Walmart vs Sears: Profitability Analysis

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EXECUTIVE SUMMARY

This report is intended analyze and compare the operating profitability of Sears, Roebuck and Co. (SRC), and Wal-Mart Stores Inc. (WM) for the accounting periods of 1996 and 1997.

It is concluded that:

SRC offers superior returns on common equity (ROCE). This undoubtedly reflects the greater amount of debt in the capital structure vis a vis WM, and a stronger gross margin. However, SRC’s ROCE has declined in the last year mainly because a reaffirmation charge (40% of Net Income) generated in lawsuits and a possible violation of the United States Bankruptcy Code. We need to highlight the uncertainty associated with the reaffirmation charge; this means that the actual results can differ from the company’s estimates.

WM, on the other hand, is a strong cash generator that has a significant potential for growing in the future. Moreover, its ROCE has grown in the last two years, and is very proximate to SRC’s.

We have utilized an Intermediate Decomposition method for analyzing the ROCE and its value drivers of each company. You can find a graphical description of this method for each company in the Appendix at the end of this report.

RETURN ON COMMON SHAREHOLDERS EQUITY (ROCE)

ROCE measures a firm’s performance in using and financing assets to generate earnings and unlike ROA, explicitly considers financing costs. Hence this broadest of measures of profitability incorporates the results of operating, investing and financing costs. Fig. 1 compares the ROCE for SRC and WM for 1996 and 1997.

It is clear that SRC offers greater returns than WM. However, it should be noted that SRC’s ROCE has declined over the period. Additionally, this simple comparison does not show the effects, and potential risks, of debt in the capital structure. In order to investigate further, the ROCE is disaggregated into several components each of which will be considered further over the following pages.

Before investigating the capital structure of each unit, we will analyze the relative operational effectiveness of the two firms.

RETURN ON ASSETS (ROA)

Comparing ROA’s facilitates the assessment of a firm’s performance in using assets to generate earnings, independent of the financing of those assets. Fig. 3 clearly shows WM’s ROA is almost double that of SRC. This suggests that WM extracts much more value, or makes its’ assets ‘work harder’ than does SRC.

Further analysis reveals two main drivers behind the huge difference in ROA for the two firms.

Profit Margin

SRC clearly earns higher Profit Margins than WM. This may be attributed to the nature of WM’s business. As the largest “discount retailer” in the US, WM is clearly in the business of volume, and not price. Low prices directly affect WM’s margins, making them smaller than SRC’s.

Further, fig. 5 & 6 show that WM’s lower prices make its Gross Margin (Operating Profit before Depreciation / Sales) half of SRC’s. That also makes WM’s cost structure “heavier” in relation to sales.

Furthermore, a comparison of revenues per selling square foot. Fig. 7 shows us that WM is more efficient in the use of its selling space.

Total Asset Turnover (TATO)

The main driver of WM’s greater ROA is its high TATO. Clearly WM generates more sales per dollar of assets than SRC. In order to understand fully the difference between the two companies, the TATO was disaggregated further.

Accounts receivable were omitted and TATO was recalculated for each company. The new figures clearly demonstrate the large effects of A/R on the TATO of SRC.

In effect, SRC is offering long financing to its customers, while WM collects the cash in an average of three days. The impact on the liabilities side is also clear: SRC is able to obtain...
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