Episode Transcript
The Finance Ghost: Welcome to episode 239 of Magic Markets. I'm trying to stop laughing because Moe and I have just finished recording the Premium show, which included me running out on my prepaid electricity meter halfway through, which is wonderful. Thank goodness we record on Riverside and it always saves the audio. But absolute comedy of errors - I'm moving house this week, the show always has to go on and obviously Moe, like any good investor trying to save a bit of money, I'm running the meter a bit tight it seems - obviously too tight, to try and avoid wasting money and leaving behind expensive electricity. So anyway, like all value investors have also learned at some point in the market you can sometimes be too snoep and then miss out. I was too snoep on electricity and here we are. We had to save the day there, so thanks for your patience.
And to our listeners, welcome to a show in which I now have some electricity, which is kind of a key ingredient for recording a podcast.
Mohammed Nalla: Ghost, I love these problems, right? Luckily it's not a free cash flow problem. I mean, we analyse stocks. I don't know if it's a free cash flow problem. Your capex wasn't high enough. I'm shooting the breeze here.
The Finance Ghost: It's a bad management problem. Just a bad management problem. That's all it was. I can't even blame load shedding because that doesn't happen anymore.
Mohammed Nalla: In all honesty, when you actually just popped off the screen when we were doing our prior recording, I thought, there we go, it's load shedding. But we can't blame Eskom on this one. Let's move on.
Ghost, I'm just glad to have you back on the screen here. And let's get a smile out of you because I know this week we're discussing one of your favourite topics in the market. I mean, some of our longtime listeners will know you actually have a bit of a history in the retail sector. You spent some time there. You also have the history in the investment banking sector. That's where we met. And so if we put this together, we thought why not cover a show where we look at: how do we analyse stocks in the retail sector? We did one recently where we looked at: how do we analyse stocks in the banking sector. We both worked there. We have some deep knowledge. You've got some knowledge of the retail sector. We look at these stocks all the time.
In fact, this week on Magic Markets Premium, we're covering a retailer in the US called TJX. If you haven't heard about it, go and check out the show. It's only R99 a month, we do a deep dive analysis on TJX. Go and look at that share price, that should be a compelling enough reason for you to just go and have a look at the report, see what's happening under the hood.
Ghost, I'm going to pause there. Let's jump into this week's show because we want to talk to our listeners and about how do we deconstruct this? What are some of the key metrics we look at and how analysis of a retail stock might differ from analysis of maybe an industrial stock or a financial stock. I think we've got a lot to get through.
The Finance Ghost: No, we do. And retail is very much a game of inches, much like the way I apparently manage my electricity on my meter. So you've really got to try and get all those small little gains out wherever you can.
And I think maybe before we dive into what will probably be you peppering me with questions, we'll see how this goes, I think something that is important to mention is that the retail sector is important not just to any economy obviously - it's a massive employer of people, so it's always worth keeping an eye on that. I mean, this is the sector that clothes us, feeds us.
Retailers actually can fail and they do. It's one of the few sectors where you see some very high-profile failures. It's also one of the few sectors where you can do a due diligence with your feet, which is actually quite exciting. Or your mouse for that matter, in an e commerce world. You can go and check out the store, you can speak to your friends, see where they're shopping, go and look at Google reviews, go see how this thing is performing. Literally just speak to people. It actually makes a huge difference.
You can't really do that in an industrial space. I don't know about you, but if we're analysing a bearings company or something that does tractors, for example, I can't go and try out the latest John Deere product, but I can certainly go and try out some retail products. And so that I think is part of what makes it interesting.
And one last point I wanted to make about why it's such an interesting sector is because it's a really good inflation hedge. So because the products are going up with inflation, retail sales are going up with inflation - I mean, ironically, that's one of the drivers of inflation - you're basically taking a view on inflation at the source. This is the stuff you're buying in the store. So if it's getting more expensive all the time, then the thing that's hurting your monthly budget is also driving sales at your favourite retailer. So it can be quite a useful inflation hedge in a portfolio.
Mohammed Nalla: Yeah, indeed. Ghost. I think that's a good place to start because we talk of the macro - if you're doing analysis on this, I have the luxury, I can go and ride a John Deere tractor, I can just go drive down the road, I'm not too far from them, I go and check it out. So I can do that. With retail, I think you could go and walk through the stores. You can see what the experience is like.
I think with eCommerce it gets a little trickier because you don't still have the same line of sight other than maybe just pinging your friend group, seeing where people are buying stuff. So again, I think that's evolving a little bit. But talking to your inflation point, we've covered this somewhat in our show on TJX recently, is that it's actually a double-edged sword. Because yes, retailers can be a great inflation hedge, but at the same time, if inflation is severe enough that it constrains consumer discretionary spend, then within the retail sector you might see a slight divergence between those that are more exposed to discretionary spending versus those that are more exposed to consumer staples. So pay attention to some of those dynamics.
Ghost, before I actually jump in with some questions, if we're talking inflation hedge, that then plays very nicely into one of the key metrics that you've got to look at, at a retailer. Because obviously with any stock, you look at what's happening with revenue and that's where inflation comes through in any event. And you want to see some revenue growth obviously in excess of inflation. That would mean that organically the firm's actually got some real growth coming through. But for me, one of the key metrics to look at just below that revenue line is actually gross margin. Because when you're looking at retailers that have strong brands or they are scale players, if you think of a Walmart, a Costco, some of the largest retailers in the world, they actually tend to have higher margins. So if they actually have this very solid gross margin, that's a nice interplay to help assess what profitability looks like before you take into account everything that comes thereafter. So your overhead costs, what's happening with your store footprint, and so on and so forth.
I'll maybe start off there because that ties into a number of other metrics that you want to look at. But Ghost I'm going to pause - maybe your thoughts on that interplay between gross margin and then operating margin, which is just so important because some players have operating leverage, others don't. That gives you some pretty strong distinctions within the sector.
The Finance Ghost: Yeah, 100%. But Moe, the next time we cover an agricultural name, I now expect a full due diligence from you on the different types of tractors and their pros and cons. It's a bold claim of yours that you're going to go DD John Deere tractors for us.
Mohammed Nalla: I'll send you pictures of me and the daughter actually sitting on tractors this last weekend. So you know that I do my research for from the ground up. Literally.
The Finance Ghost: You give this man one podcast with Wandile Sihlobo, our South African agri expert, and now Moe is a tractor expert. Man, I don't know what's going on here, but I will speak about gross margin in retail because I think we can probably speak to that with some authority. And one of the really - oh my goodness, Moe is showing me a photo of him on a tractor. That's incredible. I expect to see that on X, actually.
Anyway, back to gross margin. The important thing to remember in a retail context is that different product categories carry very, very different gross margins. So for example, in the world of grocery, fresh goods will generally carry the lowest gross margin. It's somewhere in the high teens, certainly in South Africa. And then at the other end of the spectrum, you get all the way up to clothing. And full price clothing sales can come in at a gross margin of like 60%. And then somewhere in the middle, roughly, you get general merchandise, health and beauty - by the way, that's why health and beauty is such a wonderful retail category, is because it has a long shelf life and it has a high gross margin and it has relatively low risk of inventory obsolescence. So there's a reason why the Clicks and Dis-chems of this world enjoy premium valuations and why all of the grocery stores are very keen to get you in the health and beauty aisle because that really is a nice way for them to make money.
But the point is that over time, as a business changes its sales mix, or assuming it does change its sales mix, then you can actually see gross margin shift over time. Now one of the other ways that you can see gross margin move either higher or lower is when volumes move either higher or lower. And this is one of the ways in which a great retailer keeps pulling ahead and a weak retailer falls behind. And the reason for this is quite simply volumes-based rebates from suppliers. The bigger you are as a retailer, the better you do, the more you get rewarded with rebates from suppliers, the better your gross margin. Conversely, if you fall behind targets and you are shrinking as a retailer and you are losing market share and you are shutting down stores, often gross margin takes a knock because you lose out on volumes rebates from your suppliers and therefore it just becomes this really difficult snowball effect. That's part of why retailers are loathe to actually give up space. When you see retailers closing down stores and pulling back on space, as we're seeing the likes of Pick ‘n Pay doing at the moment in South Africa and there are lots of global examples of this, then you must know they really are out of options. They basically have no choice because they really hate doing that because they're basically giving market share up to competitors, they're losing those volumes, etc.
So the rule of thumb, I think if you remember just one thing around gross margin, the more discretionary the product and the quicker it becomes obsolete - so just think fashion on the shelf doesn't last for very long, very much a discretionary purchase - the higher the gross margin. Because for a retailer to justify stocking it, they need to make maximum money. At the other end of the spectrum, something that is very much a consumer staple - a bag of rice on the shelf - is not going to carry a huge gross margin because the retailer is not taking very much risk in stocking that item. So that's the easy rule of thumb to try and gauge where a product might sit on that gross margin spectrum Moe.
Mohammed Nalla: Yeah, I think that's such a great point because people just look at gross margin at a headline level. But understanding the dynamics just below that, which sectors and which products actually carry the higher margin stuff, is so important because so often retailers run these loss-leader type strategies. They might actually sell that bag of rice and your bread, whatever it might be, the staple, they might sell that at a loss to bring you into the store in the hope that you actually then pick up the t-shirt and pick up a pair of jeans, whatever it might be. And that's where they make their money on the overall basket. Now you've touched on a couple of points. You've touched on the gross margin point. You've also touched on the point that cosmetics, for example, obsolescence, we've seen cosmetic-focused retailers, Ulta Beauty, a great example, a stock we've covered on Magic Markets Premium before, really doing reasonably well in that subset of the retail market.
I'm going to pivot from that a little bit because we've spoken about volumes. We've spoken about the ability to maintain your gross margin if you're growing, if your store footprint is not shrinking. And this ties into another metric that I certainly like to look at. I'd like to hear your views on this as well. And that is inventory turnover. Because quite often these retailers bring in the inventory. But with a retailer, it's just so important to see: how quickly do you turn that inventory over, how quickly are the goods flowing out of the stores or are you sitting with a lot of stock? Is that obsolescence starting to hurt you? And so inventory turnover, that's a critical metric that I like to look at.
Another metric that Ghost, I know you've touched on before, is what does retail density look like? And let me explain that. If you're looking at the sales per square foot or square meter, whatever that might be, that also tells you how efficient a retailer is in terms of their physical footprint versus the amount of goods they're actually selling out there. Now that also becomes an important metric when you're looking at the rise of eCommerce because if you have a player that's both a bricks-and-mortar player as well as an eCommerce player, if you see eCommerce rising in importance, then the sales per square foot actually goes up because they're not expanding their capex and their store footprint in order to get more goods out of the store. So those are the two metrics I'd like to focus on next, Ghost. What do you think about inventory turnover as a key metric in the retail space? And then sales per square foot, because that becomes important not just for retailers, but also for real estate investments further downstream?
The Finance Ghost: Not just a tractor expert hey, Moe, you know a few things here about retail. So first one, just to talk to stock turn - here, the higher your stock turn, the better. So quite simply, the quicker your inventory is going out the door, the more times you are turning that inventory over in any given period, a week, a month, a year, it doesn't matter. As long as you measure it consistently, the better. Why is that? Because inventory on the shelf ties up your working capital and that is a huge consideration for retailers. They are very capital hungry beasts. I've got to say a lot of retailers do not do a great job of actually managing the balance sheet as well as they do their income statement. It's very much a trader's mentality where it's like okay, products, margins, etc. and there's kind of this hope sometimes that the balance sheet will sort itself out. I think the best retailers do a very, very good job of measuring the balance sheet, tracking return on capital, those sort of metrics, those are very, very important in a retail environment.
Second point you raised there quite correctly is trading density. I guess that's related to stock turn, but not 100% related to stock turn. Because trading density is a measure of the value of your sales that you can achieve per square foot or square meter of space. So if you are selling – I nearly used diamonds as an example, that's not such a great thing to be selling anymore - let's say high-end watches, that's very different to selling bags of rice. Your trading density, your sales per area square - whatever it is, square meter - will be much, much, much, much higher in that situation than if you are a big supermarket. And that's why shopping centers are built to have very large stores for your anchor tenants, for your grocery stores. They cannot possibly pay a rental per square meter that is equal to what a high-end jeweller can pay for a line shop elsewhere in the mall with heavy footfall. So that's why these malls are designed this way.
You raised eCommerce there, which is a very good point and 100% correct. And the thing I actually want to touch on there is more around omnichannel retail because that's where eCommerce hits trading density. If you have a situation where you can fulfil orders from stores, for example, or you can do something like what Bash is doing in South Africa as part of The Foschini Group, where they are enabling people on the store floor to actually help sell to customers, they all have devices where basically if the thing you're looking for is out of stock, they can try and secure the sale there and then by allowing you to buy it. allowing to be fulfilled from the store. That does wonderful things for trading density because the store footprint is the same size, but now you can use an eCommerce platform to really drive more sales through that store. If you are traditional eCommerce player, then trading density will be a strange or actually non-existent metric, right? Because it's actually warehouse space. So trading density very much for pure play retail or omnichannel. And again, the higher your trading density, the better your business is performing.
And for retail landlords, that is the owners of shopping malls, they will always report on trading density and footfall. These are the two key metrics and what we're seeing at the moment is footfall is under pressure. Generally speaking it's coming down, no prizes for guessing that is because of eCommerce, right, and on-demand shopping? People just don't need to go to the mall as often. But trading density at the moment is still trending higher because when people are going to the shops they are actually then spending more, they're making a point of going.
And some of the landlords can then capture some of that eCommerce fulfilment inside the trading density, it depends on the specifics of the lease. And here if there are any listeners who are experts in that space, I'd love to get more insight into this. But certainly what I understand is that where you've got eCommerce sales that are fulfilled by a store in that shopping centre, it's still effectively going through the till. It's effectively included in trading density, it's included in turnover clauses for the landlords because otherwise you can imagine the landlords will get themselves into serious trouble over time because there's a lot of turnover then happening from that store, but not from people walking into the mall. And that will then create a serious hole in their income.
Mohammed Nalla: Yeah, Ghost, I love that perspective because it is an evolving market. Fulfilment from a store, yes of course the landlords would do well to negotiate that into their leases. You've touched on a couple of key points. Then I want to leverage off that and go into other metrics that you can look at.
So you've touched on working capital for example, and that's just so important at a retailer. Now when you're looking at working capital, we've mentioned looking at inventory turn and how quickly you're getting the goods out. But there's also a question mark of how quickly do you get the money in? Obviously if you're a retailer, you're getting it in from the customer pretty directly. And so this really ties into: what are your terms with your suppliers? And the metric you're looking at here is the cash conversion cycle because that looks at your inventory, it looks at your receivables versus your payables and it gives you a metric in terms of how long is your cash actually tied up in operations? So, if you are looking at working capital stressors, you want to look at that cash conversion cycle. I know historically certain retailers were famous for actually making the bulk of their money on the fact that they could stretch out their suppliers.
But the second point I want to touch on is we've mentioned leases, we've mentioned landlords. And what's very important is that retailers lease a lot of real estate, certainly if they're in the omnichannel space, if they're a traditional retailer. So it's very important to look at those rental liabilities, certainly when you're looking at international stocks, certainly in the US market as well. It's not a hard form of debt, but it does actually impact the overall shape of your balance sheet. And so here you'd want to maybe look at some rent-adjusted ratios. Traditionally, if you're looking at EBITDA with just an A on the end, you want to add an R on that and look at EBITDAR, a metric that makes some of those rental based adjustments.
Now Ghost, I fear that I may be getting a little bit too technical, so I want to just bring in one final point that ties into the retail story as well. And that is when you're looking at a retailer, you could look at the ones that are kind of just the normal growth metrics that management's going to give you. But you also want to look at same store sales. I think that's important because that tells you: organically, what is the business growing at without adding new stores into the mix? I've thrown a lot in the mix there. Ghost, I know you want to jump in, give us some of your wisdom here.
The Finance Ghost: No, you have, Moe. You wouldn't be you if you hadn't included a nice compound question. I did want to just comment on that EBITDAR with a R on the end. So that's very much a hospitality industry thing. You sometimes see it in retail, but what's happened is accounting changes to IFRS have actually led us to a point where rental costs are now sitting in the interest line. Yes, that is as daft as it sounds. The leases are all sitting on the balance sheet and the rentals are sitting as a finance cost. So technically speaking these days, EBITDA is actually EBITDAR as well, because it is actually before rental payments when you're looking at these things in the retail world. But it does depend on the accounting treatment and you do always have to check and yeah, it's a whole complex thing. It's very painful, to be honest. What's happened in the retail sector is most companies have essentially - not ignored this, but they've basically gone and they obviously have to apply these IFRS changes - but then in the management commentary, in the analyst presentation, they will almost always show you EBITDA without and with lease payments, they will do net debt to EBITDA, which is a typical banking covenant, they'll show that excluding leases and including leases, just because it really has skewed so many things.
And then Moe to address the other point that you brought up there, which is just same store sales versus new stores. I mean, again, really important metrics in the retail space. The reason for that is for retailers that are rapidly expanding and this can be through their own capex, so actually opening their own stores or through acquisitions, you can easily have a situation where they are basically buying turnover. That is dangerous because it doesn't really tell you how the existing stores are actually doing. So that's where same store sales become extremely useful because that is a metric to say: never mind the new stores we opened, never mind things we acquired, and by the way, never mind the things that we closed, the same stores today that we had last year, how are they doing? And that's a very important metric for growth in any kind of retailer. And the critical thing to compare that to is growth in operating expenses. So if your revenue growth is below your growth in operating expenses, you are on the wrong side of the margin trend. You can have periods where margins still go up because maybe gross margin did better, but that is not a maintainable source of margin expansion. You've got to see revenue ahead of expense growth. And that's been really hard to come by in South Africa. Many retailers have been on the wrong side of that, which I think is an important point to mention.
Mohammed Nalla: Yeah Ghost, the reason I actually bring up that same store sales point is that in certain markets, I know South Africa has probably been one of these, you've seen some consolidation in the industry. You've seen the same thing in the US as well. And so it's very important to look at: organically, what is this brand doing? Are you getting more feet through the door? Are you growing or actually going and deploying your balance sheet, trying to bolster the numbers, acquiring your growth along the way. How sustainable is that really? I think the real intent for me as we wrap up the show here, Ghost, is that I wanted to showcase to our listeners the extent of detail we look at when we're covering stocks from the bottom up.
We've covered a lot of retailers in Magic Markets Premium. And again, I'm going to point you toward that. If you're not a subscriber, it's only R99 a month. We do detailed bottoms-up research. And it's not just a podcast, Ghost. There's a detailed report. You know this, I'm telling this to the listeners that haven't yet ventured into Magic Markets Premium - there's a detailed report that goes into this that looks at the numbers, that looks at management, it looks at trends with regards to insider buying and selling. There's a lot of detail there.
Retail, just landing on this last point, it's actually a very interesting sector because you can look at staples, you can look at consumer discretionary, there are a number of ways to slice this. You can look at specific product verticals, certainly when you're looking at global markets, maybe just beauty or maybe just staples. And I think that gives you a very interesting place to play in if you're a bit more active in the markets. And also just a better understanding of how you marry the macro stories that you're getting the macro data down into individual stock-based intelligence.
Ghost, I'm going to pause there. I'm happy to wrap the show. I think we've covered a lot of ground. Any final points you'd like to add?
The Finance Ghost: I just want to really drive that point home around just use common sense when you're looking at retailers, it really is - tractor jokes aside - the one place where you can go and visit the store and you can speak to your friends and you should do that. You really should go and see for yourself how these things work. And next time you go to a store, just look around you, look at what's on promotion, how much is it marked down by? What does that mean for their margins? Why is it that apparel retailers can do a 50%-off sale at the end of the season and still make money? Well, that's because their margins, their gross margins start at 60% at the beginning of the season and their business is very much about full price sales versus end of season sales.
So yeah, retail is a very, very interesting sector. I really do enjoy learning about it and looking at it and just looking around me when I go to these malls. So that would be my final comment I suppose is do your research with your eyes on this one because it's the one sector where you really can do that.
Mohammed Nalla: Ghost, the only retail things I'm looking forward to right now are Black Friday sales which are not that far away. So I'm keeping an eye out for that. Unfortunately that's where we've got to wrap the show this week. Let us know what you thought. Hit us up on social media. It's at @MagicMarketsPod, @FinanceGhost and @MohammedNalla all on X, or go and find us on LinkedIn. Pop us a note on there. We hope you've enjoyed this. Until next week, same time, same place. Thanks and cheers.
The Finance Ghost: Ciao!
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
