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Retail Sector and Subscription Models

The retail sector is a fundamental pillar of the economy, covering everything from supermarkets to fashion stores and department stores. This business model is characterized by inventory management, supplier relationships, and strategies to maximize profitability. Additionally, in recent years, a subscription-based model, implemented by companies like Costco or BJ’s Wholesale Club, has revolutionized the industry.

1.    Negative Working Capital Model in Retail

A key characteristic of retail is the use of negative working capital, meaning the company collects payments from customers immediately while paying suppliers within 60-90 days. This creates free financing, which can be reinvested to expand the business.

1.1  Risks of Negative Working Capital

While this model is efficient during periods of growth, it can create issues when sales decline. If like-for-like (LFL) sales are negative, the company may face financial difficulties due to lower-than-expected cash flow.

Example: Companies like Francesca’s or Michael Kors expanded aggressively by opening new stores, but their negative LFL sales indicated a real decline in operational profitability.

2.    Importance of Comparable Sales (LFL or Same Store Sales)

Analyzing comparable sales is crucial in retail to assess real company growth, excluding the effect of new store openings. It is calculated by comparing the sales of stores that have been operational for more than a year within the same period of the previous year.

A negative trend in comparable sales signals a decline in demand, which can lead to stock price drops.

Example:

  • Michael Kors had quarters with LFL between -12% and -13%, leading to a sharp drop in its valuation.
  • Francesca’s showed growth in total sales, but negative LFL figures revealed an unsustainable overexpansion.

3.    Impact of Lease Contracts in Retail

The type of store ownership significantly affects a retail company’s financial structure. There are three main types:

  • Owned stores (high initial capital requirement but lower long-term fixed costs).
  • Leased stores (more flexibility but recurring operational costs).
  • Franchises (efficient model with lower operating costs and fast expansion).

3.1  EBITDA Adjustment for Leases

To compare companies with different lease structures, EBITDA is adjusted by adding rental costs, obtaining EBITDAR (EBITDA + Rent). The EV/EBITDAR multiple is used for valuation adjustments.

Formula: To capitalize leases and add them to Enterprise Value, rental expenses are multiplied by a factor of 6-7.

Example: Home Depot explains in its reports how to adjust debt by considering lease obligations.

4.    Profit Margins in Retail

EBIT margins vary depending on the business type:

  • Restaurants: 10-12%
  • Supermarkets: 3-10%
  • Fashion stores: 10-20%

Although margins may seem low, the ROIC (Return on Invested Capital) is high due to fast inventory turnover and working capital efficiency.

5.    The Subscription Business Model in Retail

Companies like Costco and BJ’s Wholesale Club have implemented a membership-based model to differentiate themselves in the retail sector. This model offers significant advantages:

5.1  Characteristics of the Subscription Model

  • Recurring revenue: The company charges an annual membership fee, generating stable income.
  • Lower prices: Thanks to customer loyalty, they can negotiate better prices with suppliers and pass the savings on to consumers.
  • Higher customer loyalty: Paying for a subscription encourages customers to shop more frequently at the same store to maximize their value.

5.2  Costco Example

Costco charges an annual membership fee and derives most of its net profit from these fees rather than product margins.

Profitability Formula:

  • Low product margins → High sales volume → Recurring membership revenue

5.3  Risks of the Subscription Model

  • Subscriber dependency: If customers cancel their memberships, the company loses recurring revenue.
  • Need to maintain low prices: Profitability depends on the customer’s perceived value.

Example: BJ’s Wholesale Club follows a similar strategy to Costco, focusing on competitive pricing and accessible subscriptions.

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