I have evaluated both LOW and HD in a previous post, see here, and I thought to give you a list of factors that are critical in analyzing any retail business. These factors are classified into two general categories: Macro factors dealing with issues that impact all retailers, and the second set is the micro factors that are business specific and analyses the economics of each business. The first set to discuss is the macro factors.

Macro Factors:

Retailing is not a growth business nor it is a global business, so it is very much tied to the US economic activity. Retail businesses is mature and will never experience a hyper growth or fast pace growth periods rather it will be a steady pace of revenue expansion. n other words, the retail industry as a whole will have a maximum growth rate equivalent to the GDP growth rate. Retail is a play on consumer and their spending. Consumer spending makes up two thirds of the US GDP, so Retail earning is very much tied to the health of the economy.

In a slow economic periods drug and pharmaceutical retail will hold their earnings as they have demand that is not correlated to the economic cycles, you will be sick during a recession. Also, value retailers and market share leaders will be able to withstand economic downturn. Specialty retailers those who depend on discretionary spending by consumer, think LOW and Home Depot, athletic wear retailers, will be the most hurt in an economic down turn.

Some of the statistics to analyze for a recovery or judging the health of the industry are the following:

Consumer spending.
Consumer confidence. Consumer confidence in economic outlook and wages will lead to higher spending on purchases. however do not put too much weight on this indicator as it is not future looking. It describes current economic events and does not bear any weight on future trends, in addition t is much too volatile.
A consumer debt level is not helpful. However what is helpful is the debt service percentage of total income. A manageable level will not impede consumer spending.
Real Disposable income that are rising in real terms signal strong environment for retail sales.
Low unemployment in retailer's locations may signal strong demand for goods but depending on the retailers nature, it might not boost sales. If low unemployment produces low wages and income for consumers it will not boost specialty high end retailers.
Population growth in retailer locations means increased traffic to its store and higher revenues.

Obviously these factors have to be analyzed on the basis of their trends compared to previous periods.

Micro Factors:

The following 6 factors are operations specific and its usually better to benchmark these factors relative to other retailers to gain a better understanding of their economics.

1. Brand Management

Indicators and questions:

Strength of Retailer’s value proposition to customers
Clear niche in the value proposition in the customer mind
Effective communication and re enforcement of proposition
Focus and singleness of purpose
Year over year change in advertising and sales expenses to yr over yr change in sales
Trend of advertising expense as percentage of gross revenues over the last 5 years.

Retailer’s value proposition has to very clear to its customers. Customers can’t be confused by what they are getting by shopping at the store. For example, Wall Mart is known as a value retailer and offers the lowest prices, in contrast to the failed retailer Kmart which wanted to offer low prices put upscale brands like Martha Stewart. The contradiction in price and message did not serve as an effective communication with its customer and it lost both the low income customer that perceived expensive merchandize to Wall Mart and the high end ones to target a target positioned itself as a high end retailer with brand name products.

Advertising and communication with customers is what translate into traffic to stores. An effective advertising campaign is a must.

You can judge a retailer effective campaign by measuring the effectiveness of its advertising campaign. You can compare year over year change in advertising expense to it growth in sales. Does the retailer receive more growth in sales as a result of their advertising campaign or do sales stay flat? Also does the retailer keep its advertising budget stable and grow it or does it vary year over year.

2. Management and Customer Service

Indicators and questions:

Management capabilities to read consumers
Management experience in retailing
Customer Service and shopping experience
Introduction of new products
Sores are profitable after 3 yrs of introduction then the life cycle of company's stores is important, where is the company in this life cycle
Percentage of sales from new stores to old ones

One of the most important ingredients is management capability. Retail is an art form and requires a lot of experience to get the mix right and requires an intimate knowledge of your customer. Look at the length of Wall mart IT department and its information gathering efforts about customer’s habits and buying behavior.

Also retail experience is critical. Just look at Home Depot and how it lost its way with non retail executives at the helm. Nardilli may have been successful at increasing financial metrics but failed to connect with customers and employees and did not understand HD value proposition.

3. Financial Controls

Indicators and questions:

Control over debt:
Control over margins: stability of margins over the years
Shrinkage: stability of inventory shrinkage as percentage of sales over the 5 years
Stability of ROIC over years
Stability or increasing margins

As retail is a mature business, a good retailer has to understand how to create value and which growth strategies to pursue.

You need to look for retailers earning a return on capital invested in excess of their cost of capital. A retailer can’t pursue a revenue growth strategy by investing excessively. Its investment has to be measured and calculated in order not to destroy shareholder value.

4. Supply Chain Management

Indicators and questions:

Effective distribution to stores
Inventory management and turnover ratios
Economies of scale: COGS/ # of tickets to indicate economies of scale; should be declining trend
Cash to cash cycle
Shrinkage as % of sales over the years
Stable or declining inventory/ sales ratio

Maybe one of the better indicators of the health of a retailer’s supply chain is its cash-to-cash cycle. The cash-to-cash cycle measure how quickly a retailer can transform its investment in inventory to cash at hand. The lower the number of days the more efficient and effective the retailer’s operation going to be.

5. Site selection

Indicators and questions:

Trend of Store closures in the last 5 years as percentage of total or opened ones
Convenience of stores to customers
Store appearance and cleanliness
Plan for format/ upgrade cycle
Capex per store
Geographic concentration and market share

Site closures will give you an indication of the business effective ability to locate and pick sites for its retail. Effective retailers will not have a large number of closures and relocation, if they understand their customers and demographics.

Store format change is critical for newness the amount of Capex per store indicate retailer’s attention to upgrading its stores and keeping them current.

Concentration of store locations in geographic areas is far better competitive advantage than national retailers with fewer stores. Geographic concentration is a key economics of scale to retailers that it can leverage to offer lower prices and increase profitability. Geographically concentrated retailers can lower their cost of customer acquisition and increase convenience to the customer. For example Wall Mart was much successful than Kmart because wall mart concentrated geographically in Arkansas and neighboring states, while Kmart pursed national expansion. The result was a dominant Wall Mart and bankrupt Kmart.

6. Merchandising

Indicators and questions: