Retail Moats: Fact or Facade?

One topic I’ve been debating of late is whether or not retail companies can create a sustainable competitive advantage (i.e. a moat) and continually earn excess returns on capital. Business history is replete with examples of seemingly-dominant retail chains that faded toward nothingness when faced with sharper competitors; similarly, apparel retailers have seen profitability soar and plummet as their fashions have gone in and out of favor. With all the upheaval in this space, it’s fair to ask the question – is there long-term value to be had in this space?

I bring this topic up because there are several retail stocks that I either own or like – the most common ones I mention being Bed Bath & Beyond (BBBY), American Eagle (AEO), and Wal-Mart (WMT). Those offer a good combination of exposure to hardline, softline, and general retail respectively, although I could probably be convinced to swap out a Coach (COH) for American Eagle in the apparel space – I really like Rick LaMartina’s commentary on that stock.

As I’ve argued before, there are four types of economic moats that allow for above-average returns to be consistently generated. These are:

1. Incomparable Economy of Scale
2. Network Effects
3. Intellectual Property Rights
4. High Switching Costs

The nature of retail pretty much eliminates numbers two and four; number three is questionable. Retailers can’t create hard-form intellectual property rights in the form of patents that prevent competition, but they can develop brand name(s). Still, there are only a handful of readily identifiable consumer names out there that have proven their staying power over decades – again, think Coach or maybe Ralph Lauren (RL) – making most retail plays a bet that the brand name will continue to have value.

This makes me somewhat cautious about owning American Eagle, even though results have historically been very good. Continued monitoring of the brand’s image and value is necessary, and while investors have been enthused by Aeropostale (ARO) doing very well on the earnings front, I simply think this is a temporary shift down-market due to tightened spending. Apparel retail has seen a very difficult environment the last few months, but I do believe that once apparel retailers – and American Eagle in particular – properly adjust, they will continue to be handily profitable and command higher multiples. American Eagle will release earnings in three weeks, and the accompanying conference call should shed some additional light on how they are adjusting their model and fashion trends to adapt.

While the differentiated nature of apparel retail makes it difficult to create significant scale advantages – this would kind of require everyone to dress alike – the opposite holds true of hardline retail stocks like Bed Bath & Beyond, Lowe’s (LOW), and Home Depot (HD). Back in mid-January I wrote positively about those three names, as well as American Eagle. I was wrong on one of those, because the retail rally is rightly concentrated in the hardline stocks, all of which have returned a multiple of the S&P 500 since then. My top pick, BBBY, is up a nice 25% in that time, and that brings me to the point about these retailers: they do have the scale advantage, they will earn high returns on capital, and they will command a higher multiple as the market gets the story right. While I think Lowe’s has the leg up in home improvement near-term, considering that Home Depot is still executing financially on the level of Lowe’s, I believe there has to be substantial upside in Home Depot long-term if they can refocus on customer service and take some share back from Lowe’s. Bed Bath & Beyond has had a great run of late, and while I don’t believe there is a huge discount to fair value right now, it is a name I’d look at on pullbacks. As I outlined in my BBBY stock report, the company is among the most consistent performers even when stacked up against the top-tier consumer staple companies, and I still see BBBY as a $40 stock.

Rounding out the group here is Wal-Mart, the poster child for economies of scale. By outselling its next closest competitors Costco (COST) and Target (TGT) by 6-to-1, Wal-Mart has the negotiating power to get – and pass on – the absolute lowest prices. This means that while margins are very low, Wal-Mart strikes the right balance on margins and turnover to generate a 20% ROE, year after year. As times have turned tough in retail, investors have flocked to Wal-Mart. Of course, the best time to do this was back in late August when the company had few believers and the underlying business model even came into question. Now, Wal-Mart is suddenly becoming cool in the investment community, and while the concerns me slightly, I don’t think the conditions are tilted far enough positively that this is the top for WMT. The stock continues to flirt with 52-week highs, and although the current price is close to my fair value, WMT remains a solid pick.

Disclosure: I own AEO, but have no position in other stocks mentioned here.