Today, the Wall Street Journal highlighted the fact that the core domestic Wal-Mart (WMT – $55.77) chain now generates over 50% of its sales in the grocery category. 

In the article, the journalist quotes a sell-side analyst as saying the following: 

“Food goes up as a percent of sales in a recession when sales of everything else are in a slump,” said Bernard Sosnick, retail analyst at Gilford Securities.  “In an economic recovery you may see a bit of a see-saw as spending grows for more discretionary items.”  Wal-Mart is still determined to keep groceries a priority because they are such a powerful draw, Mr. Sosnick said.

Clearly, Mr. Sosnick has not bothered to read the company’s annual 10-K filing for the past 10 years.  In the attached schedule (click here), you’ll notice how the domestic Wal-Mart chain has been increasing its grocery sales mix for the past 10 years, not just during periods of recession. 

It’s become such a sore subject for the company that management even tried to mask the year-over-year comparability a few years ago (again, see attached schedule). 

Why does the company not want investors to know how successful it has been in taking grocery market share?  Because it tells investors how poor of a job the company has done in other product categories and that its sales growth happens to be in low margin groceries.

Unfortunately, analysts such as Mr. Sosnick love to be quoted and to appear on CNBC.  But, many times, in their zeal to find the right sound bite, they highlight how little they know about a particular company or sector.  We would encourage Mr. Sosnick to do something that has become something of a “lost art” in the traditional sell-side analyst community… actually read a company’s 10-K.   

Last week, WWD published an article discussing the first Federal Reserve regulations related to gift cards.  The guidelines, which limit fees and expiration dates, go into effect on August 22nd.  It will be interesting to see if retailers need to adjust their “gift card breakage” calculations and if the new regs negatively impact profitability.

Note: Gift Card Breakage is when a retailer reduces the liability and recognizes revenue when it appears that a gift card is unlikely to be redeemed. 

The very same day that the new regulations were issued, Darden (DRI – $44.54) made the following disclosure on its quarterly earnings press release:

“In the third quarter, the Company reviewed and adjusted its estimate of gift card redemptions as a result of current consumer redemption behavior.  Following this review, the Company adjusted its redemption rate assumptions which reduced third quarter diluted net earnings per share growth by approximately four cents.”

We’ve never seen a retailer/restaurant company announce that they had historically recognized too much gift card breakage. 

On the quarterly earnings conference call, DRI management suggested the following:

“What we’re seeing right now is the consumers are going through their drawers and finding all of the old gift cards and everything they can for our businesses and probably others, so we have seen a pattern that has changed.” 

Interestingly, later in the conference call management suggested the following:

“I think the other thing we see is our sales of these (gift cards) through third parties, those sales channels we’ve had meaningful increases over the past couple of years in those sales channels.  Those cards typically have a slightly higher redemption rate if you would than what we sell in our restaurants… we’ve had meaningful increases in that.” 

Ok, this brings up a couple of thoughts. 

Was the adjustment a result of “current consumer behavior” or was the company surprised about the “higher redemption rate” of gift cards sold via third parties? 

Also, it’s possible that the company may have consciously utilized an aggressive redemption rate assumption in previous periods to artificially inflate the company’s earnings. 

We’re not saying DRI management employed an aggressive accounting methodology to eek out a penny or two of incremental EPS in prior periods.  But, it’s odd that the company just recognized a change in consumer behavior 18 months after the recession kicked into high gear.  Coincidence?

The reality is that we’ll never know.  But, the sell-side analysts on the conference call seemed all too eager to give the company a pass on this topic.  We’re not as convinced.

Talbots (TLB – $13.30) continues to work on finalizing its acquisition of BPW, a special purpose acquisition company (SPAC).  Usually, these transactions are done in reverse but this deal is being done to let TLB buy out its majority shareholder (AEON, Inc.) and lower its debt by approximately $330 million.

TLB has one of the worst business models in specialty apparel retail.  Let’s be clear, the business model began to implode well before the financial crisis.  During the go-go days of 2005 – 2007, TLB struggled to make money.  That’s a sign that that are much bigger issues plaguing the company. 

Take a look at the company’s trailing 4-quarter EBIT margin and 3-year comp store sales run rate charts below.

Given the debacle in Q4 2008, the company’s dramatic EBIT margin improvement in Q4 2009 will translate into a flattish EBIT margin for the full year.  Next year, the company’s EBIT margin should return to the mid-single-digit level.  But, what allows the company to exceed the mid-single-digit level remains to be seen.  Higher profitability will be needed to justify the company’s current stock price.

Beyond the weakness of the underlying business model, what also concerns us is that this management team has a long track record of getting investors excited, only to eventually disappoint the newly raised expectations.  We wrote about this topic in August 2008 when we more actively followed the stock (click link here).  Should investors be skeptical of management’s bullish commentary of late?

Finally, it’s interesting to note that Talbots is desperately attempting to attract a younger customer to its stodgy stores known for catering to gray haired women.  But, who are they kidding.

Both the March 2010 catalog and store windows today feature “real” women of various professions confidently wearing “updated fashions” from the chain.  What’s funny is that the pictures include the ages of these women (ranging from 34 to 52 years old) as if to say, “See America, you’re not too young to wear Talbots.”

On the left is a picture from the company’s catalog.  On the right is a picture of who we generally see in stores today (sorry Grandma).  It’s likely going to take a while to convince a younger customer to shop at Talbots.

Does sales per gross square foot (SSF) matter?  Gosh, if you listen to sell-side analysts or even retail management teams, you would sometimes think that it’s the only metric that matters.  The fact is that sometimes the SSF metric is instructive and sometimes it is not.

Let’s look at two examples, one that matters (ANF) and one that does not (LTD).

Example #1 – Bath & Body Works (LTD – $25.78)
In today’s WWD, there’s an article about U.S. based retailers that are planning to expand their store base into Canada (yep, it’s 2010 and JCG and LTD are just figuring this out).  But, check out this quote from Martin Waters, the EVP of the International Division at Limited Brands:

“They’re generating 2.5 times the sales per square foot as the average U.S. store,” says Mr. Waters.

Ok, the above is an example of when the SSF metric means nothing.  Sure, it sounds great.  But, it does not provide a complete picture.  It’s likely that LTD’s “handful of stores” opened in Canada were in the country’s highest quality malls.  Therefore, the ‘average’ mall quality is likely materially higher than the 1,627 stores the chain had at the end of FY 2009. 

Instead, we argue what matters is profitability.  We’re willing to bet that the rent per square foot (RSF) is probably 2.5 times higher than the average U.S. store, if not greater. 

Here are other questions to ask a management team when they run these types of metrics by you…

Is the merchandise margin profile of the stores higher or lower than average?  Is the labor expense as a percent of sales higher or lower than average?  Are distribution costs higher or lower than average?  What were the build-out costs per square foot and the associated annual depreciation and how does that compare to your average store?

You clearly see where this is going.  In this case SSF does not matter.  The metric should simply serve as a springboard for a savvy analyst to query management further re: the chain’s cost structure.  Sales per square foot (SSF) may be materially higher, but likely so are the costs. 

Example #2 – Abercrombie & Fitch (ANF – $44.74)
Let’s stay in Columbus, OH and talk about ANF’s Gilly Hicks chain.  As we’ve previously written (click here for a link to our post dated September 28, 2009), Gilly Hicks may be the absolute worst chain roll-out in retail history.  

Today, ANF published its annual 10-K.  ANF is nice enough to provide sales and square footage each quarter for each of its chains (click link here).  When you open the link, you’ll see that Gilly Hicks generated an embarrassing $164.14 sales per gross square foot in FY 2009.  It’s worth noting that the recently shuttered Ruehl chain delivered only $239.02 in FY 2008 before the decision was made to close it in FY 2009. 

Big picture, $164 SSF for a specialty apparel retailer is an embarrassment.  But, what makes this potentially the worst specialty apparel launch ever is the company’s disclosure that build-out costs for Gilly Hicks totaled $392 per gross square foot (see FY 2007 10-K filing).  For comparison: 

Likely to save further embarrassment, ANF management decided against providing the capital expenditure build-out costs for each chain in the company’s FY 2008 10-K filing.

We fully expect Gilly Hicks to be shuttered soon.  All too often it takes management a long time to admit failure.  But, the Gilly Hicks brand launch will likely go down as the worst in specialty retail over the past decade.

But, Gilly Hicks is instructive here as a situation where the SSF does matter.  The abysmal $164 SSF is being generated in likely some of the highest quality real estate in the country.  You are certain that the real estate and amortized development costs are materially higher than average.  Not good. 

So, in this case, the chain’s SSF tells us there was no real strategic planning performed prior to the chain’s launch and that Gilly Hicks is likely the next chain to be shuttered at ANF. 

So, as in some other aspects of life, size does not matter.  What matters is profitability.