"Strategy has been the primary building block of competitiveness over the past three decades, but in the future, the quest for sustainable advantage may well begin with the business model," said Ramon Casadesus-Masanell and Joan E. Ricart in the article "How to Design a Winning Business Model." Featured in the Harvard Business Review, the article provides an overview of what it takes for companies like Wal-Mart Stores (NYSE: WMT ) to excel in highly competitive industries.
Gross margin: a measure of business model efficiency
Gross margin percentage is the first indication of profitability for a company. It is often used as a way to measure the effectiveness of a company's business model, especially within the same industry. As a result, investment analysts study trends in gross margin to gain clues about the early direction of company earnings.
Wal-Mart, Target (NYSE: TGT ) , Dollar General (NYSE: DG ) , Family Dollar Stores, Tuesday Morning Corp, Dollar Tree Stores, and Big Lots are all considered discount retailers, but it's hard to say which one is the better investment -- 2013 was a difficult year for most discount retailers. Let's compare gross margins to see if any trends emerge that can tell us which discount retailers to stay away from in 2014.
Declining trends in gross profit margin
The average gross profit margin of the seven companies in this comparison, according to the 2013 calendar third quarter earnings report, is 32%, and Dollar General, Target, and Wal-Mart are the lowest -- these are the companies we'll focus on.
Dollar General had the third-lowest gross profit margin in the third quarter of 2013 at 30.3%, down from 30.9% in 2012. According to the earnings report, enhancements or opportunities exist in "category management, the expansion of private brand offerings, increased foreign sourcing, shrink reduction, distribution and transportation efficiencies and improvements to our pricing and markdown model..."
While there are clearly many opportunities for improvement at Dollar General, the company is second in same-store sales growth among the same list of competitors and is one of the few companies in the industry to post positive earnings growth. In other words, Dollar General has done a good job of finding the right balance between product cost and price. Prices are low enough to attract customers but high enough to make a profit.
Target has the second-lowest gross margin at 30%. Citing seasonal markdowns as the cause, Target's gross margin rate declined as well from 30.3% in 2012, according to the company's third-quarter report. Among its competition, Target is a great example of a "high-end" discount-retail business model. The model allows for fewer transactions because prices are higher. Indeed, transactions and units per transaction are trending down at Target, so the company pushed prices a little higher in the third quarter to compensate -- the only thing that's saving Target right now is pricing.
Surprisingly, Wal-Mart, the company that sells more in one year than the nominal GDP of Hong Kong, had the worst gross margin rate at 24.5%. If gross margin is a function of inventory costs, shouldn't Wal-Mart have a higher gross margin due to economies of scale? Something is very wrong with this picture.
The Foolish bottom line
While gross margin won't tell you which stocks to purchase, it can help to understand why a company is performing the way it is. It can also help to determine whether or not performance issues are temporary or structural.
What have we learned from analyzing the companies with the worst gross margins?
- Even though Dollar General has a low gross margin, the company was able to strike the right balance between price and demand with its suppliers.
- Target may have structural issues. The company suffers from low transaction volume but has a business model that allows for higher pricing. Without higher prices, Target's gross margin may have been even worse than Wal-Mart's.
- Wal-Mart may also have structural issues. Like Target, the company suffers from lower transaction volume, but the business model doesn't allow for higher pricing, placing increased pressure on earnings.
- Traditional business models may be challenged in the current economic environment due to increased competition and price inflation.
Dollar General appears to be a good pick despite the low gross margin percentage, however, Target and Wal-Mart have a few issues to work out -- the former can only raise prices so much and the latter can't raise prices at all. Both companies will need a business model overhaul to stay competitive in 2014.