A Guided Tour of the Market 2

Consumer Services

The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever.

Because many consumer purchases other than food are discretionary (can be put off for later), it's not surprising that retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.

Demographic shifts and changes in the workforce make the long-term outlook for restaurants pretty bright. Eating food prepared by restaurants is becoming a more attractive alternative to home meal preparation – with both parents working in many households, there's little time to cook and even less for grocery shopping and cleanup. The economics of meal preparation are shifting in favor of eating out as well because families are getting smaller.

One of the best ways to distinguish excellent retailers from average or below-average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Retailers Accounting 101 (A Conceptual Overview)

Investing in Retail:  Understanding the Cash Conversion Cycle (CCC)

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles.

The CCC tells us how quickly a firm sells its goods (inventory), how fast it collects payments for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier.

Wal-mart is one of the best in the business at this:  70% of its sales are rung up and paid for before the firm even pays its suppliers.


COMPONENTS OF CCC

INVENTORY TURNS
Looking at the components of a retailer's cash cycle tells us a great deal.

A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favour.

This leads to excess inventory, clearance sales, and usually declining sales and stock prices.


RECEIVABLES TURNS
Days in receivables is the least important part of the CCC for retailers because most stores either collect cash directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price.

Retailers don't really control this part of the cycle too much.

However, some stores, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves.  

The credit card business is a profitable way to make a buck, but it is also very complicated, and it is a completely different business from retail.

Be wary of retailers that try to boost profits by taking on risk in their credit card business because it is generally not something they  are good at.


PAYABLES TURNS
If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers.

It is also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they are one of the few (if not the only) games in town.

The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retail has a huge advantage when ordering inventory:  It can push for low prices and extended payment terms.

Extending payment terms to their suppliers allow the retailers to hold on to its cash longer and to reduce short-term borrowing needs; effectively increasing the retailers' operating cash flows .



Additional Notes:
In retail and consumer services, most economic moats for the sector are extremely narrow, if they exist at all.

Therefore, not surprisingly, you don't find a ton of great long-term stock ideas in retail and consumer services.

The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'.

It can do this by offering unique products or low prices.

Although you can do well buying high quality specialty and clothing retailers when the industry sees one of its periodic sell-offs, very few of these kinds of firms make great long-term holdings.

Analyzing Retail Stocks - Economics of the business, and what it means for investors

In this post, the nature of retailing and the key factors that affect a retailer's health is described. It broadly forms the base of the investment thought process for investments in retailers.

The nature of the retail business

and the fundamental drivers of success

The retail business is a tough one, and very few retailers succeed in building enduring businesses. The retail landscape has changed tremendously over the last few decades. Fast food restaurants have replaced Automats, and big box retailers have risen to prominence at the expense of high-street/city center retailers. Retailers have to adapt to changes in fashion, lifestyles and consumers tastes. Large established retailers that fail to adapt can fall swiftly; witness how bellwethers like Sears, K-Mart and Circuit City have gone from boom to bust in a matter of years.

Retailers are fundamentally in the business of distribution. They create value by getting products to consumers, in a manner accessible to them when they need it. For a retailer to be successful, it needs to:

1. Stock products that customers intrinsically want.Retailers are rarely able to generate intrinsic demand for a product. The intrinsic demand for a product is determined by a combination of product marketing, consumer lifestyles and the prevailing zeitgeist. What retailers do is to meet that demand by making the products available to consumers. Retailer merchandising and presentation play an important role in stimulating the desire to purchase a product, but they only work if the customer has a fundamental need/demand for the product.For example, it's unlikely a retailer will succeed in selling chicken feed in New York city, no matter how creatively the product is merchandised. 

Retailers can either create their own items to stock (such as retailers like the Body Shop, or the general provisioners of the early 1900s who sold brand-less commodity items), or stock items made by other companies, as long the products are what people desire and fit into the position and mind share occupied by the retailer. FMCG companies add value for the retailer by supplying them with products that their customers want, at a lower cost and with less hassle than having to develop the products themselves. This symbiotry between FMCG companies and retailers has evolved over the years, since it started in the late 1800s when P&G, Colgate and other FMCG companies were founded.

Retailers need to adjust their merchandise mix over time as tastes and needs change over time. Products that are considered necessities today may become irrelevant in a decade, and products that people aspire to change over time. Many retailers fail because they do not keep up with lifestyle and zeitgeist changes.

2. Make it convenient for consumers to buy. Because people generally do not derive value from the buying process; they see it as something they have to go through to get to the value that products deliver (e.g. refreshment from a drink, the cleaning power of a soap, etc.). People tend to buy from the store that is the most convenient to buy from. 

What about people who enjoy shopping? While it's true that they derive value from the shopping activity, the actual purchasing process is not something they would place much value on. Their shopping expeditions will generally be to places which are convenient, being both accessible and a one-stop destination for the merchandise being sought. So making it convenient for consumers to buy is key to successful retailing. To do this, retailers must:

• (a) be accessible in the context of its customers' lifestyles. People will only visit stores that are conveniently accessible to them. The only exception is when a store sells something that a person has become addicted to or induces a strong physiological response, such as pornography and addictive items.
  
  For example, malls and big box stores fit the car-centric lifestyle of suburban shoppers in the U.S. Big box grocers find it harder to succeed in Japan because many people there do not drive, and also have small fridges which cannot store a week's worth of shopping. Instead, convenience stores scattered amidst the urban alleys are more suited to the Japanese lifestyle, because most Japanese consumers walk to subway stations on their way to and from work.
  
  The way people shop changes with changes in their lifestyle, which is typically driven by technological advances and changes in the zeitgeist. For example mail order used to be a convenient way to buy things, but is today rarely used as (1) people are more mobile and able to travel to stores easily, (2) modern logistics networks bring all kinds of goods to local stores, obviating the need to buy from a faraway mail-order retailer, and (3) the prevalence of Internet shopping, which has made mail order less relevant (though not extinct - for example, NBrown in the UK still runs a large home shopping operation)
• (b) be a one-stop shop for the position that it has carved out in people's minds. Each retailer has a position in the customer's mind (for example, a store to buy "natural remedies" or "imported groceries" or "stuff at bargain prices"), and the merchandise mix in the store must support that position. When a customer walks into a store, he/she should be able to find all the items that he/she is looking for. A successful shopping trip reinforces the retailer's position in the customer's mind, while a wasted shopping trip makes it more likely that he will choose another store in future. No amount of positioning marketing will help if the store doesn't have the range of goods a customer looks for.

The economics of the retail business
and sources of competitive advantage

The economics of the retail business are similar to that of the distribution business. Both are a combination of a logistics network and a trading business (inventory management). Like distributors, retailers are price-takers when there are multiple competitors serving the same target customers. On the other extreme, a dominant retailer in a town enjoys a natural moat that gives it pricing power. This does not mean that a retailer's pricing power grows with size, rather there is a tipping point between the two extremes.

• A retailer generally has no price-setting power when there is a competitor serving the same group of customers. (i.e. targeting the same customer profile, and present the same assortment of goods at the same locations/customer touch points). The economics of the distribution business are such that a customer faced with the choice of buying from 2 or more distributors will not be willing to pay much more for one distributor's services as opposed to another. Certainly some people may be willing to pay more to visit a cleaner/less crowded store, but the premium they are willing to pay is minimal. The players are price-takers, and the only sustainable competitive advantage is to be the lowest cost operator within its market. Having the lowest cost of operations and procurement allows the retailer to match all competitor price actions while remaining profitable.
• However a retailer has price-setting power if no other retailer is serving the same group of customers. For example, if a grocery store is the only one that is accessible to the residents of a town, then the retailer can generally set the prices for its services. Likewise, the only store to sell specialty cheeses in a city can set the price for its services.

Size is a source of competitive advantage. All things being equal, the economics of retail are such that the value that a retailer brings to customers increases naturally in proportion to the size of its operations. The largest retailer will almost by definition (a) be the most accessible to customers with the best network of sites by virtue of the in-place nature of the business, and (b) have the widest range of goods. The economies of scale that exist in distribution means that the largest distributor is also likely to have the lowest unit costs, and thus able to offer the lowest prices in order to fend off competitors who try to compete on price.

The largest enjoys a positive feedback loop where its increasing size improves its competitive position, which in turn increases it size, and so on. Once a dominant position is achieved, the economics of distribution gives the retailer a structural competitive advantage and makes it very difficult for smaller competitors in the same category to compete.

This doesn't mean that no other retailer competitor will survive, because consumers don't just base their buying decisions on these factors; there will be people who prefer the competitor's store because of its color scheme, etc. (This applies less to distributors who sell to businesses, because business buyers tend to make economical decisions. Take for example, the different buying behavior between consumers and fleet-buyers when they buy cars. The former will be influenced by styling, while the latter will be driven by fuel efficiency and maintenance costs.)

Building an enduring long-term retail business
with a sustainable competitive advantage

The economics of the business means an enduring retail business is one that is able deliver value to its customer and achieve and retain dominance. This means that an enduring retailer is one that is able to:

(1) Constantly adjust its inventory to continuing stocking products that its customers want, and adjusting its mindshare position in its customers' minds accordingly. (or it could try selling products that are relatively insulated from fashion trends and quick changes in demand)

(2) Constantly adjust it store accessibility, to be accessible even when its customer's lifestyles change. (or it could be serving a consumer group whose lifestyle that isn't expected to change much)

(3) Achieve the lowest cost of operations. In the retail business, this means:

• (a) Maximizing inventory turns. Moving inventory as quickly and efficiently as possible. Fast moving inventory also allows the retailer to reduce the capital intensity of the business, and increases the flexibility to quickly change stock when customer needs change. Conversely, slow moving inventory means that capital is tied up (and financing costs incurred), and also prevents the retailer from purchasing new stock to cater to seasonal or changing customer demands.
• (b) Maximizing sales per square foot. A higher sales intensity increases capital efficiency and productivity. Per unit operating costs are also reduced through the efficiencies gained from selling more in a single location.
• (c) Maximizing economies of scale. This is a business where there are economies of scale. A retailer that has higher purchasing volume will be able to extract more price concessions from its suppliers. Likewise, higher merchandise volume means that the retailers logistics and distribution infrastructure will be better utilized. For example, trucks will travel with full loads, and the fixed costs like warehouse management systems will be amortized a larger volume of merchandise.

Openings that an upstart competitor can exploit
to displace a dominant retailer

The competitive landscape of retail is like an open savannah, where the playing field is flat with few natural defensive positions. The factors of production, technology and merchandise used in retail are available to all competitors. Likewise consumers can switch retailers easily, and lifestyle and fashion changes affect all retailers. A competitive retail landscape is like a highly evolved Savannah ecosystem, where individual players have carved out their own survival space (value to customer, delivery model etc), and their incumbency is evidence of their competitive strength within a niche. In other words, they will likely have found the best way of utilizing existing factors production for a particular customer niche. The more competition the incumbents have defeated, the less likely it is that there are unexploited factors that the incumbent has overlooked.

In this landscape, competitors can establish a survival space only if one of the following openings exist:

(a) They ride a changing consumer wave or change in zeitgeist. In other words, exploit a changing customer profile which the incumbent isn't attuned to. For example, Sears used to be the dominant retailer in the United States, but the rise of suburbia, the auto-culture and changes in tastes allowed big-box stores and category killers to muscle in on Sears' dominance.

(b) They find some technology or operating technique which the incumbents have overlooked. This is difficult, but not impossible. Walmart did just that to K-mart, by exploiting the logistics efficiencies of building store in geographically contiguous fashion. It built out its network of stores in small towns by going into towns next to each other. This logistics efficiency allowed it to achieve lower costs that the incumbent discounter K-Mart, which had store that were situated in big cities hundreds of miles apart.

(c) The incumbent messes up. The dominant retailer may also mess up, for example, by allowing its store to be infested by rats. Dominant retailers can also the mistake of muddying its position and deviating from the formula that made it successful. For example, a retailer with the position of lowest-cost discounter may try to become an aspirational retailer that sells higher-end goods. Because of the Savannah like competitive landscape, deviating from a survival space means that a retailer is exposing itself to open competition from other players who have already found the competitive advantage in their survival space. The dominance in one survival space often does not translate to another survival space, and the retailer will be starting from zero in its competitor's stronghold. This doesn't mean that a grocery discounter will be unsuccessful selling discount electronics, because the competitive dynamics of both areas are similar. But a discount grocer trying to sell fashionable clothes is going to find it tough going, because the survival dynamics in each space are vastly different.

What this means for Investors
who invest in retail companies

Investing in retailers involves a quantitative assessment of the retailer's cost position and dominance, and a qualitative assessment of whether its position, customer base, and accessibility to its customers are likely to continue relative to zeitgeist and technological changes. It basically means:

1. identifying retailers that have established strong survival spaces, and
2. constantly monitoring the landscape for evidence of competitive openings that may have been created, and
3. constantly monitoring the changes in consumers' lifestyles and evidence that the retailer is keeping up with these changes

It is more than a simple spreadsheet exercise, unless we are planning to liquidate the retailer for its assets.

http://www.ventureoutlook.com/2009/07/investing-in-retail-stocks-business-and.html
SUNDAY, JULY 19, 2009

Recession-proof fashion retailers do better than others during a bear market

Recession-proof fashion retailers do better than others during a bear market
Written by Lim Siew May of theedgemalaysia.com
Tuesday, 06 December 2011 09:43


KUALA LUMPUR: In Malaysia, only three home-grown fashion brands — Padini Holdings Bhd, Bonia Corp Bhd and Voir Holdings Bhd — are listed on Bursa Malaysia, but they have been surprisingly resilient. Each remained profitable during the 2008 financial crisis.

Padini Holdings Bhd, which is widely covered by analysts, was the first retailer to list, doing so in 1998. It retails fashionwear and accessories through its brands — Seed, Vincci, P&Co, PDI, Padini Authentics Miki and Padini.

In early November, it boasted the highest market capitalisation [among the three] of RM657.91 million, and profits have been growing consistently y-o-y from 2001 to 2010. It has consistently paid out dividends of at least 30% of its net income, and for FY2011, it is expected to distribute RM26.3 million (34.7%) out of its net profit of RM75.7 million.


The market capitalisation of Bonia Corp Bhd, which retails branded leatherwear, footwear as well as men’s apparel and accessories, is about half of Padini’s at RM328.56 million. It made a net profit of RM33.55 million for FY2010. The company owns the Bonia, Sembonia and Carlo Rino brands and the licence for international labels including Santa Barbara Polo and Valentino Rudy.


Voir Holdings Bhd has the smallest market capitalisation of RM60.60 million. The company owns brands such as VOIR, Applemints and SODA as well as licensed international brand Diadora. Besides selling women’s apparel, shoes and accessories, the company also designs and sells clothes for men and children. It made a net profit of RM7.7 million for FY2010.


Compared with luxury fashion houses listed in Hong Kong, local fashion stocks are much cheaper. The three companies are trading at price-earning ratios (PERs) of between 8.42 times and 8.75 times. In comparison, Italian luxury brand Prada SpA, which listed in Hong Kong in June, is trading at 28 times.

Recession-proof?


The possibility of a double-dip recession for the global economy is certainly alarming but the stock market will offer great bargains. Certain resilient industries do better than others during a bear market.

There are two opposing schools of thought on the prospects of non-utilitarian stocks such as fashion during a recession. On one hand, branded wear can be seen as luxury, not a basic need, which is eliminated from a tightened budget.

The opposing view is that people tend to seek an escape from hard times and are more likely to indulge in shopping. The latter helps to explain the resilience of Padini, Voir and Bonia during the last financial crisis.


An analyst, who requests anonymity, is sanguine about the local fashion stocks. “Malaysians love sales. Fashion companies can spur customer spending via sales and promotions, even though they do incur marketing costs. I believe that our middle-class fashion range will fare better than high-end fashion stocks in Hong Kong, given their affordability.”


A consumer-sector analyst, however, is cautious: “Fashion is not a staple. I believe the sector will be affected by the current conditions in the global economy. People will hold back during uncertain times.”
Here are ways to evaluate a solid fashion stock, regardless of whether we will see a global.

Branding counts


Branding is said to be the most important component of a fashion retailer. “Everyone has heard of Padini. It is available at almost every retail outlets across the Klang Valley, and people usually prefer to stick to an established brand,” says the first analyst.

“Padini offers a wide range of products for various market segments, and they are affordably priced. When a fresh graduate needs to buy working clothes, he buys from Padini instead of foreign fashion brands such as Zara, which costs 50% more.”


Is the company actively growing its brand? This is reflected by mergers and acquisitions as well as decisions to spend 2% to 3% of its revenue on marketing initiatives and/or aggressive openings of more outlets. “Organic growth will not result in a premium valuation for fashion stocks,” says the analyst.


A HwangDBS Vickers Research report indicates that there is a correlation between a newly opened store and the company’s revenue stream. For instance, when Padini expanded its retail space by more than 50%, or 143,955 sq ft, in 2008.

Padini is setting its sights on rural areas like Sabah, where there is enhanced purchasing power. The group has started selling its affordably priced garments in the Brands Outlet in Suria Sabah in Kota Kinabalu, 1st Avenue Mall in Penang, as well as 1Borneo Shopping Mall and 1 Multi-Concept Store in Sabah.

“Residents don’t really have access to swanky and established malls. I believe Padini should perform relatively well there,” says the analyst. Brands Outlet, a Padini standalone store, has been instrumental in driving the company’s revenue growth, contributing a compounded annual growth rate of 85% since its debut in 2007, says the HwangDBS Vickers Research report.


Starting a standalone store is also a good move for the fashion company. “When you move beyond [renting space in a department store], you will have more space and better control over your operations. And if your brand is the anchor tenant, you can probably negotiate for favourable rental terms,” says the consumer-sector analyst.

Increasing same-store sales


Same-store sales are used in the retail industry to reflect the difference in revenue generated by the retail chain’s existing outlets over a certain period of time. This statistic differentiates between sales generated from new stores and those from existing stores.

“This metric shows the organic growth of a store. New outlets usually reach their peaks after three or four years, then you won’t see fantastic double-digit growth,” says the analyst.

Growth of same-store sales reflects the management’s acumen in predicting fashion trends while the reverse signifies inaccurate expectations or a saturated market.


Unfortunately, growth figures are not readily accessible to retail investors, although analyst’s reports or news reports may feature them. To compensate, evaluate the company’s financial performance.

“It all boils down to the company’s ability to give its customers what they want. Look at the big picture. You can assess its ability to meet customers’ demand through the sales figures in the financial statements. You can also go to the stores and observe the foot traffic,” suggests the analyst.



Expect months of lower sales. According to HwangDBS Vickers Research’s report, Padini sees lower sales during non-festive seasons, such as in 2Q2011. However, the report explains that this is a common characteristic of the retail industry.

Stocks and threats



Holding a high volume of inventory for a long time is not a good sign for a fashion retailer. Inventory takes up storage space and affects liquidity. High inventory may also compel a company to significantly mark down its out-of-season stocks, leading to compressed margins.


To cater for festive celebrations such as Christmas and Chinese New Year, there will be a surge in inventory, the analyst says. “The inventory volume depends heavily on the management’s view. If it takes a sanguine view of the economy, it will increase stocks accordingly.



“However, if a great deal of the inventory in December does not translate into sales by March or April, it can mean a weak quarterly financial performance for the company.”



Rising raw-material (such as cotton) costs and the minimum wage hike in China are some of the key threats facing fashion retailers around the world. Gross margin, which measures the percentage of each ringgit of revenue retained as gross profit, is used to evaluate the management’s ability to manage cost.

The higher it is, the more the company is able to retain each ringgit of revenue to meet other business costs and obligations. A reduced gross margin can be a result of plunging revenue and/or increased business costs — all of which impact earnings.


http://www.theedgemalaysia.com/personal-finance/197332-malaysians-love-shopping-so-recession-proof-fashion-retailers-do-better-than-others-during-a-bear-market.html

The Retail Game

The Retail Game

Great companies in attractive industries generate returns on invested capital that far exceed the cost of capital.

1. However, retail is generally a very low-return business with low or no barriers to entry.

Retail bellwethers Wal-Mart and Walgreen earn little ore than 3 cents profit for every dollar of sales, so store management is critical. The problem is that many retailers don't execute as flawlessly as these two and flame out as soon as trouble hits.

2. The sector is rampant with competition.

Think of all the specialty apparel shops that try to imitate Abercrombie & Fitch and Gap. A few succeed; most fail, but the point is that nothing exists to prevent new concepts and stores from being launched. There are few, if any, barriers to entry. Customers may be swayed to buy a cool $50 sweater, but they'll quickly go to the store next door if the same sweater can be had for $40.


3. The primary way a firm can build an economic moat in the sector is to be a low-cost leader.

Wal-Mart sells items that can be purchased just about anywhere, but it sells it all for less than the competition, and consumers keep coming back for the bargains. Others may try to imitate Wal-Mart's strategy in the short run but lack the economies of scale to remain profitable employing the strategy in the long run.

How Healthy Is the Balance Sheet with All Those Leases?

Common Investing Pitfall: How Healthy Is the Balance Sheet with All Those Leases?

Many retailers use operating leases to "rent" space for their stores. Because these leases aren't capitalized and are kept off the balance sheet, they understate a firm's total financial obligations and can artificially inflate financial health. The leases aren't inherently bad or sneaky; in fact, their existence is core to most retailer's expansion plans. Lease obligations can be found in the footnotes of a firm's 10-K under the heading "commitment and contingencies."

Be sure to give a retailer a thorough checkup before declaring it to be in tip-top financial shape.

For example, Tommy Hilfiger appeared to have pretty good financial health going into 2002. The firm had $387 million in cash and $638 million in total debt. However, the specialty apparel firm also had $273 million of future financial obligations in the form of operting leases. If we add off-balance sheet leases to the debt on the balance sheet, the toal comes to $911 million, and the coverage ratios don't look as robust. Tommy Hilfiger entered 2002 with declining sales and stagnating profits and cash flow. When Hilfiger announced that it neede to close many of its retail stores in October 2002 and pay to break the leases, the stock price was hammered.

Are Those Same-Store Sales (SSS) Growth Numbers Accurate?

Common Investing Pitfall: Are Those Same-Store Sales (SSS) Growth Numbers Accurate?

Every quarter and, for most restaurants and retailers, every month, same-store sales (SSS) numbers are released. SSS growth measures sales at locations open for at least a year and excludes sales increases attributed to current openings (also known as new store sales growth). For purposes of reporting, SSS are also know as comparable-store sales or comps.

But, what if a new store doesn't fully mature in 12 months? The process of that new store reaching maturity in year two or year three helps boost the SSS figure, while sales at older stores may not be growing at all or are declining.

This is a very important consideration for companies that are transitioning from aggressive growth into slower or steadier growth. As long as they can open a greater number of stores year after year, the SSS or comps will look impressive. But every company's expansion plan reaches an inflection point - they're still growing, just not as fast. This has two effects.

• First, opening fewer stores obviously translates into smaller new store sales growth.
• Second, having fewer stores entering those productive years two and three also lowers SSS or comps.

The combination of slower new store growth and lower SSS or comps can send overall growh and the stock price plunging quickly.

From 1995 to 2000, Office Depot averaged 14 percent per year in new store growth. However, the office supply store business quickly became saturated when competitors Staples and Office Max also engaged in aggressive expansion plans. In 1999 and 2000, the last two years of its rapid expansion, Office Depot's total SSS increased 6 percent and 7.5 percent. In 2001, new store growth stopped and SSS declined 2 percent; the stock price sank below $10 from a high in the mid $20's in 1999.

Investing in Retail: Understanding the Cash Conversion Cycle

Investing in Retail: Understanding the Cash Conversion Cycle

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Figure: The cash conversion cycle

= Days in Inventory + Days in Receivables - Days Payable Outstanding

= 365/Inventory turnover + 365/Receivables turnover - 365/Payables turnover

Where,
Inventory turnover = Cost of goods sold/Inventory
Receivables turnover = Sales/Accounts receivable
Payables turnover = Cost of goods sold/Accounts payable

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best-case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier. Wal-Mart is one of the best in the business at this: 70 percent of its sales are rung up and paid for before the firm even pays its suppliers.

Looking at the components of a retailer's cash cycle tells us a great deal. A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favor. This leads to excess inventory, clearance sales, and, eventually, declining sales and stock prices.

Days in receivables is the least important part of the cash conversion cycle for retailers because most stores either collect cah directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price. Retailers don't really control this part of the cycle too much.

However, some stores, such as Sears and Target, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves. The credit card business is a profitable way to make a buck, but it's also very complicated, and it's a completely different business from retail. We're wary of retailers that try to boost profits by taking on risk in their credit card business because it's generally not something they're very good at.

If days in inventory and days in receivables illusrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they're one of the few (if not the only) games in town. For example, 17 percent of P&G's 2002 sales came from Wal-Mart. The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retai has a huge advantage when ordering inventory: It can push for low prices and extended payment terms.

Home Depot finally started taking advantage of its competitive position by squeezing suppliers in 2001 and 2002. Days payable outsanding for the home improvement titan has historicaly been around 25. In 2001, the figure hit 33 days, and by 2002, it exceeded 40 days. By holding on to its cash longer and reducing short-term borrowing needs, Home Depot increased its operating cash flow from an average of $2.4 billion from 1998 to 2000 to $5.6 billion from 2002 to 2003.