Only 3 retail chains considered ready to succeed indefinitely


Why is it so difficult for a retailer to establish a wide economic moat?

I found that right now our analysts have determined that there are 91 companies under coverage on that have a wide economic moat rating. Of those, only three are retailers: Walgreen, Home Depot and Wal-Mart.

There are dozens of nationally known companies out there, exactly the type favored by the Peter Lynch school of investing, so why do only three make the cut as companies able to fend off competitors for the long haul?

By our definition, the only way a retailer can have a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'. It can do this by offering unique products or low prices. The former is difficult to do, especially on a large scale, because unique products don't remain unique for long. Most large retailers establish their moats by building up big market share and offering the lowest prices on their goods. In other industries, companies with wide moats can have such competitive advantages as patents and government licenses, unique corporate cultures, high customer switching costs and network effects, but those simply do not apply to retail.

Here's a quick look at the short list of retail companies with wide economic moats.

Walgreen: The drugstore chain gets our top moat rating due mainly to its market share. It's the nation's largest by sales, and it's soon to be the largest by number of stores, too - it's continuing to blanket the country with stores. What's more, it has been able to fund the expansion internally, without taking on debt.

This expansion, and its nearly flawless execution, has given Walgreen more bang for its marketing dollar, among other pluses. A flyer in the newspaper or an ad on the radio reaches more households near a Walgreen's than ever before. And thus far, cannibalization, or the risk that Walgreen will steal market share from its own stores, has been almost nonexistent.

Home Depot: Big Orange's wide moat also stems mainly from its market share, but one must consider as well its status as the low-cost provider of its goods. The wild card here, though, is Lowe's (LOW), Home Depot's main home-improvement rival. There is very little differentiating the two companies, but between the two of them, they have pretty much established a rational duopoly: an occasional price war flares up, but there's no indication that they're going to compete away each other's profits anytime soon. We've considered awarding Lowe's a wide-moat rating too, because there's still a lot of market share to be grabbed between the two of them.

Wal-Mart: Huge market share in groceries, apparel, general merchandise and even diamonds (through its Sam's Club warehouse club chain), combined with its low-cost-provider status in each of these categories, give Wal-Mart its wide moat.

Wal-Mart is the largest seller in the world of thousands of different consumer items - 23 percent of Clorox's sales, for example, are through Wal-Mart - so it demands better pricing from suppliers than its competitors get. It also has inventory management practices and supply chain efficiencies that are second to none. How sustainable is it? Even when retailers' wide moats do exist, they can dry up right before investors' eyes. More so than with other industries, determining the sustainability of retail companies' competitive advantages is tricky.

Think about the great things you like to see in a retailer. Inventory controls. Innovation. Margin protection. Strength of management.

The problem is, none of these qualities is unassailable or necessarily long-lasting. Take margins, for example. Gross margins on general merchandise were 35 percent in the early 1960s; they now stand at around 22 percent. Contrast that with Microsoft or Genentech, more typical wide-moat companies, where gross margins are north of 80 percent.

Of our 91 wide-moat companies, only Dell and General Dynamics have lower gross margins than Wal-Mart. Excess profits, already extremely small in discount retail, have been whittled away to almost nothing.

Some argue that it's Wal-Mart's relentless focus on containing costs that will allow it to maintain its economic moat against would-be competitors. Surely no one of sound mind would try to start up a discount retailing chain today, right? Wal-Mart simply has too great a lead.

But there's no guarantee Wal-Mart can hold on to its advantage. In 1977, Wal-Mart's sales were only 5 percent of Kmart's.

Wal-Mart's competitive advantage isn't going away tomorrow. Neither is Walgreen's or Home Depot's. But economic moats, when they do exist, eventually get breached or disappear in any industry. Just because these companies are kings of the hill now in terms of market share and cost advantages doesn't mean they always will be.

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