4.10 Analyzing Profitability

The profit margin ratio in the DuPont can be decomposed into finer components by working with net income from continuing operations, commonly referred to as EBIT (Earnings Before Interest and Taxes).  Dividing EBIT by Sales converts it into a margin, and the EBIT to Sales ratio provides data that can be compared across companies.  It yields information on a company’s costs relative to sales.

Two refinements discussed in the Business Ratio chapter were the Gross Profit Margin, defined as Gross Profit expressed as a percentage of Sales, and Operating Income Margin, which includes selling and administration costs associated with operations.

The primary difference between these two ratios is that the Gross Profit is defined as Sales less COGS, and thus does not include Selling, General and Administration (SG&A) costs.  EBIT on the other hand does include Selling, General and Administration because it is net income less interest and taxes.  Under US GAAP a further distinction is made between continuing operations versus discontinued operations.  This is not the case for IFRS.

Continuing with Target and Wal-Mart, recall that an important difference in their business strategies hinges on “shopping experience.” This implies that SG&A is more important to Target.  Therefore, it is useful to compare: the Gross Profit Margin, Operating Income Margin and also the Selling and General Administration Margin when comparing Target and Wal-Mart.  In the tables below, the year refers to the beginning of the year (i.e., the year the 10-K became available) so 2010 refers to the annual results from 2009.  COGS is “Cost of Goods Sold” while SG&A is “Selling, General and Administrative Expenses.”

Observe that the Gross Profit Margin is higher for Target than Wal-Mart, consistent with their respective business strategies.  Target’s Gross Margin has declined over the last three years; they have been much harder hit by the recession than Wal-Mart.  In fact Wal-Mart has managed to increase its Gross Margin over these same years!  Target’s business strategy is reflected in the SG&A and its impact on Target’s profitability is reflected in the Operating Income Margin.  Overall, Target maintains an Operating Income Margin (the column titled Operating) that is a little above Wal-Mart’s. 

Two recent trends are that Wal-Mart has been increasing its marketing expenditure (i.e., SG&A).  This has been increasing over the last three years and suggests that Wal-Mart is increasing its attention to “shopping experience.”  However, you can see that Wal-Mart’s increased Gross Margin has been applied to this shift in strategy so that there has been no impact upon its Operating Margin which is level at 5.9%.   From the ratios above you can see that Target appears to be responding to its recent declines in Gross Margin from the recession by reducing its marketing expenditure (as revealed by the trend for the SG&A margin) in an attempt to recover their previous Operating Margins.  This has resulted in the reversal of the declines in 2009, and Target’s current Trailing Twelve Months Operating Margin is 7.40%. 

These numbers and trends can be placed in context of the actual shift in Target’s business strategy since 2008.  In 2009 Target modified its strategy towards Wal-Mart, with its “Expect More Pay Less” marketing strategy.  In July 2009 it started matching competitors’ advertised prices on identical items in local markets.  Further it has been actively working with vendors to keep costs in check and has increased its reliance on higher-margin private label goods (Barron’s August 9, 2010 “Right On Target”).  In the next section we consider some of the implications of this strategy.