Thursday, January 29, 2009

How to benefit from Retail companies

Retail is very competitive business and usually has very few competitive advantages. Many retail businesses have low operating margins and make their money by having high turnover of inventory. I view low operating margin for a business as low margin of safety for business errors. If that's the case, why bother playing this segment? The answer lies in some impressive gains if right retail business is acquired. Think buying Walmart even in late 80's! We will look at some factors that can maximize our success in finding good investments in this field.

First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.

1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.

2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!

Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.

1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.

2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.

3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.

4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.

[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]

5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.

So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!

6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.

7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.

Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.

Please leave your thougths....