Wednesday, October 5, 2011

Comparing Retailers Using DuPont Analysis

Long-term investors often look for companies with a demonstrated earning power over a period of 10+ years, as measured by the Return on Equity (“ROE”). In the words of Warren Buffett, “We're looking for... businesses earning good returns on equity while employing little or no debt.” DuPont analysis is a particularly useful tool for examining trends and causes of ROE. In this article we apply DuPont analysis to compare four retailers: Kohl’s (KSS), Macy’s (M), Target (TGT), and TJX Companies (TJX).

The returns on equity earned by these companies span the range from mediocre to stellar. Here are the median ROEs for these companies since 1996 - 97, according to StockPup.com:
M: 10%
KSS: 16.8%
TGT: 18.4%
TJX: 40.8%

Macy’s is below average for the S&P 500, Kohl’s and Target are solid performers, while TJX results are phenomenal. Not surprisingly, TJX shareholders saw their shares appreciate from $4.70 in 1997 (adjusted for dividends) to $55.50 today – a compounded annual growth rate (“CAGR”) of 19%, while Macy’s shareholders watched their shares slog from $16.43 to $26.32 over the same period – a CAGR of only 3.4%.

One of the key questions for an investor is what kind of performance can be expected from these companies going forward. History, seen through the prism of DuPont Analysis, offers some clues. In its most common form, DuPont equation is a decomposition of ROE into 3 factors:
ROE = (Net Margin) * (Asset Turnover) * (Asset to Equity Ratio)
Net Margin indicates operating efficiency, Asset Turnover measures the total asset use efficiency, and the Asset to Equity Ratio is a measure of financial leverage.

Let’s start with TJX, and look at its return on equity, and its components:

We observe that its ROE has been consistently between 30 and 50%. Changes in ROE have been mostly driven by changes in the Net Margin and the Asset to Equity Ratio, while asset turnover has been extremely stable. The Net Margin reached the top of its 4-6% range this year. The Asset to Equity Ratio has been generally going down since 2006 – a positive sign of financial health. Indeed, while the Equity of the company has been growing, its long-term debt is roughly the same as in 2006:

Let’s compare this with the runner-up – Target (TGT). At Target we also find a relatively consistent ROE track record, generally hovering around 18%.


The Net Margin’s at TGT are historically around 5%, similar to TJX, although lower in the past few years. The big difference lies in asset utilization. While the Asset Turnover at TJX gets as high as 300%, meaning that for every $1 tied up in Assets, TJX produces $3 in Sales, TGT saw its Asset Turnover slide from 200% to 150% over the past 10 years or so. This is nearly two times worse than at TJX. If you were considering TGT and TJX for your investment portfolio, you would want to dig deeper into the causes of this difference.

Let’s add Kohl’s (KSS) to the picture. The ROE at KSS is roughly similar to TGT – a bit lower. The Asset Turnover is also similar to TGT. However, we see a consistently higher Net Margin and significantly lower leverage, as measured by the Asset to Equity Ratio. The lesson is that Kohl’s is operationally more efficient than TGT and even TJX, and chooses a much safer financial structure, with over a 60% of its Assets coming from Equity, compared to less than 40% at TGT or TJX. This choice of a safer balance sheet reduces Kohl’s earning power, but makes it more attractive to investors seeking safety.

Finally, let’s take a look at a very different picture at Macy’s (M). The earning potential here is very inconsistent. Even in good times, Macy’s rarely achieves returns on equity above 15%. Further, in 3 out the past 10 years the company has suffered losses, manifested by dips on the ROE chart.

The last of these big losses came in 2009, when the company had to write off some $5B of Goodwill it picked up as a result of a $12B acquisition of May Department Stores in 2005 (the “M” indicator on the chart below)

Macy’s problems are not limited to corporate action that destroyed shareholder equity. The company has the lowest Asset Turnover of the four retailers in this comparison, at the same or lower margin. Further, its leverage is much higher. While leverage props up ROE, it is a warning signal for investors that the company may not be able to weather bad economic times as well as its competitors.

For investors looking to build a stock portfolio of strong long-term performers, a high Return on Equity is one of the most desirable characteristics in a company. DuPont analysis provides a way to study the ROE, and understand the key factors that define this metric. In the case of the four retailers we examined, DuPont analysis sheds light on the trade-offs between business performance and balance sheet risk. It also points at further research questions, e.g. “why are Asset Turnovers different among these companies”, that an investor would want answered to choose among these companies.