Investing in retailers focuses on three points: personal observations, income statement trends, and the balance sheet. Personal observations give you an idea of what the company's brand is like. Income statement trends help identify companies that are growing both sales and profit margins. Key lines on the balance sheet give clues about the company's direction. Tying all of these together will go a long way toward successful retail investing.
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Observation
There are two parts to the observation side of the equation. First, visit the stores. Now, the statistically inclined among us are crying foul here, since an individual cannot visit a large enough number of stores to generate statistically relevant data. However, this isn't what we're looking for.
A retail store is the main point of interaction between a company and its customers. Within the store, the company has complete control over the presentation of its brand, especially the customer service and shopping experience aspects. This is where a company must explain to its customers exactly what the brand is all about. If it fails in its own stores, I suspect that other marketing efforts will also fail.
So, among other things, look at how the brand is portrayed within the stores. What are the sales associates like? How pleasant is the shopping experience? Other basics to look for are what inventory levels look like on the displays. Is the store out of a certain size, color, or item? Is every store location out of a certain item? Finally, check for markdown or sale merchandise. If most of the store is on sale, this implies some inventory control problems that usually come back to haunt a company's profit margins.
While you're in the mall, be sure to check out what people are wearing and where they are shopping. If you notice that every high-schooler is walking by with three Abercrombie & Fitch (NYSE: ANF) bags, this could be something important. Maybe you notice that every third boy has a Nike (NYSE: NKE) swoosh on his chest. These types of trends at your local mall could give you ideas about what is popular elsewhere.
After looking around, you need to examine the financial statements to see how healthy the company is.
The income statement
Once you're home, fire up the PC and start getting some financial info. Look first at the income statement to get a quick overview of the last quarter. The first thing to look for is same-store sales (or comps) growth. Growing comps are very important for retailers, as this growth shows that existing stores are growing well, and growth at existing stores is cheaper than building new stores.
Strong comps growth tends to help the company on other lines of the income statement as well. If comps are strong, companies can leverage occupancy costs and labor expenses, improving operating margins. If you are able to increase sales 5% without increasing your store size or your labor force, you'll make more money, right?
Be sure to check out the gross margins. Strong margins imply that the company is selling its products at close to full price. I realize there is a certain "duh" factor to this point, but the relevance of full price is important. Selling items at full price indicates consumers are willing to pay extra for the company's brand, which is the sweet spot for retailers. High margins also imply effective inventory management. As we'll cover later, this ability is crucial for the long-term success of a retailer.
Below gross profits, you should find sales, general, and administrative costs (SG&A). This line covers a variety of important expenses, but we'll focus on three: labor, overhead costs, and marketing. Labor expenses tend to be significant for retailers because of the numbers of sales associates and managers they usually have for their stores. Recently, the tight labor market has made it difficult for retailers to find people to work for them, which means that they have been paying higher wages. Obviously, higher wages will hurt profit margins.
Overhead costs cover a variety of expenses, including the cost of running the corporate office, shipping products from warehouses to stores, and managing warehouses. Investments made in the "back-office" systems, such as inventory management, also fall into this category.
Finally, marketing expenses reflect how much the company is spending on getting customers in the doors. This could reflect advertising costs or other promotions.
For all of these costs, it's important to watch the changes over time relative to sales. Marketing costs increasing $10 million year-over-year is not as important as an increase from 10% to 12% of sales. For many retailers, marketing costs are their version of research and development. This is the money they spend to communicate with consumers about the brand and to bring customers through the doors. Not all marketing is effective. That's something investors should pay attention to, but the easiest way to watch this category is to see how much the company is spending compared to sales.
Finally, we like to see strong net margins. Largely, this line will reflect how well management has controlled its operating costs. The only concern is interest expense, which is tied to debt. Retailers often issue debt to pay for their growth, under the assumption that the new stores will generate a higher return than the cost of the debt. When sales slow down, this tactic can backfire, as the company is now saddled with extra costs, especially interest expenses.
The income statement is a good place to start because it offers an overview of how strong the brand is. There are also clues to future problems in the gross margin, marketing, and interest expense lines. However, to complete the picture, investors need to look at the company's balance sheet.
The basics -- balance sheet
While there is a lot of important information on the balance sheet, we're going to focus on just a few lines. First we'll look at assets, specifically faux assets. From there, we'll look at some liabilities.
One of the first lines we find under current assets is inventory. For those already familiar with the Fool, you should remember that we believe inventory is a liability masquerading as an asset. With retailers, this is especially true. Inventory represents the merchandise the company has available for sale. For most retailers, we're talking about finished goods sitting in warehouses or on store shelves.
The reason we consider this a liability is because of inventory risk. Essentially, inventory risk is the risk that the value of the inventory will decline before it's sold. The problem that many retailers face is that their goods are perishable, either literally in the sense of food spoiling, or theoretically in the sense that items could go out of fashion.
How big is this risk? It depends on the type of retailer. For retailers that sell fashionable items, this risk is significant. If they cannot sell products when they are "hot," it will be hard if not impossible to sell them at full price in the future. The result is lower prices or "markdowns" on the inventory to entice customers to buy the merchandise. Because of the lower prices, the company will make less money, thus profits fall.
Furthermore, when it comes time to buy merchandise for the next season, the retailer finds itself a bit short of cash. In fact, the retailer could decide to buy fewer items next time to hedge against inventory risk.
The point here is that high levels of inventory are often a leading indicator of problems for a retailer. One metric we pay attention to is making sure that inventory growth year-over-year is less than sales growth year-over-year. Why? This measure helps take into account more or larger stores and any seasonal factors that might affect the company's preferred inventory levels. If inventory levels are growing faster than sales, it could be a warning that products aren't selling and the company will have to mark down merchandise.
Another way to look at inventory is the Foolish Flow Ratio. This measures how well the company manages its accounts receivable, inventories, and accounts payable. The idea is that accounts receivable are not really assets. Rather, they represent cash that the company had to spend to get their customers to buy. On the other hand, accounts payable represent the free temporary use of the items the company purchases. To get the Flow Ratio, we use this formula:
(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
As with all companies, we would like to see the Flow Ratio as low as possible. For retailers, this ratio most likely won't reach 1.00 or lower. Few retailers have accounts receivable, since this form of credit is usually extended to business, not consumers. Even so, this metric helps show how effectively the company is managing its current accounts.
The next critical line to analyze is the long-term debt line. We mentioned that positive comps are very important for retailers, and part of that reason is debt. If sales aren't growing through improving comps, then the retailer needs to add more stores. When a retailer is adding many new stores, it often turns to the debt markets to fund the additions.
This is not necessarily bad. Each company has what management believes to be an optimal capital mix -- how they fund expansion through their cash flow, debt, and equity. Debt is not always bad, because interest payments help lower tax bills and debt is often easier to issue than equity. However, too much debt is bad. If debt levels rise too high, the retailer needs to pay more and more interest, which lowers profits. Also, if the company has already issued a lot of debt, it may be unable to issue more debt when needed.
One way to monitor a company's borrowing is to calculate its long-term-debt-to-equity ratio and the total-debt-to-equity ratio. Then, compare them to the ratios of industry peers, and to the company's own historical levels. If a company's ratios are high relative to peers and/or its past, then the company may be limiting its options.
Conclusion
These few measures are the most important when looking at retailers. Obviously, we're voting with our typing as far as which is more important. Inventory takes up two-thirds of this article, and this point is important. Arguably, no single aspect of retail management is more critical to the long-term success of a retailer than inventory management.
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