Retail is an extremely difficult business. The retail market is characterized by tough competition, high sensitivity to economic cycles and by the ever changing tastes and preferences of shoppers. All these factors take a big bite of the gross profit margin of retail chains. As margins slowly erode over time, only the very few who are capable of maintaining a lean structure can survive and prosper, usually at the expense of other retail chains that vanished from the world. It’s no wonder that Warren Buffett stated numerous times that in retail, you always want to side with the biggest, most prominent rival. There’s usually a reason why it became so big in the first place. As time goes by, this dominant leader will usually take its rivals out of business, one at a time.
There are a few traits that distinguish the retail leader from its many pretenders.
1. The leader will always maintain a low, yet very consistent profit margin. The retail business isn’t a branded consumer product like Coca Cola. Hence, Retailers will never enjoy the 37% profit margin that Coca Cola enjoys. It’s important to realize that and act accordingly.
2. The leader knows his shoppers well. Because of that, the leader never has to reinvent itself or go on some insane discount spree for shoppers, at the expense of its shareholders. The leader is always laser focused on its goals and on how to gain market share gradually with time.
3. The nature of retail is cyclical. It responds well to boom times but it reacts exceptionally badly to tough times. Hence, it’s a must to maintain a cash cushion for tough economic times, and to always watch your cash flow statement very carefully. You simply can’t put all your groceries in one shopping bag.
In contrast to the leader, retail pretenders will do exactly the opposite of what I described above.
Who’s what, and why
I believe that Wal-Mart Stores, Inc. (NYSE:WMT) is the ultimate leader in the retail arena, and that J.C. Penney Company, Inc. (NYSE:JCP) is the ultimate pretender. We can learn a lot from J.C. Penney on how not to make costly mistakes and lose a lot of money. Wal-Mart will be a better teacher. Let’s review J.C. Penney by the parameters I set above.
1. Gross Profit margin: J.C. Penney Company, Inc. (NYSE:JCP) is losing money and has a negative gross profit margin of 7%. But not so long ago, the company used to have a gross profit margin of around 8%. That’s a very high (and unsustainable) rate for a mass retailer. Wal-Mart Stores, Inc. (NYSE:WMT), on the other hand, has always displayed a consistent operating margin of 6% and a gross profit margin of 3%. That’s all it takes to win.
2. Retail strategy: J.C. Penney Company, Inc. (NYSE:JCP) is very confused. It used to be a coupon chain but then it changed. Johnson, its new CEO, eliminated promotions and discounts (a J.C. Penney trademark) in favor of a “fair and square” pricing model. He also made the stores more upscale by creating a “store within a store” shopping experience with brands like Levi’s and Izod. Wal-Mart Stores, Inc. (NYSE:WMT), on the other hand, doesn’t need to do all that. It’s globally known as a low- cost retailer which profits from scale and size.
3. Cash management: J.C. Penney Company, Inc. (NYSE:JCP) only has $525 million of cash on its balance sheet. That’s down 41% from last quarter. The company burned through $380 million in free cash flow last quarter. That will amount to a roughly $1.3 billion burn rate for the year. If the company continues reporting 20%-plus sales declines, it will burn through its cash within nine months. That’s an extraordinary rate. Wal-Mart Stores, Inc. (NYSE:WMT), in contrast, has raked in more than $4.3 billion of cash flow in its last quarter alone.
The Fool thinks retail
It’s usually a sound investment advice to pick the stock of the dominant company in the sector. But in retail, more than anything, it’s a must. Wal-Mart, due to its scale, strategy and cash gushing capabilities will outperform any other retailer. J.C. Penney Company, Inc. (NYSE:JCP), on the other hand, is likely to become another “Wal-Mart Stores, Inc. (NYSE:WMT) victim” before 2013 comes to an end.
The article Who’s the King of Retail and Who’s the Pretender? originally appeared on Fool.com and is written by Shmulik Karpf.
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