Case: Profitability and cost structures of Nordic discount retailers

Translation: Original comment published in Finnish on 11/29/2023 at 7:22 am EET.

In this review, we look at the profitability trends and drivers of the largest Nordic discount retailers over a longer period. The review includes listed Finnish companies Puuilo and Tokmanni, Norwegian Europris and Swedish Rusta and Clas Ohlson.

Material costs make up the majority of expenses

Source: Annual reports and IPO prospecti of the companies

In the retail sector, material costs make up the majority of costs. However, the sales margin is higher for discount retailers than for grocery and certain specialty product groups, typically due to high volumes and a high share of own brands. For example, Tokmanni buys in high-volume one-offs, which improve item-specific margins, and Rusta's own brands account for well over half of its revenue. The average sales margin for the period 2018-2023 among the surveyed companies was around 39%. All the players in our review group are large players in terms of revenue (>300 MEUR per year), which allows them to have high purchase volumes. Some companies achieve even greater economies of scale in their purchasing operations, with, e.g., Europris and Tokmanni cooperating on own-brand purchasing and direct importing through a shared purchasing organization. Similarly, Clas Ohlson has its own procurement office in Asia.

In addition to high volumes, the sales mix also plays an essential role in margin accumulation. Specialty and discount products typically have healthier product margins than grocery products. In turn, the margin of groceries is supported by a very efficient inventory rotation. The exception is consumer electronics, where price competition pushes product margins to very low levels (around 15% on average). The rule of thumb in retail pricing and mark-up is price awareness of the customer in the product categories concerned. In other words, freer pricing (and thus higher margins) can be found for products where consumers have low price awareness.

Over time, players in the retail sector, especially discount retailers, have added their own brands to complement their range. Through private label or direct imports, sector companies are able to maintain a lower price point thanks to cheaper purchase prices and at the same time achieve a relatively and often also absolutely better margin on third-party products. Private label margins can at best reach more than 50%, depending on the product category.

Source: Annual reports, IPO prospecti and other materials of the companies

On average, our review group's private labels accounted for 42% of revenue in 2022. Although Tokmanni is the largest of the companies, its private label penetration (32%) is lower than its Nordic peers. The success of private labels is partly determined by the chosen product mix strategy and customer preferences. Rusta, which tops the list, is in our opinion quite well suited to private label products (64%), as a large part of its range is "brand-free". In turn, Tokmanni customers also appreciate products from well-known A-brands. So far, the share of own brands of Puuilo, the smallest player in the group in terms of revenue, is at 20%. However, like other discount stores, the company aims to increase the share of own brands over time.

During the period of low purchasing power and weakened consumer confidence starting in 2022, the role of private labels has been emphasized thanks their low prices. In times of uncertainty, consumers have chosen lower price point substitutes in their shopping carts. However, this cannot be viewed in a vacuum, as at the same time the purchase prices of products have risen due to inflation, and so the overall impact on sales margins is ambiguous. On the positive side, however, consumers have inevitably become familiar with the operators' own brands and may continue to consume them despite the return of purchasing power. This would fall on the companies' coffers in the form of margin accumulation, but the impact on revenue would be smaller. The growth in the popularity of private labels has been driven by improvements in product quality and the general acceptance of a culture of sensible shopping.

Inventory management, among the other factors mentioned above, plays an essential role in the companies' margins and, in the case of rented warehouses, also in fixed costs. Companies are therefore investing in fast-circulating products to avoid inventory bloat and loss of margin. However, companies may keep a limited number of low-volume products in their range if they add value in another way, for example through a naturally higher margin or the uniqueness of the product (attracting customers to the store).

Minimizing fixed costs is one of the most important factors for discount retailers

Source: Annual reports and IPO prospecti of the companies
*NB! The adoption of IFRS 16 in 2019 makes 2018 costs less comparable with other years

The review group's fixed costs as a percentage of revenue have averaged around 22%. Puuilo stands out positively, with an average fixed cost rate of 15-16%. We estimate that this is influenced by the company’s still smaller size compared to other players, but also by its disciplined cost control. Puuilo aims to keep store and sales costs as low as possible, while at the same time taking care not to over-inflate administrative functions. However, we believe that as the company grows larger, it will need to supplement its management resources, even as its systems scale to much higher volumes. Even so, we believe their impact on the cost rate will be limited.

Like Puuilo, Tokmanni has managed to keep its cost structure lean compared to its peers. Tokmanni's fixed cost rate has varied between 20-21%, which is a good level compared to other Nordic peers. We see Tokmanni's profitability improvement coming from the sales margin. On the other hand, after the Dollarstore acquisition, the Group's Swedish operations have not only growth opportunities, but also the potential to improve profitability significantly through synergies. Tokmanni's 2023-24 cost ratio will be boosted by the consolidation of Dollarstore's figures due to the higher relative cost profile of the acquired company.

Rusta, which has shown strong growth over the past few years, has the highest fixed costs in the review group at around 27%. In our view, internationalization, new store openings and growth are factors that have contributed to the company's high fixed cost ratio. By scaling down costs, the company is well placed to make good profitability, aided by a high sales margin.

High sales margin does not always guarantee good profitability

There is a surprisingly large variation in profitability between companies. The average profitability over the period is around 10%, with a high of 18% and a low of less than 2%. Although Rusta's sales margin % is one of the highest in the industry, it does not guarantee it the highest profitability in its peer group.

It is interesting to compare the characteristics of two companies that are very profitable but have different cost structures. Europris, the second largest company in terms of revenue in the last 12 months (790 MEUR at current FX rates), has the highest sales margin % in the peer group. At the same time, the smallest company in the review group, Puuilo (LTM revenue 320 MEUR) has the lowest sales margin %. Nevertheless, these two companies have an EBIT margin of 15-16%, which is clearly higher than the other companies in the group. The fixed costs of Europris are significantly higher than those of Puuilo. In other words, Puuilo makes up for the lower margin accumulation with a very low cost structure.

We see significant potential for Tokmanni to improve its profitability through improved relative margin and the scaling of Dollarstore. At the same time, Clas Ohlson's difficulties have squeezed the company’s profitability from levels of 6-8%. However, we believe that Clas Ohlson's profitability potential is limited by the partial overlap of its range with certain consumer electronics players.

In the future, as volumes increase, automation will provide essential solutions to streamline cost structures. So far, the biggest beneficiaries of automation in terms of efficiency have been the operators with high online sales, such as Amazon worldwide and Verkkokauppa.com and Kesko in Finland. The share of online sales is still low for discount retailers and significant growth will require structural changes. Until now, customers have preferred physical shopping because of the low average purchases and the immediate need. Low-cost retailing thus emphasizes multi-channel and click-and-collect functions.