Why declining sales are retail poison
If you've ever wondered why Amazon and online retailing are significant threats to bricks-and-mortar retailers, here's the lowdown.
Yesterday we published Amazon and the Aussie hit list – Part 2. In the review we looked at which major ASX-listed specialty retailers are most at risk from Amazon's Australian launch and online retailing in general.
(We also identified one retail baby that might have been thrown out with the bathwater. We'll continue our research to determine if it's a Buy.)
The review argued that it could be a decade before Amazon takes even 2% of total Australian retail sales. So you might be thinking: what's everyone worried about?
Well, the answer is that very small sales declines – even flat sales – can kill a retailer.
Take JB Hi-Fi (ASX: JBH), one of Australia's retailing success stories. In 2016 (before the acquisition of appliance retailer The Good Guys, which will boost sales in 2017 and beyond), the company generated sales of almost $4bn. Based on operating profit of $221m, the company's margin was 5.6%. You can see the company's actual results in the second column of Table 1.
2016A | $200m sales decline |
/(–) (%) |
|
---|---|---|---|
Sales ($m) | 3,955 | 3,755 | (5) |
Gross profit ($m) | 865 | 822 | |
Gross margin (%) | 21.9% | 21.9% | |
Cost of doing business ($m) | 603 | 603 | |
EBITDA ($m) | 262 | 219 | (16) |
Depreciation/Amort. ($m) | 41 | 41 | |
Operating profit ($m) | 221 | 178 | (19) |
Operating margin (%) | 5.6% | 4.7% |
So let's assume that Amazon manages to nab $200m of sales from JB Hi-Fi. Using the same gross margin, and assuming the company was unable to cut its cost of doing business, you can see the effect on operating profit and margins in the third column.
For a sales decline of just 5%, JB Hi-Fi's operating profit falls by 19% and margins contract sharply. You can imagine how another year of sales decline could quickly turn ugly. This is why Amazon's Australian entry is so worrying.
Operating leverage
It's called ‘operating leverage', and retailers have it in abundance. Retailers are low margin businesses and, when they're unable to reduce costs, falling sales will produce much greater declines in earnings.
In fact, a retailer doesn't even need sales to fall to strike trouble. Even flat sales can result in lower earnings and margins.
The reason is that, like many businesses, retailers have cost inflation baked in. Staff wages generally increase every year, while rental payments are often indexed to inflation. Flat sales and rising costs implies margins will contract.
Once a retailer's sales are flat or falling, other things usually start going wrong. For example, former market darling OrotonGroup (ASX: ORL) announced sales down 10% for the half-year to 28 January 2017. But with cash on the balance sheet of more than $5m at that date, you'd be forgiven for thinking it would muddle through.
The problem, however, is that retailing is generally very seasonal. Most retailers experience a peak in their cash balance after Christmas as customers empty their wallets over the silly season. So the cash balance on a December or January balance date is unlikely to be representative of the average cash figure over the entire year.
(As an aside, consumer electronics deadbeat Dick Smith Holdings was placed into administration in on 4 January 2016. As its cash holdings would have been close to peak levels then, the timing was advantageous to the company's banks).
Precarious position
OrotonGroup's 20 June announcement painted a rather different picture than at 28 January. At mid-June the company had drawn down debt of $16m to fund the purchase of inventory for the spring selling season. With a statement that ‘the Company is in ongoing discussions with Westpac on the terms of that facility', it's clear that OrotonGroup's June financial position was much more precarious than its January cash balance suggested.
Operating leverage and seasonality are two significant reasons why investing in retailers is a tough game. Things can go seriously wrong very quickly. Add to that operating lease commitments that can stretch out for decades, and sometimes retail businesses are worth less than zero.
This is why you might see retail businesses sold out of administration for a song (because new owners take over the lease liabilities). Others – like Dick Smith – are simply not viable, which is why all its stores were closed following administration.
Amazon and other online retailers are certain to eat away at the sales base of bricks-and-mortar retailers for a while yet, which makes traditional retail a challenging sector in which to invest. For every retail baby we identify, we expect to be drenched in a lot of very, very dirty bathwater.