Retail is tough. One thing that has previously worked in the model has been the ability to reinvest profits from existing stores and expand out a network of new stores. Walmart in the US was a great example.
Bunnings has been able to build out a big box store network in Australia. They have share of my mind. When I need something hardware related I will travel past my smaller local hardware store and drive an extra few k’s as I know Bunnings will have the selection of the ‘thing-mes’ I need but don’t know I need yet.
Think about how many billions were thrown into Masters by Woolworths to try and compete against Bunnings. You know you have a great business when you survive this level of competition and after the event your share of mind becomes even greater.
Anyway the tailwind that retail had in the past of new store roll outs to grow earnings is certainly being challenged. Take this reinvestment opportunity away then retailers are now growing due to same store growth, which really they can not grow much more than nominal GDP. If they grow more then GDP then retail is an incredibly competitive space which will make sure your growth reverts back to the mean.
So the challenge to these models is not necessarily the threat of Amazon, while real, I see it is more the threat to the reinvestment runway these retail businesses have had as their tailwind. Imagine a department store wanting to open new stores. Shareholders or debt will not finance this.
I know this is simple stuff but a few tables show this reinvestment metric. In the table below, we can see that this business can compound intrinsic value at 10.5% if it can reinvest 70% of its earnings at a return on capital of 15%. This is the long runway store roll-out model that retail has leveraged for the good part of the last 50 years.
But what does the model look like now if the roll-out model can not be relied on in the future? Imagine there are no opportunities for store expansion and the business can only reinvest 20% of its earnings in its existing stores for working capital and store refurbishment. The table shows that the company is growing its intrinsic value at 3%.
So really you should only be paying low multiples for businesses that cannot reinvest retained earnings at high returns. Remember as investors we do not get to buy what the company could reinvest at in the past.
But there are a still a few retailers that are following this store roll out model. One I have looked at recently is Baby Bunting (BBN). Their long term target is to expand their store network to 80 stores from the current 43. BBN sells baby goods via a store network across Australia.
For FY2017 BBN generated $278m in revenue and made NPAT of $13m on invested capital including goodwill of $96.8m. BBN return on invested capital was 14%.
BBN wants to double its store network. They can fund this expansion by retained earnings, debt or equity or a combination of all. So if BBN can reinvest 70% of its earnings and achieve a 14% return on this incremental capital then it would compound its intrinsic value at 9.8%.
The table below shows what BBN could earn if it managed to reinvest 70% of its NPAT into new stores achieving a 14-15% return on this investment. If after 5 years they achieve this then they may earn $21.5m. Bear in mind I have not included any adjustments for same store growth and operating margin changes.
The interesting thing to note from the table is that BBN is reinvesting earnings in its store network but is maintaining a dividend payout ratio of 70%. In other words BBN is using debt to make up the short fall in its reinvestment program caused by a high dividend payout ratio.
Would they be better off not paying these dividends and reduce debt and reinvest in their growth? Maybe but who wants to incur the wrath of the SMSF dividend army.
What would you pay for BBN earnings in 5 years time once the network relies on same store growth which might just track GDP, 10-12x? Think JB Hi-Fi (JBH) which is trading on forward FY2018 PE of 10-11 and who have flagged in their recent presentation their preference for a more cautious approach to future store roll-out after the bedding down of the Good Guys.
Compare that to the market cap of around $220m for BBN then there is not a lot of margin of safety in the store roll-out model if the runway slows down.
Once again retail is hard, bloody hard.