Of the industries that exist in our modern economy, none appear more cutthroat than traditional retail. Stores have come and gone, from your local mom and pop corner store to large entities like Toys 'R' Us. As you may know, I tend to look for quality businesses that have strong brands and distribution, are embedded in business services, or have patent protection to fuel long-term growth and weather downturns. At first glance, the retail sector seems as if it falls outside the “investable category” for quality growth, and predicting which retailers will perform well over a longer timeframe should be a Herculean task, if not a Sisyphean one. Regardless, let’s see if there are any ways to push the rock up the proverbial hill.
Unlike physics or chemistry, economic science tends to be imprecise. However, some economic formulas are exceptions to this rule. When attacking the retail question, an equation that explains a lot is the DuPont formula, shown below.
Return on Equity = Net Profit Margin * Asset Turnover * Leverage
Simplicity reigns! Your return on equity capital is your net profit times how many times you can turn over your assets multiplied by the amount of leverage you use.
To use the lemonade stand metaphor: If my lemonade stand, lemons, water, sugar and cups cost $10, and drinks make me $11, my margin is 10%. If I do this twice (i.e., turn my assets over again), my multiple is 2 (I make an additional $1). Finally, if my mom and dad lent me $5 to start the stand and I put in $5, my leverage multiplier is 2 ($10 of assets / $5 of my equity). My return is as follows:
10% Net Profit * 2 Asset Turnover * 2 Leverage = 40% Return
In this example, I make $2 off my $5 in equity - quite an impressive number for a small entrepreneur! The key takeaway is focusing on the first two items – profit margin and asset turnover. Access to leverage, either from a bank or parents who want me out of the house, is not a major differentiator for a retailer; the ability to generate consistent healthy profit margins or sell large volumes of inventory and turn over assets much more frequently, is.
Inventory Turnover
For retailers in particular, inventory is their most prevalent asset. Inventory turnover equals total Cost of Goods Sold (COGS) / Average Inventory. While both asset turnover and inventory turnover are important efficiency metrics, in my opinion it is better to focus on inventory turnover, since that is the retailer’s core asset base. Going forward, I’ll reference inventory turnover for this reason. Though it deviates from the DuPont formula, the metrics tend to correlate, and we are focusing on retailers.
You Can’t Be Everything to Everyone – Part I
As previously stated, the best merchants are focused intensely on either maximizing profit margins or asset and inventory turnover. Intensely focusing on one will differentiate you; trying to balance them out will relegate you as a retailer. Let’s look at O’Reilly Automotive and Costco Wholesale as examples of retailers who exemplify both paradigms.
O’Reilly (ORLY) Net Profit Margins1
O’Reilly’s profit margin is 11% at its lowest and steadily increases to almost 16% - fantastic in retail! Retail firms with higher profit margins tend to fall into a sub-category known as “specialty retail.” Specialty retail firms are generally able to drive higher margins because of their expertise in a niche segment where they provide additional value. In O’Reilly’s case, this is auto parts. Let’s also check their inventory turnover.2
O’Reilly’s business over the past 10 years maintained a relative degree of consistency with an inventory turnover of 2.9 to 3.6 times. Taking an average of the Net Income Margin and Inventory Turnover ranges, this leads to an unlevered adjusted DuPont metric of 43.55 (13 * 3.35). Keep this number in mind, and let’s move onto Costco.
Costco (COST) Net Profit Margins3
Obviously, Costco Wholesale will have lower margins than O’Reilly – their name says as much. However, this doesn’t mean they can’t excel as a retailer. To get a fuller picture, observe their inventory turnover.4
Economics 101 at work! Lower prices offered at Costco result in higher inventory turnover - in this case, 13.2 to 14.1 times more for Costco. Using the same formula as we did for O’Reilly, Costco’s unlevered adjusted DuPont is 2.3 * 13.7 = 31.5, slightly lower than O’Reilly but still very strong. For the grand finale, let’s observe how this translates into long-term performance with the broader S&P 500 as well as the S&P Retail index subset.5
The longer-term performance speaks for itself with 21.8% annualized total returns for O’Reilly and 16.5% annual returns for Costco, compared with roughly 9% for the S&P 500 and S&P Retail subset. In an industry that would compete away any advantages if they couldn’t be defended, focusing on niches that command more service and margins or competing vigorously on price and turning over higher levels of merchandise are both respectable strategies to generate sustained profits. Given this, let’s explore what’s less sustainable.
You Can’t Be Everything to Everyone – Part II
I mentioned earlier that a retail business should focus on either profit margins through specialization or inventory turnover through lower prices and maximum efficiency. The worst dynamic for a retailer is falling in the middle of the spectrum where it is neither specialized nor the low-cost option. Hell is purgatory. As an example, let’s look at Kohl’s:
Kohl’s Net Income Margin6
Offering a variety of merchandise ranging from apparel to home furnishings, Kohl’s has been a familiar name to U.S. households as one of the largest department store chains in the country for roughly half a century. Kohl’s larger scale has helped negotiate prices to better compete with traditional mom and pop stores, build the business, and achieve economies of scale. With margins closer to Costco’s, we should expect numbers in between Costco’s 13.7 and O’Reilly’s 2.3 for inventory turnover – slightly less than Costco since Kohl’s doesn’t sell certain categories like groceries.7
Kohl’s turns over its inventory less than 50% of Costco, but with its margins, turning inventory roughly 5.2 times on average is far below what makes for a growing retailer. With these metrics, Kohl’s gets an adjusted DuPont metric of 17.16 (3.3 * 5.2, significantly less than Costco and O’Reilly. 17.16 is normally sustainable and could warrant an investment at a lower valuation multiple than O’Reilly or Costco; however, Kohl’s has one main impediment.
Thinking About the Business Cycle
When bad economic times hit, few things face more headwinds than traditional retail. “Sale” and “All Goods Must Go” signs dominate storefronts. People tend to be conservative with their finances in turbulent times, browsing for lower prices, wearing their current wardrobe, and driving their car for another year instead of upgrading to a new one. With that backdrop, Kohl’s faces a more severe decline in demand than other retail areas. Liquidating its inventory through massive sales stresses the business and causes it to lose ground. This consideration limits Kohl’s ability to compound the growth of the business over time due to lower ROIC through the full business cycle.
To illustrate this effect on returns, here is a breakdown of the performance of the equity to the broader S&P Retail segment.8
A $100 investment in Kohl’s over a 16-year period on a total return basis would be worth roughly $82 dollars today before inflation. Compared to a 3.6x return over that timeframe for the broader retail category, these dynamics over a longer period are self-explanatory. To reinforce and demonstrate this isn’t an aberration, I’ll also overlay Macy’s stock from the same timeframe. Macy’s is another household-name department store with similar economics, margins and turnover.9
Summary
Macy’s had a 5% total return over the 16-year period, similar to Kohl’s. Over time, valuations tend to reflect the underlying earning power of the business, as shown in the business’s respective earnings potential. This doesn’t mean that Kohl’s and Macy’s aren’t worthy of an investment or that they can’t reform their operations; it simply means that the more attractive segments of retail focusing on either margins or turnover should build upon their gains and add shareholder value at a respectable rate over time.
Dean Schwefel, CFA®
Senior Investment Analyst
SOURCES:
1. YCharts. ORLY Net Profit Margins (Dec. 2015 - Dec. 2022)
2. YCharts. ORLY Inventory Turnover (12/7/2012 - 12/7/2022)
3. YCharts. COST Net Profit Margins (Dec. 2015 - Dec. 2022)
4. YCharts. COST Inventory Turnover (1/6/2013 - 1/6/2023)
5. YCharts. ORLY, COST, SPY, XRT Total Returns Since XRT inception (6/30/2006 - 2/14/2023)
6. YCharts. KSS Net Profit Margins (Dec. 2015 - Dec. 2022)
7. YCharts. KSS Inventory Turnover ( (1/10/2013 - 1/10/2023))
8. YCharts. KSS, XRT Total Returns Since XRT inception (6/30/2006 - 2/14/2023)
9. YCharts. KSS, M, XRT Total Returns Since XRT inception (6/30/2006 - 2/14/2023)
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