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Retail is detail. Discount stores face a challenging marketplace where they have large fixed costs and slim margins. The industry has slowly grown more concentrated with the emergence of superstores like Wal-Mart (NYSE:WMT) and a constant push towards ever-greater scale to enhance purchasing power.

The recent Great Recession has pushed more consumers towards these stores for many of their needs. Shoppers have scaled back from department stores and specialty stores to discounters. Even within the industry, other shoppers have scaled down further. Discount stores are now furthermore pressured from below by alternative options ranging from eBay (NASDAQ:EBAY) to thrift stores and even garage sales.

Evaluating retail stocks requires significant assessment of their operational capabilities. Metrics such as inventory turnover and cash conversion cycles are key. Table 1 shows the leading publicly-traded discount stores with some basic data. The discount store industry is dominated by a few larger names to a greater extent than the grocery store industry.

Table 1: Publicly Traded Discount Stores

Ticker Name Price ($/share) Enterprise Value ($ Billions) Trailing P/E Forward P/E Revenues (ttm) ($ Billions) Fiscal Year End
WMT Wal-Mart Stores Inc. $55.69 $ 245.2 13.8 12.6 $419.2 January
COST Costco Wholesale Corp. $75.04 $ 27.8 24.6 18.6 $79.9 August
TGT Target Corp. $54.39 $ 53.5 14.3 12.2 $66.9 January
DG Dollar General Corporation $27.24 $ 12.5 19.3 12.9 $12.7 January
BJ BJ's Wholesale Club Inc. $49.37 $ 2.3 18.9 15.2 $10.8 January
FDO Family Dollar Stores, Inc. $44.16 $ 5.3 16.1 11.5 $ 8.0 August
DLTR Dollar Tree $50.50 $ 6.1 17.5 13.4 $ 5.7 January
BIG Big Lots, Inc. $41.57 $ 2.5 15.0 10.4 $ 4.9 January
FRED Fred's Inc. $13.07 $ 0.5 19.2 14.6 $ 1.8 January
PSMT PriceSmart Inc. $37.68 $ 1.1 20.9 15.6 $ 1.5 August
NDN 99 Cents Only $16.63 $ 0.9 15.7 12.7 $ 1.4 March
TUES Tuesday Morning Corporation $4.92 $ 0.2 17.9 9.9 $ 0.8 June

Data sourced from Yahoo!Finance on February 13, 2011.

Analysis

The following analysis looks at four metrics:

  1. Inventory Turnover.
  2. Cash Conversion Cycle.
  3. Asset Turnover.
  4. Profitability Margins (based on the most recent trailing 12 months to assess whether the previous measures in operating performance resulted in higher profitability).

Inventory Turnover

For a retailer, inventory turnover is one of the most basic measures of operating efficiency. Basically, how rapidly can the company sell a set of goods and replace it? Stores with larger assortments of goods may take longer. Furthermore, stores with grocery operations are often forced to have higher turnovers simply due to the perishable nature of their goods.

Table 2: Inventory Turnover
Ticker Most Recent Full Year Year Prior
COST 12.3x 11.9x
BJ 10.1x 10.4x
PSMT 9.4x 9.1x
WMT 9.0x 8.7x
TGT 6.6x 6.8x
DG 5.5x 5.2x
FDO 5.0x 4.8x
DLTR 5.0x 4.6x
NDN 4.9x 5.3x
FRED 4.3x 4.1x
BIG 3.8x 3.8x
TUES 2.2x 2.2x
Data sourced from Yahoo!Finance on February 13, 2011

Here the large-scale operations dominate, taking four of the top five spaces. The notable exception is PriceSmart, which is ranked just 10th in revenue. It should be noted that PriceSmart has had a more recent fiscal year-end which may skew the results, making its most recent year longer post-recession; however, its prior year performance was equally strong, and these metrics show little change from one year to the next.

Cash Conversion Cycle

Cash conversion cycle is a measure of how quickly a company pays its suppliers, receives money from customers, and the amount of inventory it carries. Negative numbers represent float on which the company can earn interest. High numbers represent either low inventory turnover, demanding terms from suppliers, or an inability to get cash from customers.

Table 3: Cash Conversion Cycle (Days)
Ticker Most Recent Full Year Year Prior
WMT -14.7 -9.9
COST -4.7 -4.8
PSMT -3.8 -2.4
BJ 2.7 8.4
FDO 5.9 8.0
DG 15.4 17.8
TGT 22.0 34.1
NDN 26.5 39.6
BIG 35.0 45.7
DLTR 46.3 50.8
FRED 55.3 65.8
TUES 102.5 106.6
Data sourced from Yahoo!Finance on February 13, 2011

This metric shows few surprises. WMT is the leader and the larger companies by revenue tend to perform better, with the notable exception of PSMT.

Asset Turnover

Table 4: Asset Turnover
Ticker Most Recent Full Year Year Prior
BJ 4.87x 4.93x
COST 3.40x 3.35x
FRED 3.20x 3.28x
BIG 3.05x 3.23x
FDO 2.69x 2.67x
PSMT 2.63x 2.67x
TUES 2.47x 2.43x
WMT 2.44x 2.47x
DLTR 2.42x 2.43x
NDN 1.92x 1.99x
TGT 1.47x 1.47x
DG 1.33x 1.18x
Data sourced from Yahoo!Finance on February 13, 2011

This metric is reasonably consistent with expectations. The large wholesale clubs with no frills stores have the highest asset turnover, followed by Big Lots, which is a smaller-scale operation but also lacks frills inside its stores. The bottom of the list includes Target, which has been trying to move more upscale with remodeled stores.

Profitability Margins

Table 5: Profitability Margins (Percent)
Ticker Gross Margin Operating Margin Profit Margin
DLTR 35.3 10.3 6.5
DG 32.0 9.0 3.9
NDN 41.3 7.9 5.2
TGT 29.8 7.6 4.2
FDO 35.7 7.3 4.5
BIG 40.8 7.2 4.4
WMT 25.2 6.1 3.6
PSMT 16.6 5.6 3.7
COST 12.8 2.7 1.7
TUES 38.2 2.6 1.4
FRED 28.4 2.3 1.5
BJ 12.3 2.2 1.3
Data sourced from Yahoo!Finance Stock Screener on February 13, 2011 and reflects a trailing twelve months which is different from Table 6 that looks at fiscal years.

Table 6: Net Margin for Last Three Years
Ticker Most Recent Full Year Year Prior Two Years Prior
DLTR 6.1% 4.9% 4.7%
FDO 4.6% 3.9% 3.3%
NDN 4.5% 0.7% 0.2%
BIG 4.2% 3.3% 3.4%
TGT 3.8% 3.4% 4.5%
PSMT 3.5% 3.4% 3.4%
WMT 3.5% 3.3% 3.4%
DG 2.9% 1.0% 1.0%
COST 1.7% 1.5% 1.8%
FRED 1.3% 0.9% 0.6%
TUES 1.3% 0.0% 1.6%
BJ 1.3% 1.3% 1.4%
Data sourced from Yahoo!Finance on February 13, 2011

The profitability data shows some interesting trends and suggests that not all discounters compete in the same space.

Conclusion

I previously wrote an article on managing cash at grocery stores which have to operate with very slim margins. It is quite apparent that the same principles apply to discount stores, which offer significant overlap, with Wal-Mart and Target being larger retailers of food.

PriceSmart appears to be a potential long option, given its strong operational metrics and reasonable margins. One interesting aspect is that, despite one of the lowest gross margins, it provides an average net income. However, its operational requirements are probably a necessity, since despite a gross margin 3-4 percentage points higher than Costco and BJs, PriceSmart has a profit margin only 2 percentage points higher. The key question is how much better will PriceSmart look once it scales up in size.

Fred's and Tuesday Morning appear to be poorly positioned; despite high gross margins, they provided two of the lowest three net margins. Both companies lack scale and have limited recent growth. While they have decent asset turnover, their inventory turnover and cash management are ranked near the bottom.

The final interesting company is Dollar Tree, which shows high margins but average operational metrics. Additional analysis should always be completed prior to making an invesment decision.

Source: Picking the Best Discount Store Stocks on Cash Management and Operational Performance