Consumer & Retail

Consumer Products & Retail Industry Primer

Consumer companies involve a business-to-consumer (B2C) experience where customers purchase a finished good or service. Usually, consumer goods are segmented into consumer staples (or consumer non-cyclical) and consumer discretionary (consumer cyclical). Retail is a channel which consumer goods are sold.

Consumer staples are items where pricing and volume sold do not change very much with the economy (toothpaste, detergent, Coca-Cola, groceries) whereas consumer discretionary items do (luxury bags, Nike sneakers, vacations). For consumer discretionary in particular, we are seeing a secular shift in industry giants from traditional stores such as Sears and COSTCO to online merchants.

Businesses that fall into this coverage universe include restaurants, consumer packaged goods (CPG), fashion brands, sports apparel, retailers, grocers, food & beverage, cigarettes, automakers, and online merchants.

Major Consumer & Retail Companies

Major global consumer staples companies include Walmart [WMT], Procter & Gamble, Unilever [UL], Anheuser Busch Inbev (Budweiser), and Philip Morris (Cigarettes).

Major global consumer discretionary companies include Amazon [AMZN], the automakers (Toyota/GM/Ford), Disney, McDonald’s, Priceline, Nike, LVMH (Louis Vuitton Moet Hennessy) and Starbucks.

Major Canadian consumer & retail companies include Saputo, George Weston & Loblaws [TSE:L], the Hudson Bay Company [TSE:HBC] (HBC, which now includes Saks and possibly Macy’s), Alimentation Couche-Tard, Canadian Tire [TSE:CTC], Metro, Gildan Activewear, Dollarama, Empire (Cineplex) , LuluLemon [TSE:LULU], Restaurant Brands International(Burger King & Tim Hortons), Aritzia [TSE:ATZ] and Canada Goose [GOOS].

Advertising and Promotion

When thinking about goods to purchase, stores to shop at or restaurants to dine at, the product itself is associated with a marketing campaign (or for certain brands such as Tesla, the absence of a concerted marketing campaign).

Companies spend a significant percentage of revenues on advertising. Advertising is key in terms of communicating with the end user, whether it is business to business (B2B) or business to consumer (B2C) and what the end user wants – price, convenience or brand association. An understanding of what niche is being targeted is key in determining what marketing is most effective.

For example, Budweiser is mass market across incomes and subcultures. However, advertising may still be tweaked for different countries to cater to local sentiment. Conversely, a Patek Phillipe watch will be focused and would not be well served by widely viewed television (now over the top or OTT ads via YouTube [GOOGL]) commercial. Deciding what channels to use, be it print media, online or cable can be a serious consideration.

Strong advertising agencies such as Wieden+Kennedy have a history of success in putting forward iconic campaigns that invoke feeling and create positive brand association.

Supply Chain for Consumer Products and Retail

In looking at any consumer company, forecasting changes to input costs is key in accurately predicting net income. For many companies, sourcing raw materials means that traded commodity prices must be observed. For instance, a coffee company should follow the prices of sugar and coffee beans closely as direct inputs and possibly paper and packaging products.

Hedging can get rid of one variable and lock in margins (provided revenue is as predicted), however hedging is not free as the bank or trader will take a spread and over the long run it is difficult to hedge commodities effectively. Also, hedging is usually for a set volume, and needs may change depending on demand.

Ignoring intermediaries, some companies can be proactive in looking at supply chain risk and lock-in long term contracts and diversify the supply base. This is much easier for companies with scale like Unilever as opposed to a regional fashion brand.

Retail Business Model

For consumer and retail companies, revenue is a function of traffic (volume) and average ticket (price), although many consumer companies may collect membership fees, whether on a monthly or annual basis (For example, a Costco membership). At each store/restaurant (or segment, for online companies), traffic will be a function of foot traffic – this can be boosted with better advertising or offering certain items (possibly loss leaders).

Average ticket may be increased by new products, promotions (Tim Hortons Roll Up The Rim) or cross-selling (buy one get one free – Burger King Coupons). For company wide profit growth, growing store sales must be combined with well curated store expansion growth – for an online company, this means increasing market penetration in terms of unique users.

Retailers cannot control the economy but the economy has a material impact on the profits of retailers. As such, it is important to watch macroeconomic data such as inflation via the consumer price index (CPI) in forecasting the operating environment for consumer companies.

Many grocers will have pharmacies within the store and will separate drug sales from normal consumer purchases. At least in Canada, drug sales are immune to changes in the economy but continuously face competition (quality of service, proximity to doctor’s offices or walk-in clinics).

Retailers have been pushing credit cards for a while (in Canada, credit card programs are usually in conjunction with a bank) with prominent ones including the WestJet RBC Mastercard, the HBC Mastercard, and the President’s Choice Mastercard. Credit card fees will be split with the issuing bank (1-2% of transaction value) and encourage shoppers to return to the retail outlet for extra points.

Credit cards take a sizable amount of infrastructure spending to get a program in place and has to deal with credit losses, but benefits other than fee sharing with banks include consumption growth and demand creation (for cash poor consumers).

Technology and Retailers

Traditional brick-and-mortar stores are increasingly looking to technology to augment their store sales. Loyalty programs have become popular, with payment systems moving from Starbucks cards to Starbucks apps – ensuring that customers will return to redeem free items and win points.

This is very good from a working capital perspective as well, as Starbucks obtains a large amount of cash up front, with a significant portion of it never used as cards are lost or forgotten. Starbucks has become so successful with its payments system that it can white label their payments platform (a similar rewards program can be operated for Tim Hortons or other competitors) for additional profits.

Technology penetration pertaining to wireless and internet communications has pushed retailers to offer an omnichannel customer service model. Now when a customer wants to see the latest product offering or has an inquiry or complaint, they can reach the company through 24/7 instant messenger live chat, an automated service, website FAQs and various other options as opposed to a traditional phone line only. From a cost perspective, this reduces the need for a physical location and automates labour cheaply.

Private Labels and Brand Value

Although increasing the average ticket is a positive for retailers, decreasing the cost of goods sold may be more beneficial for grocers and department stores. Many stores have pushed private labels and generic brands to increase margin on standard items that would normally be sold through famous brands (P&G’s Crest or Colgate-Palmolive’s Colgate) can be replicated at a much lower cost through Loblaws’ President’s Choice.

The only reason why established names such as Tylenol can continue to outsell nameless replicas is due to the perceived quality of the brand. It also speaks to the importance of quality control – a loss of goodwill for whatever reason can have severe ramifications to the bottom line.

Market segmentation is also important. With premium brands such as Whole Foods Market or Holt Renfrew (owned by George Weston [TSE:WN]), the shopping experience and product differentiation can yield much higher margins from a more affluent customer base.

Restaurant Industry Primer

Consumer & Retail Stocks – Valuation

As consumer and retail stocks follow standard business models, analysts will adhere to standard multiples – predominantly 1) Price/Earnings; 2) EV/EBITDA; 3) P/BV (for retail only).

Price/Earnings

Price/Earnings is a good measure for retail and consumer stocks due to the mature nature of the industry. Price/Earnings is post-leverage and considers whether capital structure decisions are prudent (is the debt to equity mix appropriate and shareholder friendly).

For multiples, franchise royalties may command a premium to corporate owned stores due to the difference in operating leverage & operating margin and return on invested capital (generally, companies with a higher ROIC will receive a premium valuation).

EV/EBITDA

EV/EBITDA is another standard multiple, like Price/Earnings, except that it is independent of capital structure and reflects the strength of the underlying business. Despite the simplicity of calculating the multiple, getting to the appropriate multiple is much more difficult as it demands a strong understanding of the company’s strategy and competitive position.

Getting to the appropriate valuation requires the evaluation of growth prospects versus the premium or discount that the market has prescribed versus the peer group. Historically, Starbucks has traded at a premium to other quick service restaurants, so forming a proper investment thesis will stem from whether the premium is warranted.

Factors that may drive this growth thesis include demographics for each retailer’s target – for instance, burgers and donuts may be popular with Generation X while health food (Freshii, CMG) may be more popular with millennials. Forecasting growth trends accurately for the target market will add precision to a revenue forecast.

Given the international operations of many consumer & retail stocks, attention must also be paid to foreign exchange risk and hedging. Different jurisdictions can command different multiples.

Price/Book Value

The reason why Price-to-Book is relevant, especially for leveraged retail operations, is because book value is a measure of liquidation value. If real estate is accounted for at fair value instead of at cost, book value is a fair indication of market value for real estate assets.

Real estate holdings are a large component of many retail businesses from restaurants to department store companies. Given that this assumes ownership of real estate under property, plant and equipment (PP&E), if the company leases its real estate, this metric is less relevant.

This is far less valuable for consumer staples and discretionary product companies (a Procter & Gamble or PepsiCo, both whom have prominent operations in Ontario) as they are more dependent on brand value (goodwill), supply chain, procurement and research & development. For a Lululemon, the value of its real estate will pale in comparison to product launch sentiment and consumer habits momentum.

Sum of the Parts

Sum of the parts may be the best way to value retail stocks when there are several separate components, including a large real estate holding (which may be independent of real estate leased to franchisees).

For several retail outlets, this could be value that is worth a higher multiple than the business operation due to the stability of the income streams (which are contractual obligations). A spin-out could unlock value for the firm.

Also, equity ownership in a subsidiary (for example, McDonald’s previous stake In Chipotle Mexican Grill [CMG]) should be valued on a unique basis.

Ownership of company-owned stores and franchises may also be segregated due to the rationale presented in Price/Earnings above.

Consumer & Retail Metrics and Ratios

Revenue and Gross Margin for Retailers

These are somewhat explained by SSS and S/SF (see below) – revenue should be evaluated to see if the increase comes from change in volume or change in average ticket size or both. Ideally, it is both.

Net New Stores

New Stores – Store Closures.

An expanding footprint suggests that there is room for growth –a company would only open new stores if they were profitable with their existing stores; this metric should be checked against the fundamentals of the company and the thesis behind the expansion – if a company expands too quickly, it may run into quality control issues and cost problems which will force closures of many stores later. An example is Starbucks’ [SBUX] mass expansion (much of it franchised) in the US after Howard Schultz’ first exit from the firm. This expansion was ill-fated and share prices plummeted until many new stores were closed.

Franchising

% Franchised Stores – Franchised Stores/Total Stores

Franchising is a mixed bag – on one hand, it requires barely any capital from the corporation as franchisees tend to provide most of the investment upfront, are forced to purchase goods from the corporation and pay an initiation fee as well as royalties. The catch is that the company does not receive the same profits as a company owned store and depending on how strictly the franchisee upholds the standards of the firm, could lead to certain actions hurting the brand.

Prominent retail companies such as McDonald’s and Starbucks have very strict control over franchisees. Quizno’s and Cosa historically have not, which have contributed to financial problems. While Starbucks prefers to have calculated growth with more company-owned stores, QSR goes with a 100% franchise model. Interestingly, pure franchise/royalty operations have historically received higher valuation multiples from the market.

Globally, this can be different. To enter into foreign markets, sometimes company-owned stores are not a viable option. McDonald’s and Starbucks’ Asian operations were done through joint ventures at varying points in time and sometimes cannot be the majority owner. McDonald’s recently sold off their majority stake in McDonald’s China and will depend almost entirely on royalties.

Same Store Sales (SSS)

Sales (LTM)/Sales (Previous Comparable Period) for all stores open for at least 13 months

Same Store Sales shows the revenue trend for stores. If SSS are going up, it means that the average ticket for existing customer bases is rising, whether it is from better cross-selling or higher margins on product. If total group revenue is rising but SSS are falling, this may be a cause for concern. Good retailers will actively seek to discontinue products that do not meet sales velocity targets (if it’s not flying off shelves, get rid of it) or dollar margin requirements (if a pair of Lululemon pants costs $30 to make and sells for $35, that’s not good from a retailing perspective). SSS must also be compared with industry peers. If SSS are growing but at a slower clip than competitors while the market size is rising, this may be perceived as a negative.

Sales Per Square Foot

Similar metric to SSS, S/SF also gives a picture of how much the company is generating for its real estate and can inform leasing decisions going forward. For example, if a company clears $x for S/SF, maybe it can afford a place in Pacific Centre in Vancouver, the Bay-Bloor Corridor in Toronto, Causeway Bay in Hong Kong or Fifth Avenue in New York.

Free Cash Flow (FCF)

Free cash flow is imperative for retailers, consumer companies and restaurants. Existing stores are obviously expected to generate strong and stable operating cash flow (otherwise the decision to shutter them must be made) but capital expenditures must be evaluated to see if there will be strain in meeting interest payments and whether these capex plans will result in profitable new stores (an example is a $15 million new Cactus Club Café restaurant and the incremental free cash flow that will come with it after it begins operations). Working capital movements are an important part of FCF and favorable programs such as gift cards can enhance FCF by providing strong cash upfront.