Free Singular Diligence Issue: Village Supermarket (NASDAQ:VLGEA)

Want some good reading for the weekend? Check out this research report on Village Supermarket provided for free via Gannon on Investing.

You find the report here.

Disclosure: I am not receiving any compensation for any of the links provided. I have no business relationship with any company or individual mentioned in this article. I have no position in any stock mentioned. 

Retail (Part II): Edward S. Lampert on Same-Store Sales

“For retailers that aggressively open new stores, the reported SSS metrics are helpful, but far from complete. Rather, an investor would want to know how the stores greater than four years old are doing from a sales and profit perspective and how much money is being invested in those stores. In addition, an investor would like to know what is being spent on the newer stores and how they are performing from both a sales and profit standpoint. Without that information, any interpretation of SSS performance lacks real meaning. But so often today, SSS figures are cited without providing that critical additional information – giving investors only part of the picture.” 

—Edward S. Lampert, Chairman of the Board, Sears Holdings

Same-Store Sales: An Important (and Overrated?) Metric for Retail Performance

It’s Sunday today and outside my window the sun is actually shining. After getting some fresh air and sun in the face, it’s time to do the best to become a little wiser. Today we will dig into the topic of same-store sales.

First, we will read an excerpt about same-store sales from Eddie Lambert’s 2005 letter from the chairman. Lampert is the Chairman and CEO of Sears Holding Chairman, and he also is the Chairman and Chief Executive Officer of ESL Investments, Inc., which he founded in April 1988.

Second, we take a look at an excerpt from an article written by Howard Schilit, author of the great book Financial Shenanigans. In this article Schilit discusses same-stores sales and the potential pitfalls an investor should be aware of.

Let’s go. Enjoy (emphasis added).

Same-Store Sales

The discussion of profitable growth brings me to the issue of same-store sales, and why I believe it is not always the best measure of a retailer’s performance. Many analysts and commentators focus on same-store sales (SSS) as the most important statistic in retail, almost to the exclusion of any other statistic (even above profit). I consider SSS to be an important metric for retail performance, but one that is vastly overrated. Like any single metric, SSS has significant limitations. Let me offer a framework to help explain my thinking on SSS and why we do not rely on it to judge our success at Sears Holdings to the degree others in our industry do.

If we take a simple example of a single store, then a comparison of SSS from year to year is fairly straightforward. If a store does $1 million in sales at a 10% operating margin this year, generating $100,000 in operating profit, and does $1.1 million in sales next year at the same operating margin of 10% generating $110,000 in operating profit, it will report a 10% increase in SSS. Now, let’s add another dimension. Imagine that this same store spent $500,000 to improve the store experience during that year. The 10% increase in SSS generated an additional $10,000 in profit. Whether the $500,000 investment makes sense or not in hindsight will depend on the future performance of the store. Obviously, if the store only improves by the $10,000 in profit, the $500,000 investment doesn’t make sense. I believe that companies that pursue SSS growth at any cost often fall victim to these traps.

In reality, the calculation of SSS becomes even more difficult. Individual retailers are opening, closing, and remodeling stores all the time. In this context, the simple comparison of a single store breaks down. Let me explain. Imagine that a new store opens on January 1, 2006. In the first year of operation, this store would be excluded from a company’s calculation of SSS because most calculations only include stores that have been open at least a year. A retail store matures over time and the first year of sales is often at a level that is a fraction of its potential. If we assume that a store opens at 60% of potential and matures to potential over four years, we know that this store will grow by 67% over that period of time (from $6 million to $10 million, let’s say). On that $10 million-in-sales store that opens at $6 million in year 1, the SSS increase over the next three years will average 18.6% per year, with the higher growth rates occurring in years 2 and 3 rather than year 4.

At the end of that period of time, the $10 million store may be at a relative steady-state, and let’s say it is earning at a 10% operating profit, or $1 million per year. The key question is not how well the store did from a SSS standpoint but rather how much money was invested to generate the $1 million profit. If the store cost $5 million to build, a $1 million profit represents a 20% pre-tax return on investment, which is attractive. However, if the store cost $20 million to build, the 5% return on that investment would not be attractive at all. Nevertheless, regardless of cost, the store would still have reported 18.6% compounded growth in SSS.

Complicating things further and bringing things even closer to reality, the more stores that are opened relative to the outstanding base of stores, the higher the SSS metric a company can produce, regardless of whether the new store openings make economic sense or not. If the mature stores (i.e., those that are over four years old) grow at a 1% rate and the new stores grow at the 18.6% per year rate (remember, it is likely that in years 2 and 3 the rates are materially higher than the 18.6%), then mathematically it is simple to show that the more new stores that are opened, the higher the SSS calculation. Only after a period of years will one know whether the new store investments actually made sense and actually contributed to the creation of value.

With Sears and Kmart, given that we have chosen not to open new stores at the pace of our competition, one can get a more accurate measurement of SSS performance. For retailers that aggressively open new stores, the reported SSS metrics are helpful, but far from complete. Rather, an investor would want to know how the stores greater than four years old are doing from a sales and profit perspective and how much money is being invested in those stores. In addition, an investor would like to know what is being spent on the newer stores and how they are performing from both a sales and profit standpoint. Without that information, any interpretation of SSS performance lacks real meaning. But so often today, SSS figures are cited without providing that critical additional information – giving investors only part of the picture.

In our case, starting with Kmart three years ago, we had many stores that were operating with low levels of profit or at a loss. If we had attempted to sustain our sales levels, it would have been difficult to improve our store and company profitability. By changing the objective from maintaining sales to growing profit, we were able to make a substantial improvement in our company’s profitability. No longer are we carrying excessive inventories, spending excessive amounts on marketing, and scheduling excessive labor dollars all in the pursuit of a given level of sales. Instead, our focus is on understanding our customers and figuring out how to provide them products and services that they value, so that we can build relationships with them and profitably serve them over the long term. While reducing sales is not a prescription for success on a base of healthy, profitable stores, it can be a prescription for success where profit was not the primary objective and where sales came from “giving product away” rather than from providing value to the customer. Improving our stores and our store experience will take time, and I am pleased with the progress that we have made to date.

(Source: Sears Holdings, Letter From the Chairman via Edgar –

Next, some wisdom from Howard Schilit on the uses and misuses of same-store sales, a key metric for retailers (emphasis added).

Same-Store Sales

Revenue growth at retailers and restaurants is often fueled by the opening of additional stores. Logically, companies that are in the middle of a rapid store expansion show tremendous revenue growth, since they have many more stores this year than they had the prior one. While total company revenue growth may give some perspective on a company’s size, it gives little information on whether the individual stores are performing well. Therefore, investors should focus more closely on a metric that measures how the company’s stores have actually been performing.

To provide investors with that insight, management often reports a metric called “same-store sales” (SSS) or “comparable-store sales.” This metric establishes a comparable base of stores (or “comp base” for short) for which to calculate revenue growth, allowing for more relevant analysis of true operating performance. For example, a company may present its revenue growth on stores that have been open for at least one year. Companies often prominently disclose SSS in their earnings releases, and investors use it as a key indicator of company performance. Many consider same-store sales to be the most important metric in analyzing a retailer or restaurant. We agree that if it is reported in a logical and consistent manner, same-store sales is extremely valuable for investors.

However, because same-store sales fall outside of GAAP coverage, no universally accepted definition exists, and calculations may vary from company to company. Worse, a company’s own calculation of same-store sales in one quarter may differ from the one used in the previous period. While most companies compute their same-store sales honestly and disclose them consistently, “bad apples” try to dress up their results by routinely adjusting their definition of same-store sales. Investors, therefore, should always be alert to the presentation of same-store sales to ensure that it fairly represents a company’s operating performance.

Compare same-store sales to the change in revenue per store. When a company experiences fairly consistent growth, same-store sales should be trending up consistently with the average revenue at each store. By comparing same-store sales with the change in revenue per store (i.e., total revenue divided by average total stores), investors can quickly spot positive or negative changes in the business. For example, assume that a company’s SSS growth has been consistently tracking well with its revenue per store growth. If a material divergence in this trend suddenly appears, with same-store sales accelerating and revenue per store shrinking, investors should be concerned. This divergence indicates one of these two problems: (1) the company’s new stores are beginning to struggle (driving down revenue per store, but not affecting same-store sales because they are not yet in the comp base), or (2) the company has changed its definition of same-store sales (which affects the SSS calculation but not total revenue per store).

This framework was used by the Center for Financial Research and Analysis (CFRA) to successfully identify problems at Krispy Kreme Doughnuts Inc. (KKD) in 2004 and Starbucks Corp. (SBUX) in 2007, and to warn investors before these companies unraveled. As shown in Figure 1, Krispy Kreme maintained its high SSS level in 2003 and 2004, despite a tremendous drop-off in total revenue per store.

Figure 1. Krispy Kreme’s Same-Store Sales Versus Revenue Per Store Growth

Watch for changes in the definition of same-store sales. Companies usually disclose how they define same-store sales. Once the definition is disclosed, investors should have little difficulty tracking it from period to period. Companies can manipulate same-store sales by adjusting the comp base in two possible ways. The first involves simply changing the length of time before a store enters the comp base (for example, requiring a store to be open for 18 months, versus 12 months previously). The second trick involves changing the types of stores included in the comp base (for example, excluding certain stores based on geography, size, businesses, remodeling, and so on).

Watch for bloated same-store sales resulting from company acquisitions. The comp base can also be influenced by unrelated company activities, such as acquisitions. For example, from 2004 to 2006, the universe of stores in the comp base of Starbucks kept changing each quarter as the company continuously bought up its regional licensees and put them into the comp base. As a result, Starbucks calculated same-store sales using a slightly different universe each quarter—hardly a comparable metric. If Starbucks had been purchasing its strongest licensees, this acquisition activity would have had a positive impact on SSS performance, thereby misleading investors about the company’s underlying sales growth.

As with Krispy Kreme, Starbucks’ 2006 same-store sales trend began diverging from its revenue per store trend. The gap widened in 2007, and in September 2007, Starbucks reported that U.S. traffic had fallen for the first time ever. When same-store sales in the United States turned negative in December, Starbucks announced that it would no longer disclose same-store sales, stating that it would “not be an effective indicator of the Company’s performance.”

Be wary when a company stops disclosing an important metric. Just as Starbucks stopped disclosing same-store sales when business went sour, Gateway stopped disclosing the number of computers sold when times were tough in late 2000. This metric had been an important data point provided to investors, and Gateway’s change in disclosure led the SEC to censure the company and label its actions “materially misleading” because it obscured the softening consumer demand for computers.

Look for strange definitions of organic growth. Affiliated Computer Systems (ACS) had an odd way of presenting its organic growth, or what it called “internal growth.” Rather than simply excluding all revenue from acquired businesses when calculating internal growth, ACS calculated a fixed amount to remove based on the acquired business’ revenue for the previous year. This meant that ACS was able to include in its own internal growth any large deals that the acquired company booked just before the acquisition.

(Source: AAII Journal, August 2010)

Additional Reading

Consumer Services: A Look at Retail (Part I)

“The crowd of companies in this section [Manufacturing, Service and Retailing Operations] sells products ranging from lollipops to jet airplanes. Some of these businesses, measured by earnings on unleveraged net tangible assets, enjoy terrific economics, producing profits that run from 25% after-tax to far more than 100%. Others generate good returns in the area of 12% to 20%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operated.

—Warren Buffett, Letter to Shareholders 2013

What Everyone Should Know Before Investing in the Retail Sector

The mantra “understand the business before you invest in it” may seem like a trivial statement. But it’s not. I have done it myself, and I guess that many of you know what I’m talking about. Sinned by buying shares in a business I didn’t understand good enough (I say enough, since you cannot know everything—at some point you have to make a buy/sell decision or just move on). It’s easy to buy shares in a business before having collected enough facts about the situation and circumstances at hand. Psychological factors and emotions often play too big a role when it comes to buying and selling shares.

Understanding why it is important to know the fundamentals of a business before investing in it most likely seems like a no-brainer to most of us—at least in theory. The hardest part, I guess, is to live as you learn. To start with, you have to understand yourself. Never fool yourself. Easier said than done, I know, but that doesn’t make it less relevant. It probably makes it even more important to repeat it time and time again. Becoming aware of the problem in situations like these is the first step. We all need to be aware of things before we can do our best to address them.

Except for the business, you need an understanding of the industry—the playing field where competitors battle each other. This is where the fight for profits takes place. The inherent industry structures will impact the way in which incumbent businesses compete, and also whether any entry and exits is likely to happen. The inherent industry characteristics differ between different industries in terms of entry barriers, number of competitors, profitability, growth, number of competitors, competitive advantages (or moats) and returns on invested capital etc. Beyond understanding the business, an understanding of the industry is highly critical since it will impact the profit and return potential.

Understanding the industry could of course be part of “understand the business.” Anyway, understanding a certain business most likely requires basic understanding the industry (or industries) in which it operates. All this talk about “understanding” has one, and only one goal in the end, to mitigate the risk of a permanent loss of capital.

Now that we’ve discussed the importance of understanding the business and the industry, a fair question to ask is; How do you obtain this understanding? As always, you have to start somewhere. You have to start building your own circle of competence. No one will do it for you.

In this post we will take a closer look at the retail industry, too learn what this industry looks like, what could be expected from a retailer, the likely returns on invested capital, the degree of competition, among other things. For now, we’ll leave the part about understanding the business. Let’s improve our understanding of retailing and the retail industry in general.

Basically, everything you read could give you hints and improve your knowledge and understanding of the things at play in a certain area. Your knowledge data base (your brain) will accumulate new facts along the way, building on the things you’ve processed earlier, hopefully replace any facts that turned out to be wrong. All this in an attempt to increase and improve your skills when it comes to industry structure, profitability, returns on invested capital. The more you learn, the better you will get at detecting differences between industries and businesses, and also understand why there are differences—what forces can explain and sometimes even predict what happens. Some industries are inherently more attractive (that is, more likely to provide sustainable above-average returns on invested capital) than others.

A few useful sources to start with are:

  • Annual reports
  • Shareholder letters (for example Warren Buffett’s shareholder letters)
  • Earnings calls or transcripts
  • Research reports (some could be found via a Google search if your lucky)
  • Investor presentations or transcripts from such events
  • Books (for example Competition Demystified, Competitive Strategy, The Five Rules for Successful Stock Investing, Why Moats Matter, The Little Book That Builds Wealth, Good Strategy Bad Strategy)
  • Business journals
  • Articles or white papers
  • Lectures and other public presentations (for example Google Talks, Greenwald lectures on YouTube)
  • Lecture notes
  • Business and investing blogs/sites (for example CSInvesting, Value Investing World, The Manual of Ideas, Fundoo Professor—see below for excerpt from

The above examples are just that, examples.  There is a ton of stuff to learn from that I didn’t include.

The Oracle of Omaha on the Difficulties of Retailing

Someone who’s been in the investing game for some time is Warren Buffett. And when it comes to investing in retailer even Buffett has his fair share of, let us say less satisfactory results. Let’s see what Buffett himself has to say about the difficulties an investor could encounter in this area.

What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lambert do at bringing Kmart and Sears together?

Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1966 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.

It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins. (Source: BuffettFAQ)

Retail is a tough game to play, or as Buffett says; “Retailing is like shooting at a moving target.” Buffett’s advice? “We would rather look for easier things to do.” Let’s look at one more before we move on (emphasis added).

What economic laws have worked best for Berkshire?

It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low-cost producer. In a capitalistic society, all moats are subject to attack: if you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord. [Charlie Munger: We also like to look for low agency costs on that lord, economies of scale and ““economies of intelligence.””]

Buffett elaborated on the ““economies of intelligence””: the idea is to find businesses where you have to be smart only once instead of being smart forever. Retailing is a business where you have to be smart forever: your competitors will always copy your innovations. Buying a network TV station in the early days of television required you to be smart only once. In that kind of business, a terrible manager can still make a fortune. Given the choice between the two (a business where you have to be smart forever or one where you have to be smart once), Buffett advised, pick the great business – be smart once. (Source: BuffettFAQ)

A Closer Look at Retail

One of the books mentioned above is a book written by Pat Dorsey—The Five Rules for Successful Stock Investing. There is a section in this book that discusses and goes through a number of different industries, of which one is retail (as part of consumer services). The remaining part of this post will focus on the consumer services sector, and more specifically retail. We will do this by reading the part about retail.

Below is an excerpt from the Five Rules of Successful Investing, explaining and discussing the industry fundamentals and some of the pros and cons of retailing (emphasis added).

Consumer Services

NOT SURPRISINGLY, WE generally don’t find a ton of great long-term stock ideas in retail and consumer services because most economic moats for the sector are extremely narrow, if they exist at all. 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. It’s rare to find a retailer or consumer service firm that maintains any kind of economic moat for more than a few years.



The retail game has undergone a major facelift over the past two decades. First came the development of category killers, with specialized merchandise and service. Chains such as Home Depot and Lowe’s put many smaller, regional players out of business in the home improvement area. In 1992, the two firms posted combined sales of $8 billion; in 2002, they sold more than $80 billion worth of nails, hammers, and appliances. Office Depot, Office Max, and Staples did the same thing to the office supply business in the late 1980s and 1990s.

The second major shift has been the move off the mall. Once upon a time, department stores were infallible in the world of retailing. Well-known chains such as Sears that were once destinations in their own right became the anchor tenants for malls. The stores aimed to provide customers with a one-stop shopping experience, and some even housed full-service restaurants. Customers had more time to shop and placed more value on the personal attention these stores provided.

Over the past 20 years, however, traditional department stores have become dinosaurs. Nowadays, companies such as Sears and JC Penney are struggling to remain relevant—a battle that chains such as Montgomery Ward and Woolworth have already lost. Changing consumer trends are largely, but not totally, to blame. In this era of dual-income households, shoppers want selection, quality, and reasonable prices, and they want it fast. And they’ve shown a willingness to shift their spending to stores that can provide this experience.

Firms such as Wal-Mart, Target, and Kohl’s have stolen the thunder of the traditional department stores with innovation and efficiency. These are the firms that developed everyday low prices, pioneered centralized checkouts at the front of stores, and set up shop in freestanding locations with more convenient parking. Whereas, Sears and Penney averaged 0 percent and 1 percent annual sales growth, respectively, from 1998 to 2002, Wal-Mart, Target, and Kohl’s averaged 15 percent, 10 percent, and 24 percent, respectively. Over the next several years, we expect this divergence to continue.

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 15.1 illustrates the cash conversion cycle, and Figure 15.2 shows the conversion cycle for Home Depot.


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, usually, 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 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, 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 illustrate how well a retailer interacts with customers, days payable outstanding shows haw 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 retail 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 outstanding for the home improvement titan has historically 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.

Hallmarks of Successful Retailers

• Sometimes you never get a second chance to make a good first impression. Retail is a fickle business, and shoppers have plenty of alternatives, so companies have to make a concerted effort to keep stores clean and fresh. Lowe’s has benefited mightily in its battle with Home Depot because its stores are widely perceived to be more aesthetically pleasing and easier to navigate. Home Depot is reinvesting in its stores, but as we mentioned in the restaurant section, maintenance and renovation is easier than reinvention.


• Keep an eye out for store traffic. You don’t want to see a traffic bottleneck at the checkout aisles, but you don’t want to see empty parking lots on weekends either. This is particularly true for specialty retail companies such as clothing stores that cater to a particular demographic. Traffic to teen hot spot Abercrombie & Fitch and women’s outfitter Chicos FAS has remained relatively robust even in times of lax consumer spending. These stores have carved out a brand identity and won customer loyalty, and their stock prices held up during the tough market conditions in 2001 and 2002. Remember, though, specialty retailers have a much shorter shelf life than traditional retailers do, so these investments have to be monitored much more closely.

• Successful retailers have a positive employee culture. After all, retail is about customer service—period. Sam Walton helped build Wal-Mart into the largest retailer (and largest company) in the world based on sales using the premise that the customer is always right. During its growth heyday in the 1990s, Home Depot’s employees were always visible and customers usually walked away satisfied. In 2001 and 2002, Home Depot’s service waned noticeably, largely due to an influx of part-time employees who didn’t have the same connection to the company.



As we’ve mentioned numerous times in earlier chapters, great companies in attractive industries generate returns on invested capital that far exceed the cost of capital. However, retail is generally a very low-return business with low or no barriers to entry. Retail bellwethers Wal-Mart and Walgreen earn little more 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.

The sector is rampant with competition. Think of all the specialty apparel shops that try to imitate Abercrombie &2 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.

The primary way a firm can build an economic moat in the sector is to be the 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.

Investor’s Checklist: Consumer Services

Most consumer services concepts fall in the long run, so any investment in a company in the speculative or aggressive growth stage of the business life cycle needs to be monitored more closely than the average stock investment.

Beware of stocks that have already priced in lofty growth expectations. You can make money if you get in early enough, but you can also lose your shirt on the stock’s rapid downslide.

• The sector is rife with low switching costs. Companies that establish store loyalty or store dependence are very attractive. Tiffany’s is a good example; it faces limited competition in the retail jewelry market.

• Make sure to compare inventory and payables turns to determine which retailers are superior operators. Companies that know what their customers want and how to exploit their negotiating power are more likely to make solid bets in the sector.

• Keep an eye on those off-balance sheet obligations. Many retailers have little or no debt on the books, but their overall financial health might not be that good.

• Look for a buying opportunity when a solid company releases poor monthly or quarterly sales numbers. Many investors overreact to one month’s worth of bad same-store sales results, and the reason might just be bad weather or an overly difficult comparison to the prior-year period. Focus on the fundamentals of the business and not the emotion of the stock.

• Companies also tend to move in tandem when news comes out about the entire sector falls—keep that watch list handy.

Learn Something New Each Day

Charlie Munger once said that “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.”

I hope that reading through this post, and reflecting on the content, made you a little wiser.

Wish you all a great weekend.

Click here to Retail (Part II): Edward S. Lampert on Same-Store Sales

Additional Weekend Reading

Walmart: Where is the moat?

“The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” —Warren Buffett

In this post I will take a look at Walmart’s operating segments to see if there are any different characteristics between them. Do they all enjoy a moat, i.e., a sustainable competitive advantage, or not?

Let’s start with a brief business description taken taken from the 2014 annual report 10-K form. Underlinings and boldings made by me.

Business description

WMT2Wal-Mart Stores, Inc. (“Walmart,” the “Company” or “we”) helps people around the world save money and live better – anytime and anywhere – in retail stores, online, and through their mobile devices. We earn the trust of our customers every day by providing a broad assortment of quality merchandise and services at everyday low prices (“EDLP”), while fostering a culture that rewards and embraces mutual respect, integrity and diversity. EDLP is our pricing philosophy under which we price items at a low price every day so our customers trust that our prices will not change under frequent promotional activity.

Our operations comprise three reportable business segments: Walmart U.S., Walmart International and Sam’s Club. Our fiscal year ends on January 31 for our United States (“U.S.”) and Canadian operations. We consolidate all other operations generally using a one-month lag and on a calendar basis. Our discussion is as of and for the fiscal years ended January 31, 2014 (“fiscal 2014”), January 31, 2013 (“fiscal 2013”) and January 31, 2012 (“fiscal 2012”).

During fiscal 2014, we generated total revenues of $ 476 billion, which was primarily comprised of net sales of $473 billion.

Walmart U.S. is our largest segment and operates retail stores in various formats in all 50 states in the U.S., Washington D.C. and Puerto Rico, as well as its online retail operations, Walmart U.S. generated approximately 59% of our net sales in fiscal 2014 and, of our three segments, historically has had the highest gross profit as a percentage of net sales (“gross profit rate”), and contributed the greatest amount to the Company’s net sales and operating income.

Walmart International consists of the Company’s operations in 26 countries outside of the U.S. and its operations include numerous formats of retail stores, wholesale clubs, including Sam’s Clubs, restaurants, banks and various retail websites. Walmart International generated approximately 29% of our fiscal 2014 net sales. The overall gross profit rate for Walmart International is lower than that of Walmart U.S. because of the margin impact from its merchandise mix. Walmart International has generally been our most rapidly growing segment, growing primarily through new stores and acquisitions and, in recent years, has been growing its net sales and operating income at a faster rate than our other segments. However, for fiscal 2014, Walmart International sales growth slowed due to fluctuations in currency exchange rates, as well as no significant acquisitions, and operating income declined as a result of certain operating expenses.

Sam’s Club consists of warehouse membership clubs and operates in 48 states in the U.S. and in Puerto Rico, as well as its online operations, Sam’s Club accounted for approximately 12% of our fiscal 2014 net sales. Sam’s Club operates as a warehouse membership club with a lower gross profit rate and lower operating expenses as a percentage of net sales than our other segments.

We maintain our principal offices at 702 S.W. 8th Street, Bentonville, Arkansas 72716, USA.

Operating segment moat watch

The operating segments disclosure in the annual report provides some figures that could be used in trying to figure out the moatiness of each individual operating segment.

A great business generates high and sustainable returns on invested capital. The same holds true for any operating segment. For an operating segment to be considered great, it also has to be able to generate high and sustainable returns on invested capital.

Some of the metrics provided in the operating segments disclosure are net sales, operating income (or, Earnings Before Interest and Taxes — EBIT) and total assets. In the notes to the financial statements – Goodwill and Other Acquired Intangible Assets – goodwill per operating segment is disclosed. Having the goodwill figures at hand allow us to calculate tangible assets per operating segment (Total Assets minus Goodwill).

From this we can calculate return on invested capital (ROIC) per operating segment by taking EBIT divided by tangible assets, below called EBIT Return on Total Tangible Assets (EBIT ROIC).

Walmart as a whole generated an EBIT ROIC in fiscal year 2014 of 14.5%. Per operating segment Walmart U.S. generated the highest EBIT ROIC of 22.7%, compared to 8.2% for Walmart International and 14.4% for Sam’s Club.

What stands out is two things, 1) the superb returns generated by Walmart U.S. and 2) the not so good returns generated by Walmart International.

Clearly, Walmart U.S. seems to enjoy a moat which is consistent with earlier posts discussing the issue of likely competitive advantages enjoyed by Walmart. In the U.S. market Walmart seems to enjoy a moat through the benefits of captive customers via its Every Day Low Prices (EDLP) and economies of scale mostly in distribution, even if it seems reasonable to assume there also are some scale advantages from marketing and purchasing. Walmart International does not seem to have any of these advantages at the moment, at least not to the extent that it shows up in great returns as measured by the EBIT ROIC calculation. Upon reflection, this may not look as surprising as one might expect. Just as Walmart enjoys advantages in U.S., other retailers most likely enjoy, at least to some degree, the same advantages in their own domestic markets.

ROC1Below is a breakdown of EBIT ROIC and its two main drivers, EBIT margin (Operating income / Net sales) and Tangible assets turnover (Net sales / (Total Assets – Goodwill)).

  • EBIT ROIC = EBIT margin × Tangible assets turnover

In recent years, Walmart U.S. has shown a high and increasing EBIT margin. During the same period Walmart International’s EBIT margin has declined from 5.8% in 2006 to 4.0% in 2014. Sam’s Club’s EBIT margin has been pretty consistent during these years, close to 3.5%. At a consolidated level, Walmart’s EBIT margin has declined from 6.0% in 2006 to 5.6% in 2014, mainly due to the deterioration in Walmart International’s EBIT margin.


The second driver of EBIT ROIC, the tangible assets turnover shows that Sam’s Club enjoys the highest asset turnover. Asset turnover for Walmart U.S has been pretty consistent in recent years, hovering around 2.9 times. Walmart International has improved its asset turnover from 1.6 to 2.0, but due to the decline in EBIT margin the EBIT ROIC has not improved.


So, the Walmart operating segment moat king, at least as of today (and also in recent years) is Walmart U.S.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.