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Identifying a Retailing stock: Do's and Don'ts - Views on News from Equitymaster

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Identifying a Retailing stock: Do's and Don'ts

Apr 9, 2008

Retail as a whole can be divided into various categories, depending on the types of products serviced. It covers diverse products such as food, apparel, consumer goods, financial services and leisure. The proliferation of hypermarkets and supermarkets has led to a growth in food and grocery retail; thus, value retailing is seen to be gaining ground in India. The other high growth verticals are apparel and durables. Impulse goods like books and music are also gaining a larger share in the organised retail market, with players making stores more accessible to consumers. Retail business is linked to consumption patterns of the consumers and hence dependent not only upon likes and dislikes and changing preferences regarding goods and services but also on availability of disposable income in their hands. Thus, the growth of the sector is linked to discretionary income in the hands of the people, which is linked to economic growth.

Here is an attempt to simplify the analysis of a retailing company.

Revenues drivers
Growth in Indian retail industry has been driven by the country's economic fundamentals over the past few years. Increasing number of nuclear families, easy financing options, increase in the population of working women, emerging opportunities in the service sector and rising disposable incomes during the past few years have been the key growth drivers of the organised retail sector in India. Consumers are now showing a growing preference for organised retail, which has resulted in increased penetration.

In case of retailing business revenue is a factor of sales of per square feet and total area under operation during the period under consideration. Since retailing is a business of volumes, analysis of revenues on per square feet basis provides better insight into topline growth - indicting whether the growth achieved is owing to more sales on the same footage or is the result of increased reach across geography.

The company may witness topline growth but revenue per square feet (sq ft) may witness reverse trend i.e. declining revenue per sq ft. In this case, the topline growth can be attributed to the increased area under operation (increased sq ft) as new store sales generate more revenues than the same store sales. Thus, the topline growth alone does not help to evaluate performance, rather at times is camouflaged owing to new store momentum. To negate the effect of the same one should consider the revenue per sq ft, which helps to understand whether the topline growth is the result of additional area under operation or effect of penetration, or better merchandising mix or the effect of increased footfalls and the retailer's ability to convert increased footfalls into cash memos.

While evaluating a retail business on revenue per sq ft basis to find out whether there is actual volume growth one must also consider whether the retailer is in the business of 'value retailing' (low margin - high volume business) or 'lifestyle retailing' (high margin - low volume business) as margin scenario depends upon the type of retailing mix. A lifestyle retailer showcasing private labels (own brands) will have better margins compared to value retailer.

Cost and margin analysis
Raw material cost: This is one of the major cost head on which gross margin scenario is dependent apart from the industry related costs. A retailer's cost of goods sold includes the cost from its supplier plus any additional costs necessary to get the product into inventory and ready for sale. Generally its seen that in case of retailer who sources the final product i.e. the one who sells products of different brands, the margins will be on a lower side as compared to the retailer who sells in-house brands or private labels. The margins may differ to the extent of 25% or more, depending upon merchandising mix. It is not uncommon for a retailer to expect a minimum gross margin of 50% (also referred to as keystone mark-up) and fluctuates depending upon level of operation, competition, region etc.

Personnel and administrative cost: Retailing is a service-oriented business. Apart from products offered what matters more is the attending customers and helping them in their purchase decisions. Thus, these costs are incurred to cater to the consumers' needs (front end staff). Costs are also incurred for planning marketing strategies, administrative purposes, providing a good ambience for shopping, etc. Further, retailing companies do spend a considerable amount on advertising, in order to position themselves the minds of the consumer, to increase footfalls, bring to notice new offers and new initiatives.

Rentals: This is one of the major costs. Store roll out and expansion plans depend a lot on availability of real estate at desired place at reasonable price. The location is the one of the main key factor that impact sales and earnings. Right location can boost sales, but high rentals take a toll on margins. In the light of expansion plans and new store roll out programme, this is an important decisive factor for domestic players. Rentals have been escalating in past two years owing to booming real estate sector and eating up into retailers' margins. The rentals are around 10% of sales, and operating at such high lease rentals for a business with already skinny margins is not lucid. To combat the same retailers are tying up with mall developers or real estate developers or venturing into more profitable areas, or delaying their expansion plans.

Other operational costs: Apart form these costs retailers also have to incur power and electricity charges, general administrative costs, transportation and handling expenses etc. Cash outflow is also accounted for maintenance and other services such as parking facilities etc. that result in shopping convenience and may also turn out to be a decisive factor for choosing a particular retailer. Expenses are also incurred on technology such as e-billing, tagging, security, etc.

Other than operational costs, like any other business retailers too have to incur costs such as interest cost, tax payments, replacement (maintenance cost or depreciation charges w.r.t stores-the asset of the retail business) cost. Incase of e-retailing concept huge technology related costs are involved. In a service industry like retail, the one who is not only able to increase footfalls but also convert them into cash memos is considered to have understood the nerve of the consumer. The increased cash memos from the same stores owing to increased footfalls directly flows to the bottomline.

Key parameters for selecting a retailing stock

  • Sales growth and revenue per sq ft: One should look at the past five years sales growth and revenue per sq ft growth. Whatever be the trend - robust, stagnant, declining trend or volatile, one needs to look further and evaluate the reason behind same as mentioned above. Further, consider whether the company has increased space, have taken up new initiatives etc.

  • Operating margin comparison with peers provides an insight of company's operational efficiencies. Find out how has been the trend in the past. If the company is able to sustain margins despite cost-push and competitive scenario, it is positive. If margins have been eroded. The same needs to be evaluated with much care, is it that the company has underperformed or the same has been impacted owing to rising cost of operation and increased competition, such issues to some extent are industry wide and impact players across industry. An efficient player and well-managed company is able to overcome these issues with improved sourcing, revised expansion plans (as many players in recent have started tapping Tier II and Tier III cities to boost sales and reduce costs). If margins have increased owing to increased sales from same stores or increased cash memos, it is an encouraging sign.

  • While operating margin takes care of majority of the cost heads one should also look at gross margins that precede operating margins. Gross margin comparison with peers, help to understand the business and highlights the reason behind the same. As mentioned earlier, retaillier dealing in private labels or more focused towards lifestyle retailing with better sourcing capabilities will have better margins.

  • Look at ratios such as current ratio and/or working capital to sales inventory levels, lower the better, and whether the company is able to generate cash for working capital requirement. Low levels of inventory indicate quick stock turnaround (either because of efficient sourcing capabilities). A negative working capital to sales ratio indicates that the company is able to generate revenue from operations to fund working capital requirements, which is a positive sign.

  • Return ratios such as return on asset (whether the company has be able to leverage space to boost topline), return on invested capital (indicate whether the company has used its resources optimally or not). Look at dividend payout ratio, which also indicates whether the earnings are shared with the shareholders or entirely are ploughed back into the business.

Valuations
Retail industry is not fixed cost or capital intensive but is highly co-related to consumption patterns that decide spending. The growth prospects are indirectly related to the economic growth. Further, it is a working capital intensive industry. A look at price to earnings ratio will help to compare to the two companies and provide earnings visibility. Companies with better margins, working capital efficiencies and execution capabilities (fulfilling consumers' demand, expansion plans on track etc.) will command premium.

One must also take a note of the management quality, as ultimately the company's future prospects are dependent upon the management's moves. If the management is not proactive and does not react timely to changing situations, the company's growth may hinder and in turn impact the returns to shareholders.

Click here to identify stocks from other sectors.

Related Links for Retail Sector: Quarterly Results  NEW | Sector Analysis Report | Sector Quote | Over The Years


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