Analyzing Retail Stocks - Economics of the business, and what it means for investors

In this post, I describe the nature of retailing and the key factors that affect a retailer's health. It broadly forms the base of the investment thought process for investments in retailers.

The nature of the retail business

and the fundamental drivers of success

The retail business is a tough one, and very few retailers succeed in building enduring businesses. The retail landscape has changed tremendously over the last few decades. Fast food restaurants have replaced Automats, and big box retailers have risen to prominence at the expense of high-street/city center retailers. Retailers have to adapt to changes in fashion, lifestyles and consumers tastes. Large established retailers that fail to adapt can fall swiftly; witness how bellwethers like Sears, K-Mart and Circuit City have gone from boom to bust in a matter of years.

Retailers are fundamentally in the business of distribution. They create value by getting products to consumers, in a manner accessible to them when they need it. For a retailer to be successful, it needs to:

1. Stock products that customers intrinsically want. Retailers are rarely able to generate intrinsic demand for a product. The intrinsic demand for a product is determined by a combination of product marketing, consumer lifestyles and the prevailing zeitgeist. What retailers do is to meet that demand by making the products available to consumers. Retailer merchandising and presentation play an important role in stimulating the desire to purchase a product, but they only work if the customer has a fundamental need/demand for the product. For example, it's unlikely a retailer will succeed in selling chicken feed in New York city, no matter how creatively the product is merchandised.

Retailers can either create their own items to stock (such as retailers like the Body Shop, or the general provisioners of the early 1900s who sold brand-less commodity items), or stock items made by other companies, as long the products are what people desire and fit into the position and mind share occupied by the retailer. FMCG companies add value for the retailer by supplying them with products that their customers want, at a lower cost and with less hassle than having to develop the products themselves. This symbiotry between FMCG companies and retailers has evolved over the years, since it started in the late 1800s when P&G, Colgate and other FMCG companies were founded.

Retailers need to adjust their merchandise mix over time as tastes and needs change over time. Products that are considered necessities today may become irrelevant in a decade, and products that people aspire to change over time. Many retailers fail because they do not keep up with lifestyle and zeitgeist changes.

2. Make it convenient for consumers to buy. Because people generally do not derive value from the buying process; they see it as something they have to go through to get to the value that products deliver (e.g. refreshment from a drink, the cleaning power of a soap, etc.). People tend to buy from the store that is the most convenient to buy from.

What about people who enjoy shopping? While it's true that they derive value from the shopping activity, the actual purchasing process is not something they would place much value on. Their shopping expeditions will generally be to places which are convenient, being both accessible and a one-stop destination for the merchandise being sought. So making it convenient for consumers to buy is key to successful retailing. To do this, retailers must:

• (a) be accessible in the context of its customers' lifestyles. People will only visit stores that are conveniently accessible to them. The only exception is when a store sells something that a person has become addicted to or induces a strong physiological response, such as pornography and addictive items.
  
  For example, malls and big box stores fit the car-centric lifestyle of suburban shoppers in the U.S. Big box grocers find it harder to succeed in Japan because many people there do not drive, and also have small fridges which cannot store a week's worth of shopping. Instead, convenience stores scattered amidst the urban alleys are more suited to the Japanese lifestyle, because most Japanese consumers walk to subway stations on their way to and from work.
  
  The way people shop changes with changes in their lifestyle, which is typically driven by technological advances and changes in the zeitgeist. For example mail order used to be a convenient way to buy things, but is today rarely used as (1) people are more mobile and able to travel to stores easily, (2) modern logistics networks bring all kinds of goods to local stores, obviating the need to buy from a faraway mail-order retailer, and (3) the prevalence of Internet shopping, which has made mail order less relevant (though not extinct - for example, NBrown in the UK still runs a large home shopping operation)
  
  
• (b) be a one-stop shop for the position that it has carved out in people's minds. Each retailer has a position in the customer's mind (for example, a store to buy "natural remedies" or "imported groceries" or "stuff at bargain prices"), and the merchandise mix in the store must support that position. When a customer walks into a store, he/she should be able to find all the items that he/she is looking for. A successful shopping trip reinforces the retailer's position in the customer's mind, while a wasted shopping trip makes it more likely that he will choose another store in future. No amount of positioning marketing will help if the store doesn't have the range of goods a customer looks for.
  

The economics of the retail business
and sources of competitive advantage

The economics of the retail business are similar to that of the distribution business. Both are a combination of a logistics network and a trading business (inventory management). Like distributors, retailers are price-takers when there are multiple competitors serving the same target customers. On the other extreme, a dominant retailer in a town enjoys a natural moat that gives it pricing power. This does not mean that a retailer's pricing power grows with size, rather there is a tipping point between the two extremes.

• A retailer generally has no price-setting power when there is a competitor serving the same group of customers. (i.e. targeting the same customer profile, and present the same assortment of goods at the same locations/customer touch points). The economics of the distribution business are such that a customer faced with the choice of buying from 2 or more distributors will not be willing to pay much more for one distributor's services as opposed to another. Certainly some people may be willing to pay more to visit a cleaner/less crowded store, but the premium they are willing to pay is minimal. The players are price-takers, and the only sustainable competitive advantage is to be the lowest cost operator within its market. Having the lowest cost of operations and procurement allows the retailer to match all competitor price actions while remaining profitable.
  
  
• However a retailer has price-setting power if no other retailer is serving the same group of customers. For example, if a grocery store is the only one that is accessible to the residents of a town, then the retailer can generally set the prices for its services. Likewise, the only store to sell specialty cheeses in a city can set the price for its services.

Size is a source of competitive advantage. All things being equal, the economics of retail are such that the value that a retailer brings to customers increases naturally in proportion to the size of its operations. The largest retailer will almost by definition (a) be the most accessible to customers with the best network of sites by virtue of the in-place nature of the business, and (b) have the widest range of goods. The economies of scale that exist in distribution means that the largest distributor is also likely to have the lowest unit costs, and thus able to offer the lowest prices in order to fend off competitors who try to compete on price.

The largest enjoys a positive feedback loop where its increasing size improves its competitive position, which in turn increases it size, and so on. Once a dominant position is achieved, the economics of distribution gives the retailer a structural competitive advantage and makes it very difficult for smaller competitors in the same category to compete.

This doesn't mean that no other retailer competitor will survive, because consumers don't just base their buying decisions on these factors; there will be people who prefer the competitor's store because of its color scheme, etc. (This applies less to distributors who sell to businesses, because business buyers tend to make economical decisions. Take for example, the different buying behavior between consumers and fleet-buyers when they buy cars. The former will be influenced by styling, while the latter will be driven by fuel efficiency and maintenance costs.)

Building an enduring long-term retail business
with a sustainable competitive advantage

The economics of the business means an enduring retail business is one that is able deliver value to its customer and achieve and retain dominance. This means that an enduring retailer is on that is able to:

(1) Constantly adjust its inventory to continuing stocking products that its customers want, and adjusting its mindshare position in its customers' minds accordingly. (or it could try selling products that are relatively insulated from fashion trends and quick changes in demand)

(2) Constantly adjust it store accessibility, to be accessible even when its customer's lifestyles change. (or it could be serving a consumer group whose lifestyle that isn't expected to change much)

(3) Achieve the lowest cost of operations. In the retail business, this means:

• (a) Maximizing inventory turns. Moving inventory as quickly and efficiently as possible. Fast moving inventory also allows the retailer to reduce the capital intensity of the business, and increases the flexibility to quickly change stock when customer needs change. Conversely, slow moving inventory means that capital is tied up (and financing costs incurred), and also prevents the retailer from purchasing new stock to cater to seasonal or changing customer demands.
  
  
• (b) Maximizing sales per square foot. A higher sales intensity increases capital efficiency and productivity. Per unit operating costs are also reduced through the efficiencies gained from selling more in a single location.
  
  
• (c) Maximizing economies of scale. This is a business where there are economies of scale. A retailer that has higher purchasing volume will be able to extract more price concessions from its suppliers. Likewise, higher merchandise volume means that the retailers logistics and distribution infrastructure will be better utilized. For example, trucks will travel with full loads, and the fixed costs like warehouse management systems will be amortized a larger volume of merchandise.
  

Openings that an upstart competitor can exploit
to displace a dominant retailer

The competitive landscape of retail is like an open savannah, where the playing field is flat with few natural defensive positions. The factors of production, technology and merchandise used in retail are available to all competitors. Likewise consumers can switch retailers easily, and lifestyle and fashion changes affect all retailers. A competitive retail landscape is like a highly evolved Savannah ecosystem, where individual players have carved out their own survival space (value to customer, delivery model etc), and their incumbency is evidence of their competitive strength within a niche. In other words, they will likely have found the best way of utilizing existing factors production for a particular customer niche. The more competition the incumbents have defeated, the less likely it is that there are unexploited factors that the incumbent has overlooked.

In this landscape, competitors can establish a survival space only if one of the following openings exist:

(a) They ride a changing consumer wave or change in zeitgeist. In other words, exploit a changing customer profile which the incumbent isn't attuned to. For example, Sears used to be the dominant retailer in the United States, but the rise of suburbia, the auto-culture and changes in tastes allowed big-box stores and category killers to muscle in on Sears' dominance.

(b) They find some technology or operating technique which the incumbents have overlooked. This is difficult, but not impossible. Walmart did just that to K-mart, by exploiting the logistics efficiencies of building store in geographically contiguous fashion. It built out its network of stores in small towns by going into towns next to each other. This logistics efficiency allowed it to achieve lower costs that the incumbent discounter K-Mart, which had store that were situated in big cities hundreds of miles apart.

(c) The incumbent messes up. The dominant retailer may also mess up, for example, by allowing its store to be infested by rats. Dominant retailers can also the mistake of muddying its position and deviating from the formula that made it successful. For example, a retailer with the position of lowest-cost discounter may try to become an aspirational retailer that sells higher-end goods. Because of the Savannah like competitive landscape, deviating from a survival space means that a retailer is exposing itself to open competition from other players who have already found the competitive advantage in their survival space. The dominance in one survival space often does not translate to another survival space, and the retailer will be starting from zero in its competitor's stronghold. This doesn't mean that a grocery discounter will be unsuccessful selling discount electronics, because the competitive dynamics of both areas are similar. But a discount grocer trying to sell fashionable clothes is going to find it tough going, because the survival dynamics in each space are vastly different.

What this means for Investors
who invest in retail companies

Investing in retailers involves a quantitative assessment of the retailer's cost position and dominance, and a qualitative assessment of whether its position, customer base, and accessibility to its customers are likely to continue relative to zeitgeist and technological changes. It basically means:

1. identifying retailers that have established strong survival spaces, and
   
   
2. constantly monitoring the landscape for evidence of competitive openings that may have been created, and
   
   
3. constantly monitoring the changes in consumers' lifestyles and evidence that the retailer is keeping up with these changes
   

It is more than a simple spreadsheet exercise, unless we are planning to liquidate the retailer for its assets.

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses

- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.
   
   
2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position

- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:

1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.
   
   
2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:

1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.
   
   
2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.
   
   
3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.
   
   
4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.
   

Valuing commodity/resource companies

- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:

1. the earnings that will flow from its current commodity reserves
   
   
2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors
   
   
3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes

- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.