Everyone needs to shop, and as such discount retailers present an interesting investment opportunity as market watchers sniff around for signs of an economic slowdown. In this two-part series, Motley Fool analyst Bob Fredeen takes an up-close look at leaders Target and Wal-Mart.
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Let's make an assumption: All the doomsayers are right, and the U.S. is looking into the hungry, gaping mouth of a recession. What should an investor interested in retailers do? Take all his money and run? Not necessarily. Even in a recession, consumers will still be consuming -- but they are much more likely to do so at discount retailers. If the economy slows, this segment of the industry could be in for a boost. If we're going to invest in this industry, we need to look for companies that meet specific criteria. They must be well-run, have the financial strength to weather nasty economic storms, and enjoy broad interest from consumers. In this two-part series, we'll first discuss how to measure those criteria, and then we'll apply them to discount retail giants Wal-Mart (NYSE: WMT) and Target Group (NYSE: TGT). To see how well a retailer is run, I like to look at operating profit margins and the Foolish Flow Ratio. While these two criteria are not the ultimate determinants, they give us easy insight into two critical aspects of a retailer's business: profitability and cash management. I choose the operating profit margin because it includes how efficiently the company runs its stores and corporate infrastructure as well as the gross profits (the price of the goods minus the cost of the goods). The "Flowie" is a quick tool that gives us a good idea of how well a company matches its inventory and accounts receivable with its accounts payable. Here is the formula for the Foolish Flow Ratio, which is best used to illustrate a trend over time: To investigate a retailer's financial strength, take a look at the balance sheet. In this case, the first thing we are concerned about is total debt. The lower the total debt, the better able the company will be to survive an economic slowdown. Since we're more concerned about borrowing power, we'll look at the ratio of total debt to shareholders' equity as an indicator. The other important account to look at is inventory. If a retailer is going to survive an economic slowdown, they cannot have too much inventory on hand to start with. To better understand inventory, we'll look at a measure called days inventory outstanding. This measures how many days, theoretically, it would take a company to sell its entire inventory. While we want the number of days to be as low as possible, we'll settle for a number below 90 days. Here is the formula: How can we measure consumer interest? First, let's look at same-store sales ("comps") growth. Comps measure sales growth at stores that have been open for at least a year from the reporting period. Strong comps growth generally indicates a successful retail concept. We'll also include some non-scientific information, such as our experiences. The nice thing about retailers is you can personally check on these companies to see what the stores are like and how they're doing. Next, let's compare the two leaders in discount retailing using the above measures. SEE PART 2: How Wal-Mart and Target Stack Up» (Current Assets - Cash*)
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(Current Liabilities - ST Debt**)
* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term Debt = notes payable and current portion of long-term debt
Inventory
------------------- X Number of days*
Costs of goods sold
*90 for a quarter, 360 for a year
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