much ‘value-add’ the consumer perceives, but on the other, it’s a reflection of the retailer’s embedded cost structure. This might not be so apparent with unique or uniquely branded goods, for example for the ‘A+F’ stitched across the front of a garment. For branded items, however, this often becomes more apparent.
For example, if all retailers offered the same $20 (at cost) item: Costco could sell it at $23 and still make money (albeit, by making us buy it by the case); Walmart would need to charge $26; Target (and the dollar stores, on average) $28; and Macy’s and Kohl’s $31. To the extent there’s a perceived value-add, the higher-cost participants can survive. The reason Walmart switched away from its Target-like private label experience back to brands was to make this cost advantage more apparent to customers. They wanted customers to be able to compare, in their example, ‘Oreos to Oreos’.
To the extent that a retailer’s costs and margins deviate from the low-cost providers’, we have to be able to rationalize that in terms of some value that they have added. It costs Macy’s $5 more to put that item in a shopper’s hands than it does Walmart, or Kohl’s $3 more than it does Target. But does the customer perceive that value?
Think ‘market share’
We always need to think of sales and sales growth – either achieved or projected, in terms of both (a) market growth and (b) share of market. If projections, particularly, can’t be explained in those terms we should be skeptical. This isn’t just limited to retailing. Every projection in just about any business should be explained in terms of market growth (and inflation) and market share.
As we’ve seen here, we should also be careful of taking market-share estimation short-cuts. Earlier in this thread we saw the comment that if one retailer was showing a same-store-sales increase and another a same-store-sales decline, the one was ‘eating the other’s lunch’. Using this example, does ‘same store’ equate to market share? Of course not. The correct comparison is total sales, and not just the ‘same store’ component. If we think in terms of market share, and market participants, we’ll broaden our understanding of what’s actually happening in the market – who’s coming and going.
In any event, we should regularly touch base with the combination of ‘market growth’ and ‘market share’.
Not to be obvious, but one appeal to Berkshire holdings Walmart and Tesco is that, although they may be closing in on their maximum potential domestically, unlike most they have redefined their market as pretty much global. They still have relatively small shares of a larger and faster growing market than others can claim.
Five year perspective
Getting back to the 5-year perspective discussion at the top of this post --
Using 2007 as the starting point (using the retailers’ fiscal year-ends, for simplicity), and looking through to 2011, about half of the retailers in the original post still hadn’t returned to 2007’s level of profitable. Overall, for the group as a whole, 2011 earnings were still $1B behind 2007.
The two home improvement stores, the department stores and general retailers – Nordstrom, Macy’s, Kohl’s, JCP, SHLD – and Abercrombie and Talbots, were still not back to 2007 earnings levels. On the other hand, Walmart, TJX, Costco, Target, and the dollar stores – as well as the Limited (thanks to Victoria Secret)—earning more than they did in 2007.
We can read what we like into five-term trends – maybe we are able to extrapolate them into the future, maybe not. Looking at retailing history, most of the compelling story lines of the past eventually were supplanted. The dollar stores look well-position, but Walgreen’s and CVS probably aren’t going to sit still.
Beating this horse a bit more, if there’s one segment that looks like it may still be in its early years, with perhaps a good prospect of a run for awhile, it’s multinational mass marketing. Compared especially to the US, foreign markets are growing much more robustly, and markets shares are still small. Further, barriers to entry to retailing in the US are pretty low – there are enough carcasses, enough excess capacity, so anyone can start up something – but the market is saturated, and very competitive. And there’s Amazon standing right next to everyone. Serious competitiveness on a true multinational scale is an expensive proposition. If there’s a pair of retailers capable of capturing further global market share, it would seem like it might be Berkshire’s two sizable holdings: Walmart and Tesco.
Remodel = re-Model
Retailers have an ideal store format that they continually refine and occasionally revamp. It’s the format they’re using for new stores. Typically the chains perform remodels on stores gradually, on a cycle. (Remodels aren’t refurbishment or redecorating, they are re-models.) For a stretch, Target was remodeling 60 or 70 a year, or about 5% of their total. A couple of years ago, Target developed a new format, and decided to deploy their new store budget into a dramatic acceleration of this remodel program. The capex this year was about $2.7B.
Let’s put Target’s $2.7B of remodel capex this past year in perspective. Remember, Target elected to through its capex into major remodels the past couple of years rather than open new stores. In 2007 Target spent over $4B in capex, of which $3.1B was used to open 118 stores. $2.7B would have bought Target about 100 new stores, or just over a 6% increase in store count. (Doing the math, we can also infer that Target’s average store remodeling cost under this program is about one-fourth the cost of a new Target store).
In describing its remodel program for 2011 back at the beginning of the year, Target explained that the remodeling construction would take place in the first three quarters of the year. They said that when completed, it would have a 1.5% positive impact on Target’s comparable store sales. Doing some math again – 20% of stores were remodeled this year, suggesting we’d expect a 7.5% increase at the remodeled stores, above non-remodeled ‘same stores’ levels.
Now as investors, we might note that a 1.5% comp increase appears fairly meager for this level of investment – the investment equivalent of 100 new stores. But these incremental sales from remodel brought along less additional ‘fixed costs’, so maybe 1.5% revenue growth isn’t as meager as it sounds. But the question at hand is this: now that we’re in Q4 our obvious question might be, ‘how are those remodels working out?’ Did they really deliver a 1.5% ‘comp’ increase?
This is a particularly relevant question in that the program entailed some new directions for Target. For November, Target reported a 1.8% ‘same store’ increase. Enquiring minds want to know: what was the remodel component of that, and what was the base?