Retailers Spy A New Strategy

There’s more to understanding retailers than meets the eye, and that became clearer than ever last week.

 

🕰 Recap

  • Big-box retailers like Walmart reported stronger-than-expected results at the height of the pandemic.
  • But soaring inflation began hampering their earnings this year.
  • Case in point: US retailer Target issued its second profit warning in three weeks on Wednesday.
  • And on Thursday, British department store chain John Lewis announced plans to build out rental properties.

 

✍️ Connecting The Dots

Income statements are the Holy Grail for investors in the retail sector: they show how much revenue they’ve brought in and how much profit’s left over after covering their costs – and might be all investors need to assess their value. When a company is growing sales in its existing stores, it makes more in profit and investors tend to buy in. And when those sales aren’t growing as quickly as hoped, their profits might fall short and investors are more likely to sell their shares.

Some investors add in another layer of complexity by focusing on so-called “operating leases” – that is, the rental fees retailers pay for their store locations. They’re a major fixed cost for retailers and brands alike, which can either help or hurt their bottom lines. That means there’s an ongoing debate among investors and companies about whether it’s best to rent or own store locations. Luxury Swiss watchmaker Swatch illustrated one side of the debate a few years back: its high fixed costs – including rent – meant a 15% uptick in sales versus the same time the year before drove a 70% jump in profit.

But ignore retailers’ other financial statements at your peril: their balance sheets – that is, a picture of their assets and liabilities at a particular point in time – paint a thousand words. Analysts are always sure to compare a retailer’s sales growth to the growth in its inventory – the value of the products yet to be sold. They’ll want both to be growing in tandem, or inventories to grow a little slower than sales: a restricted supply could allow for higher product prices, after all.

If inventories are growing way ahead of sales, though, there might be a problem: it could indicate that retailers are stacking up products that customers don’t want. Remember, retailers were rewarded for hoarding stock two years ago, showing they could meet demand through the pandemic. But the tables have turned, and inflation-bitten consumers are buying less. The path from here is well-trodden by retailers and brands: they offer big discounts to sell leftover inventory, which hits both profit margins and customers’ perceived value of the brand. And that makes it hard to hike prices in the future.

 

🥡 Takeaways

1. The bigger they are, the harder they fall.
US giants Walmart and Target are at the start of this downward spiral: the latter just slashed its second-quarter earnings projection three weeks after lowering its initial forecast. But it’s not that customers don’t want to spend with the big-box retailers: it’s just that their preferences for products are changing. That’s why Target is sticking to its guns on its revenue forecast: it’s hoping that once it’s past the financial shame of discounting and writing off some of its inventory, its profit margin the rest of the year will be even higher than it was before the pandemic.

2. Leases matter.
Some investors love retailers that own property: it gives them the option to, say, develop new homes on top of stores, and bring in extra income. So they’ll be pleased to hear that UK department store John Lewis announced plans last week to do exactly that, especially in light of a shortage of homes in the UK and the unstoppable rise of ecommerce. Other investors, meanwhile, prefer that retailers keep the flexibility of leases, allowing them to quickly ditch flailing locations at the drop of hat.

 

🎯 Also On Our Radar

Reports emerged last week that Netflix is thinking about trying to buy rival video streamer Roku. While Roku’s 61 million users are small potatoes compared to Netflix’s 220 million, Roku’s existing advertising business could help boost the cheaper, ad-supported subscription package that Netflix is planning to launch.

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