An Introduction to Business Models: Arbitrage and Retail.
Understanding business models – Arbitrage and retail:
Hi Investors. In this post, we will be discussing an arbitrage and how it is exploited in the retail industry. If you have previously analyzed any company in the market you would already know that among the different business models one of the easiest in terms of operation is the business of arbitrage and retail.
Today we shall go a level deeper into the analysis of a retail company and discuss one of its most important metrics and its significance. The topics we shall cover in the post are as follows:
- What is arbitrage?
- How do retailers use this strategy today?
- What metric should we use to analyze whether arbitrage is working out for a retailer?
- What is the SSS growth?
- How to identify the drivers behind retailers’ business model from SSS growth?
- How are business models changing in retail and how to modify our analysis?
On the whole, this will be a long post- but we hope you find this very rewarding and is definitely worth reading. So let’s get rolling.
1. What is Arbitrage?
Arbitrage is a money-making strategy followed by traders since the very ancient times, even today it is sometimes thought to be an almost risk-free strategy. The aim of those traders in business was to profit from the difference in the pricing of goods between two regions or markets.
Let’s take the example of the famed Silk Road.
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Traders and merchants used to travel from the Mediterranean, Persia and the Levant to Central Asia and China to buy silk and other products, then they used to travel all the way back to sell these goods in their home markets.
Back then a commodity like silk was precious and luckily for all merchants, China had a complete monopoly over the production of Silk. This made them even more precious in some markets than the others. The markets farthest and wealthiest away from the production center became the areas where the silk trade was most lucrative just like ancient Egypt, the Roman Empire, Ottoman Empire etc.
2. How do retailers use this strategy today?
Modern retailers use the same strategy of arbitrage to generate profits (they buy products from manufacturers and wholesalers for lower prices and sell them to consumers at higher prices), but of course with some tweaks.
But since competition is high in the modern landscape, retailers often tweak their business models to gain an advantage over their peers.
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3. What metric should we use to analyze whether arbitrage is working out for a retailer?
As we just mentioned, retailers tweak their business models to gain competitive advantage and a lot of the times many retailers follow the same strategies. This spells trouble for us as investors, how do we know which retailer is doing the right thing and who is failing to do so?
Luckily for us, there is a metric that can help us analyze just this question. The metric is called the Same-Store-Sales growth rate.
4. What is the SSS growth?
“Same-Store-Sales” as mentioned is one of the most important and useful metrics for retail companies. This metric also has other names such as “like-for-like” sales or “Comparable-Store-Sales” and “identical-store-sales”. The concept behind the metric is fairly straightforward: the metric represents the sales growth of stores which were present for more than a single financial year.
Let’s understand this through an example, assume that we operate a retail business with 10 stores spread across Maharashtra in 2016 and as part of our growth strategy we open two more stores in 2017. Let us also assume that our revenues increased by 10% during this period. This 10% growth could be broken down into the following two sub-parts
- Growth due to new stores opened in 2017
- Growth due to increased sales in existing stores at the beginning of 2017
The second sub-part: the growth from existing stores is what is represented by the SSS growth metric.
In an ideal world, we would want to make sure that our current stores are generating sales growth for many years once they are opened. This scenario will only happen only till the day our customers find value in our products and the SSS metric helps us deduce whether our business is continuing to deliver value to our customers.
5. How to identify the drivers behind retailers’ business model from SSS growth?
In economics, we all know the scenario of perfect competition. It is the market condition where every seller sells their products at the same price as their competitors and profits are marginal. Retail is a highly competitive business since anyone with a sufficient capital and basic knowledge of logistics can become set their own store up (remember the Kirana stores at the corner of your street?).
Retailers try to outdo their competitor by employing various strategies to create an intangible or a tangible value to their customers and deny or gain an advantage over their competitors.
The drivers behind SSS growth could be any combination of the following:
- Pricing of products: retailers try to achieve higher pricing power by creating intangible value to customers by selling branded products
- The volume of products sold: some retailers do not have much pricing power so they sell large quantities at slightly discounted prices to make profits
- Net store productivity: retailers sometimes sell add-on products and accessories to boost the revenue per each sale that they have
Obviously, the most desirable and profitable route for a retailer would be to improve the pricing of products sold in their stores but most retailers would witness a drop in their volumes. But some company have created such strong brands that they can indefinitely increase their prices without facing a major drop in sales. Examples of these firms would be the sporting giant Adidas and the global luxury firms Tiffany and Gucci.
The second route is that of companies which focus exclusively on volumes, these are usually companies that have achieved economies of scale and can significantly underprice their competitors out of business. Because of their low pricing consumers flock to their stores for cheaper products. Examples of this type of retailers would be DMart, Amazon, Walmart etc.
(Please note here that economies of scale and brands that can charge a premium are significant economic moats for a retail and consumer companies)
The third most common route is to sell increase the products sold to a customer in a single transaction. It may be an auto-retailer who sells you a car and also an insurance scheme or maybe those leather covers on your seats. It could also be the restaurants that sell you the main course with starters and the side drink or even the furniture store from where you bought the table, the chair, and the table lamp.
6. How are business models changing in retail and how to modify our analysis?
With the advent of e-commerce retail players worldwide have witnessed dramatic headwinds in their operations and have begun to change their business models to adapt to the evolving business landscape. Increasingly retailers themselves are opening up their own e-commerce sites and selling products.
Eventually, as companies change so should our analysis techniques, in view of the above development, using the SSS metric along with the online/ e-commerce sales growth metrics to understand companies would better suit our goals.
Retailers although reliant on arbitrage continue to adopt strategies to give an edge to their businesses. The SSS growth metric helps us identify whether the retailers are able to put theory into practice and also identify the factors driving their growth.
The SSS metric also helps us identify whether companies are able to develop credible economic moats. In companies which have both offline and online retail presence, it would be wise to incorporate online/e-commerce growth and value metrics along with SSS in our analyses. Happy investing!!
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Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.