Strategic Profit Model Results for 2017
By John S. Strong, Lawrence J. Ring, and Khyati Muchhala
As in past years, we have updated our review of Strategic Profit Model results for publicly traded retailers for 2017.* Similar to the past two years, we observed fewer star performances, as some turnarounds faltered and some recent star companies and sectors lost a bit of luster. Retailers continued to grapple with the full consequences of online, digital, and omnichannel operations and competitors. The main theme of 2017 was topline retail growth being achieved only through aggressive price competition and lower margins. The 2017 performance also shows mixed results across consumer segments, retail formats, and within individual retail sectors. Private equity buyouts, restructurings, and consolidation continued to reshape retailing; notable transactions in 2017 (and early 2018) included the buyout of Staples, the bankruptcies of Toys “R” Us and Bon-Ton Stores, and the merger of QVC and HSN.
Table 1 (pdf) shows the Strategic Profit Model results for 2017 for the 59 largest public U.S. retailers, based on sales. Sales for each of these companies are approximately $2 billion (or more), and represent about 60% of U.S. domestic retail sales excluding motor vehicles.
Table 1 ranks this group based on Return on Sales. For our overall set of 59 U.S. retailers for whom both 2016 and 2017 results are available, the aggregate numbers were mixed, with sales up 4.1%, but profits down 4.4%. As a result, Return on Sales (ROS) rose to 3.32% in 2017 from 3.62% in 2016. Asset productivity (Sales: Assets) fell slightly at 1.96 (versus 2.01 a year earlier). As a result, Return on Assets (ROA) fell to 6.52% from 7.27%. Continued low-interest rates and share repurchases led to a slight increase in Leverage (Assets: Equity) to 3.24 in 2017 from 3.14 in 2016. (This is a continuing trend, as Leverage for this group was 2.73 in 2013.) In aggregate, Return on Equity (Net Income: Equity) fell to 21.16% from 22.83% a year earlier. Thus, except for sales, the aggregate numbers and returns for the largest publicly traded U.S. retailers went backward in 2017.
At a disaggregate level, variations in performance are striking. While almost 80 percent of the retailers (46 of 59) retailers achieved sales increases, only 33 of 59 were able to increase net income. Overall, 33 companies had increases in Return on Sales, only 29 had increases in asset productivity, and only 34 retailers had increases in Return on Assets. Only 21 companies had higher leverage. Taken together, only half (30 of 59) were able to deliver higher return on equity.
The result of soft aggregate performance but mixed company returns can be explained by two factors: (1) fewer star performers and fewer disasters; and (2) increased omnichannel competition that pressured prices and margins. Across sectors, sales increases were largely achieved only with lower margins, or companies were not able to stop sales declines despite price-cutting and margin erosion.
Table 2 (pdf) ranks these companies based on Return on Equity, along with the ROE results for the past five years. Most of the companies at the top of the ROE tables have shown consistent results during the past five years, including Home Depot, TJX, Ross, Tractor Supply, Ulta Beauty, Sherwin-Williams, and Nordstrom, although part of the high ROE results for Home Depot and Nordstrom were the result of large share repurchases which reduced book equity values.
Overall, we can divide retail performance into four groups: star performers, the weakening middle market, the adapters, and the question marks. These classifications cut across retail sectors, reflecting the fact that changes in ecommerce and competition are broad based and are no longer concentrated in some product categories.
The Star Performers
The most significant result continues to be the explosive growth of Amazon, but with the development of much stronger financial performance.
Sales grew 31% in 2017 to $178 billion. Overall, Amazon accounted for about 45% of U.S. online sales and more than half of total ecommerce growth in the U.S. in 2017. Financial performance continued to strengthen, as net income rose from $2.4 billion in 2016 to $3.0 billion in 2016.
Amazon’s CEO, Jeff Bezos, has consistently stated that the most important financial metric for Amazon is free cash flow. Amazon’s operating cash flow grew from $17.3 billion in 2016 to $18.4 billion in 2017. With this cash, Amazon invested $12 billion, predominantly in fulfillment capacity and in AWS technology infrastructure. Amazon also spent $14 billion on acquisitions during the year. Amazon also continued to build substantial cash on its balance sheet, adding $5 billion to end the year with $31 billion.
Amazon’s business model continued to evolve, with North America, International, and Amazon Web Services (AWS) business units. In North America, the extension of Amazon Prime expedited shipping to third-party sellers has resulted in rapid growth of fulfillment by Amazon. Other retailers can use both Amazon’s platform and logistics to sell online. These third-party sellers are the fastest-growing part of Amazon’s business, representing over 40% of the items listed and more than half of the unit volume. These third-party sellers increasingly sell higher-value, lower-turnover items, with Amazon collecting commission and fulfillment fees (a much higher profit margin).
AWS has become the most profitable and fastest-growing business unit; in 2017, AWS reported segment income of $4.3 billion on $17.5 billion of revenues. AWS now generates all of the company’s operating profit on just under one-tenth of total revenues. The International segment has proved challenging. The segment is only 30 percent of Amazon’s revenues, but has worsened from breakeven in 2015, to an operating loss of $1.3 billion in 2016, to an operating loss of $3.1 billion in 2017.
Other retailers turned in strong performance in terms of sales, profits, and returns. Home Depot reached $101 billion in sales, with higher returns. Sherwin-Williams’ results continued to improve. Both TJX and Ross turned in strong performances, although TJX margins were a bit below year earlier results. Dollar General added $1.4 billion in revenues with higher returns. Ulta Beauty added over $1 billion in sales while increasing returns on sales, assets, and equity. Costco was able to add $10 billion in sales while maintaining margins. Kohl’s renewed emphasis on value and operational efficiency resulted in sales growth of $500 million while increase return on sales from 3 percent to 4.5 percent and return on equity from 11 percent to 16 percent.
Retail Challenges: The Hollowing Out of Traditional Middle Market Retail
Traditional retailers who historically served the middle market continued to be under severe pressure. These challenges were particularly pronounced for promotional (high-low) supermarkets and department stores. Mainline supermarkets such as Kroger, Weis, and Ingles faced EDLP competition from Aldi, and Walmart. The department stores continued to struggle. Sears lost another $383 million, and saw its sales shrink to $16.7 billion. At the time of its merger with Kmart in early 2005, the combined company was the third-largest retailer in the U.S., with $55 billion in revenues. JCPenney continued to struggle, only able to hold onto sales by margin erosion and a loss of $116 million from breakeven a year earlier. Other department stores, including Macy’s and Dillard’s, were only able to improve profitability through closures, with revenue declines. In contrast, the EDLP and value retailers continued to take market share in the mid-market.
We describe the “adapters” as those companies who are fundamentally revising their business models to the realities of ecommerce competition and to omnichannel retailing. These changes take a number of forms, from right-sizing store sizes and store networks, to revising merchandise pricing and margins, to adding fulfillment and service capabilities across channels. This changed environment brings the challenge of lower revenues and margins, and the need for greater productivity to reduce breakeven levels and to build profitable digital operations. The best example of this adaptation has been Best Buy, which has built a new omnichannel model in an environment of fierce price competition, declining average selling prices, and legacy costs. Best Buy had another good year in 2017, growing sales almost $3b with only a slight decrease in returns.
This adaptation brings with it the financial challenge of higher sales only being achieved through lower gross margins, while omnichannel investments are front-end loaded with longer term potential payoffs. A large number of retailers found themselves in exactly this situation in 2017, with sales increases accompanied by lower margins and higher investments. The leading example was Wal-Mart, who has announced dramatic reductions in store growth and size, while reallocating its capital funding toward ecommerce investments and acquisitions. These actions have begun to pay off for Walmart, as it became the first retailer to reach $500 billion in revenues, albeit with lower margins and returns.
Walmart’s experience was broadly representative across retail sectors. The common thread was sales growth accompanied by lower gross margins, lower return on sales, and lower return on assets, with any increases in return on equity being achieved only through higher leverage. This situation characterized many retailers in 2017, including Publix (food); American Eagle, L Brands, Nordstrom (fashion); Dick’s Sporting Goods, Tractor Supply, Williams-Sonoma, (specialty).
After four years of restructuring, Target appeared to make progress in 2017, with sales growing to $72 billion and return on sales exceeding 4 percent. After major restructuring, Big Lots returned to revenue growth and profitability. After a couple of soft years, apparel retailers Gap, Abercrombie & Fitch, American Eagle turned in solid results.
The Question Marks
In a different category than the adapters were those retailers who not only struggled with declining margins and returns, but were also unable to generate top-line sales increases to help offset the changing retail environment. This group includes a broad spectrum of formerly leading retailers, including L Brands (Victoria’s Secret), Walgreens Boots Alliance, Lowe’s, Bed, Bath, and Beyond, Chico’s, and Advance Auto Parts. Acquisitions problems weighed on results at Dollar Tree. Other companies that have been in multiyear turnarounds continued to falter, including RiteAid and Office Depot.
European economic recovery and stabilization in Asia did not make 2016 a much better year for international retail. Table 3 reports similar results for a group of major international retailers. Only 10 of the 22 retailers in Table 3 (pdf) experienced increases in Return on Equity. Some these increases were quite small while others were the result of comparisons to prior year losses, write-offs, and restructurings.
Leading performances were turned in by Inditex and H&M (although inventory challenges dramatically hurt H&M in 2018). Another strong performance was turned in by Dairy Farm, the pan-Asian food and drug retailer. Fast Retailing (Uniqlo) saw improved performance as growth plans were pared back and restructuring efforts began to bear fruit. Migros Turk’s turnaround helped restore profitability, although its high return on equity was driven by the low equity value resulting from write-offs during the year.
For European retailers, the financial and economic problems from the soft economy continued in 2017. Competitive pressure from hard discounters Aldi and Lidl continued as a major challenge to European food retailers, with softer results at Ahold and Delhaize spurring the two companies to merge to reduce costs. The performance of Tesco, Morrison’s, Metro, and Sainsbury/Asda continued to be soft. In contrast, new leadership and restructured operations appear to have brought stronger results at luxury group Kering and at home improvement chain Kingfisher.
Woolworths Australia saw slight improvement in results, while rival Wesfarmers slipped. Carrefour’s series of strategic restructurings appears to stumble again, as did Foncière Euris. The largest Japanese retailers continue to post weak results, spurring further consolidation. Only Seven-Eleven Japan, long-recognized as the world’s premier convenience store chain, saw improved results.
Best Performers for 2017
Our selections for best performing publicly traded retailers are:
- Best Upscale Department Store: Nordstrom
- Best Broadline Department Store: Kohl’s
- Best Discount Department Store: Walmart
- Best Online Retailer: Amazon
- Best Off-Pricer: TJX, Ross
- Best Extreme Value: Dollar General
- Best Specialty Apparel: Inditex (Zara)
- Best Specialty Hardgoods: Ulta Beauty
- Best Consumer Electronics: Best Buy
- Best Convenience Store: 7-11 Japan
- Best Home Improvement: Home Depot
- Best Supermarket: Publix
- Best Pharmacy/Drug: CVS Health
- Best Home Retailer: Williams-Sonoma
- Best Office Supply: none
- Best Specialty Automotive: AutoZone
- Best Turnaround: Best Buy
- Biggest Challenges: Sears, JCPenney, Office Depot, RiteAid, Lowe’s
*For the full set of results, download SPM Retail Results FY 2017 (xlsx).