Latest Strategic Profit Model Results
By John S. Strong & Lawrence J. Ring
Our selections for best-performing, publicly traded retailers are:
Best Upscale Department Store: Nordstrom
Best Discount Department Store: Wal-Mart
Best Online Retailer: Amazon
Best Off-Pricer: TJX
Best Extreme Value: Dollar Tree, Family Dollar
Best Specialty Apparel: H&M, Inditex
Best Consumer Electronics: Amazon
Best Convenience Store: 7-11 Japan
Best Pet Supply Superstore: PetSmart
Best Home Improvement: Home Depot
Best Supermarket: Publix, Whole Foods
Best Pharmacy/Drug: Walgreen’s
Best Home Retailer: Bed Bath & Beyond
Best Office Supply: Staples
Best Specialty Other: Advance Auto Parts
Rising Stars: Tractor Supply, Ross
Best Turnarounds: Macy’s, Foot Locker, Walgreen’s, Williams-Sonoma
Biggest Challenges: Supervalu, Sears, JCPenney, Best Buy, Radio Shack, Office Depot, OfficeMax
As in past years, we have updated our review of Strategic Profit Model results for retailers for 2011. A year ago, we wrote that after four years of a deep recession followed by unsettled economic conditions, retailers seemed to be regaining and strengthening financial performance. That sense of optimism and promising results in the first quarter of 2011 soon foundered with softening results and much slower growth in the last three quarters of the year. In short, retail moved sideways in 2011, with mixed results across consumer segments and retail formats. There were only a few star performances. In contrast, many turnarounds appeared to founder, while a number of large, iconic retailers reported very weak results and trading environments that threatened their longer-term prospects.
As we reported last year, the economic downturn forced retailers toward a different model for generating returns. The model of the early 2000s was built around sales growth, fixed cost leverage, and substantial use of debt to generate high returns on equity. The changed economic environment required a strategy of profitability based on productivity, not growth. It also required more emphasis on returns on capital, as markets have much more conservative views about the appropriate level and potential consequences of high leverage. By 2010, the results of these efforts began to bear fruit: for 71 of the largest publicly traded retailers, 2010 sales were up 3.9 percent but profits increased 20 percent (compared with 2009). Retailers approached 2011 with optimism and plans for growth.
However, these improvements stalled in 2011. Table 1 shows the Strategic Profit Model results for 2011 for the 71 largest public U.S. retailers, based on sales. (Sales for these companies are $2 billion or greater.) Sales increased 9.1 percent to $1,736 billion, but net income declined 7.1 percent to $50.1 billion. While some sectors faced sharply rising costs of goods sold (for example, food and cotton-based apparel), profitability in the broad retailing sector was more impacted by aggressive discounting and increased promotional activity.
For our set of 71 retailers, Return on Sales (ROS) fell to 2.9 percent in 2011 from 3.3 percent in 2010. Asset productivity (Sales: Assets) slightly improved from 2.01 to 2.09, but this was not enough to offset the decline in profit margins so that Return on Assets (ROA) declined to 6.0 from 6.6 percent. Leverage (measured as Assets: Equity) was basically unchanged at 2.43 in 2011 compared to 2.40 in 2010. As a result, Return on Equity (ROE or RONW) fell from 15.7 to 14.7 percent. These significant declines in profitability were broad-based: 40 of the 71 retailers showed declines in profit margins, while the great majority of the remaining 31 retailers had only small increases.
The most significant result in the 2011 data is the explosive growth of Amazon. Sales grew 41 percent in 2011 to $48 billion. Sales doubled from 2009 to 2011. The 2011 absolute sales increase of $14 billion was exceeded only by Wal-Mart, a company 10 times larger in revenues. Amazon is now the 10th largest U.S. retailer by revenues. Amazon’s business model continued to evolve, with new online stores, products and services, some of them proprietary such as the Kindle. The company’s strategy of price, selection, and service was extended to more countries; international sales are now 44 percent of total revenues.
In terms of the Strategic Profit Model, Amazon’s profitability is marginal. Return on sales (ROS) fell from 3.4 percent in 2010 to only 1.3 percent in 2011. While asset turnover was slightly higher, return on assets fell from 6.1 to 2.9 percent. Lower leverage meant that return on equity declined even more sharply, from 16.8 to 5.9 percent. Amazon CEO Jeff Bezos clearly and consistently has stated that the company’s growth strategy is long-term and that the most important financial metric for Amazon is free cash flow. While Amazon’s operating cash flow grew from $3.5 billion in 2010 to $3.9 billion in 2011, heavy capital expenditures resulted in a decline in free cash flow from $2.5 billion to $2.1 billion. Amazon’s challenge to existing retailers continues to grow and is more difficult to address given its different operating and financial strategy.
At the individual and sector level, there were mixed results in 2011. As the sluggish recovery and uncertain economic prospects continued, consumer habits established in the recession continued, such as trading down and being more price- and promotion-driven. Value retailers continued to report strong results. Wal-Mart sales grew by 6 percent, although profits and returns declined slightly. Financial results were especially strong at off-pricers and deep discounters TJX, Ross, Family Dollar, and Dollar Tree. TJX reported its fourth straight year of Return on Equity above 40 percent.
In specialty apparel and softlines, improvements in 2010 largely stopped in 2011. Limited Stores reported moderate sales growth of 8 percent but only 6 percent profit growth. (Limited’s dramatically increased ROE was due to a $1.1 billion debt-financed share repurchase, which reduced book value equity by 90 percent.) Abercrombie and Fitch, in the wake of three years of losing share to other more value-oriented competitors, saw its more aggressive pricing policy drive sales up 21 percent, but incurring a 16 percent profit decline. Aéropostale saw a dramatic reversal in performance, as sales fell 2 percent and profits declined 70 percent. American Eagle was a lone bright spot, with sales growing 6 percent and profits 8 percent. Gap’s turnaround efforts stalled, with sales down 1 percent and profits down by 31 percent.
In broadline retailing, Nordstrom sustained its strong performance while Macy’s continued improvement in performance (sales up 6 percent, profits up 48 percent) showed that its turnaround and restructuring plan was working. Saks reported improved results for the second year in a row as well, as did Belk Stores. In contrast, Dillard’s continued to struggle, JCPenney fell off a cliff as it attempted a major repositioning, and Sears Holdings’ secular decline accelerated.
In technology, Best Buy and the office supply companies continued to face strong competition from Amazon, who saw a 40 percent increase in sales with only a small decrease in net margin. Staples finally saw improvements in both sales and profitability, while both Office Depot and OfficeMax continued to struggle. In specialty retail, strong sales and profit growth were shown by Tractor Supply, PetSmart, and Bed Bath & Beyond. Also notable was the continued strong performance of the leading automobile parts retailers Advance Auto Parts, AutoZone, and (slightly less so) by O’Reilly Automotive.
In food, the results were again mixed, with a range of performances across all customer segments. Although Whole Foods, Kroger, Ingles, and Weis Markets reported strong improvements in results, Safeway, Supervalu, Spartan, and Harris Teeter (formerly Ruddick) saw sales and profits flat to down. In drugstores, Walgreen’s customer and store initiatives sparked a much-improved performance, as sales rose 7 percent while profits were up 30 percent. CVS’ performance was flat, while Rite-Aid suffered major losses.
Table 2 reports similar results for a group of major international retailers. Half of the 30 retailers in Table 2 experienced declines in Return on Equity, driven by lower profit margins, lower asset productivity, and lower levels of leverage.
The top spot on the list is again held by Dairy Farm Group, part of Jardine Matheson, which operates food, pharmacy, and hypermarket formats in Asia. Dairy Farm reported improved return on sales, asset productivity, and return on assets, leading to an increase in RONW despite reducing its high financial leverage.
H&M and Inditex (Zara and other brands) continued their strong performance in the fast fashion segment, with each showing year-on-year improvement with sales growth of 17 percent (H&M) and 18 percent (Inditex). The profitability edge that had long been held by H&M was narrowed in 2011, as H&M absorbed much of the increase in cotton prices while Inditex passed these higher raw materials costs on to customers in higher prices.
For European retailers, the financial and economic problems from the euro crisis have started to show the same effects on retailers seen in the U.S. in 2007–2009. The European food chains generally saw lower returns on equity, slow growth, and flat to slightly down returns on sales. However, the performance of Tesco and Metro results faltered after recent improvements; each faces challenges in the home market by revitalized and low-priced value-driven competition, as well as weak performances in some other countries (most notably, Tesco’s major losses in its Fresh and Easy U.S. operations). Carrefour continued to struggle with weak results and the effects of a series of strategic restructurings. Japanese retailer Daiei again experienced major losses; indeed, the largest Japanese retailers continue to post weak results, with the notable exception of Seven-Eleven Japan, which continues to be the world’s premier convenience store chain.