The Du Pont model: evaluating alternative strategies in the retail industry.

Little, Philip L. ; Little, Beverly L. ; Coffee, David 等

INTRODUCTION

The Du Pont model is a timeless and elegant model of financial analysis that has been used by analysts and educators for almost a century. Most academic or professional books on financial analysis use some form of the Du Pont model to provide insight into return on assets (ROA) or return on equity (ROE). An effective presentation of the Du Pont model can be found in a book by Palepu and Healy (2008), who use a modified version of DuPont to evaluate management's execution of competitive strategy. They hypothesize a connection between the Du Pont factors, net operating income to sales and asset turnover ratios, and a firm's competitive strategy (cost leadership or differentiation).

For example, a cost leader like Wal-Mart may generate a relatively low net operating income to sales but balance that against a relatively high asset turnover. In contrast, a differentiator such as Target may be successful by generating a relatively high net operating income to sales and a relatively low asset turnover. Conventional wisdom is that companies can devise successful competitive strategies around either profit margin or asset turnover.

The purpose of this paper is to examine the financial performance of retail firms through the use of a modified Du Pont model of financial ratio analysis and to identify the drivers of financial success under alternative business strategies. Firms in the retail industry are categorized according to their high/low relative net operating income to sales and asset turnover ratios. Firms with high relative net operating income to sales and low relative asset turnover are assumed to be pursuing a differentiation strategy and those with high relative asset turnover and low relative net operating income to sales are assumed to be pursuing a cost leadership strategy. The performance variable used is return on net operating assets.

BUSINESS STRATEGIES

Strategy can be defined as "the direction and scope of an organization over the long term, in order to achieve advantage for the organization through its configuration of resources within a changing environment, to meet the needs of the market and to fulfill stakeholder expectations." (Johnson & Scholes, 2002, p.10.) In essence, strategy defines a company's competitive stance within an industry.

A widely recognized model for characterizing business-level strategies is Porter's (1998) generic competitive strategies. He identifies three strategies, cost leadership, differentiation and focus. For our purposes, these can be narrowed to two, because a focus (niche market) strategy is either cost leadership or differentiation-based (Price & Newson, 2003).

Cost leadership strategy attempts to achieve organizational goals by delivering a product or service comparable to competitors' at a lower cost to the customer. Firms pursuing this strategy maintain tight controls on costs and often look for economies of scale and sales volume. Palepu and Healy (2008) suggest that a firm pursuing cost leadership strategy may generate a relatively low profit margin but balance that against a relatively high asset turnover. Soliman (2008), in his analysis of the components of the Du Pont method, while not using the cost leadership/differentiation terminology explicitly, clearly suggests their existence. He states that asset turnover measures "asset utilization and efficiency, efficient inventory processes and working capital management" (p. 824). He offers Dell Computers as example of this business model.

A differentiation strategy, alternatively, attempts to deliver to consumers some characteristic of product or service that will command a premium price. Examples of such characteristics include brand name, quality, service, design, delivery method and variety. Companies pursuing a differentiation strategy must balance expenditures for marketing and R&D with ability to price their product/service competitively against others in the same market (Palepu & Healy, 2008). Firms pursuing this strategy may be successful by generating a relatively high profit margin and a relatively low asset turnover. Soliman (2008) states that profit margin is derived from "pricing power, such as product innovation, product positioning, brand name recognition, first-mover advantage and market niches." (p. 824). Abercrombie and Fitch is cited as an example of such a business model.

Retailers pursuing a differentiation strategy focus on the dimension of the product/service that commands a premium price, while not ignoring operating expenses. Likewise, cost leaders cannot ignore product characteristics desired by customers (Palepu & Healy, 2008).

Gooderham (1998) states that "no one right way to develop and implement strategy exists... The key is to get the right fit between the chosen tools and techniques, the organization's culture, capabilities and business environment, and the desired outcome." (p. 2). In addition, the theoretical underpinnings of the Du Pont model illustrate that a firm can be successful with either a cost leadership strategy through generating asset turnover or a differentiation strategy generating profit margins. This study provides empirical evidence testing this theory.

THE MODIFIED DU PONT MODEL

The original Du Pont method of financial ratio analysis was developed in 1918 by an engineer at Du Pont who was charged with understanding the finances of a company that Du Pont was acquiring. He noticed that the product of two often-computed ratios, net profit margin and total asset turnover, equals return on assets (ROA). The elegance of ROA being affected by a profitability measure and an efficiency measure led to the Du Pont method becoming a widely-used tool of financial analysis (Liesz, 2002). In the 1970's, emphasis in financial analysis shifted from ROA to return on equity (ROE), and the Du Pont model was modified to include the ratio of total assets to equity.

In order to more effectively evaluate operational managers, Nissim & Penman (2001) suggest using a modified version of the traditional Du Pont model in order to eliminate the effects of financial leverage and other factors not under the control of those managers. Using operating income to sales and asset turnover based on operating assets limits the performance measure of management to those factors over which management has the most control. The modified Du Pont model has become widely recognized in the financial analysis literature (See, for example, Pratt & Hirst (2009), Palepu & Healy (2008), and Soliman (2008). In addition, Soliman (2004) found that industry-specific Du Pont multiplicative components provide more useful valuation than do economy-wide components, suggesting that industry-specific ratios have increased validity.

The modified model is as follows:

RONOA = OPM x AT

WHERE:

RONOA = Return on Net Operating Assets

OPM = Operating Profit Margin (Operating Income / Sales)

AT = Asset Turnover (Sales/ Net Operating Assets)

Operating Income = Sales - Cost of Sales - Operating Expenses

Net Operating Assets = Cash + Accounts Receivable + Inventory + Net Property, Plant, and Equipment - Accounts Payable

Either strategy could generate a relatively high RONOA when successful or low RONOA when not successful. In a homogeneous industry such as retail firms one could expect to see both successful and unsuccessful (as measured by RONOA) firms pursuing profit margin strategies (differentiation) or asset turnover strategies (cost leadership).

The data presented below depict the set of combinations of relative operating profit margin (OPM) and relative asset turnover (AT) performance paired with the overall performance measure, return on net operating assets (RONOA).

A firm with relatively high OPM and AT will yield a relatively high RONOA. The opposite RONOA effect is true of firms with relatively low OPM and AT. The categories of special interest for purposes of this research analysis are categories 2-5. Is there a significant difference in performance, as measured by RONOA, between retail firms that employ an OPM/differentiation strategy (Categories 2 and 4) or those that pursue an AT/cost leadership strategy (Categories 3 and 5)?

RESEARCH METHOD

The Value Line Investment Analyzer (2008) was used to select a total of 146 companies from the retail industry with fiscal years ending between 10/31/2007 and 3/31/2008. Companies with missing data for the variables used in this study were eliminated, leaving 129 companies. These companies are in the following retail industry categories:

Retail (special lines)         90 companies
Retail (automotive)            12 companies
Retail (building supply)        6 companies
Retail Stores                  21 companies

The companies remaining in the sample were then sorted by the 50 highest and 50 lowest relative values for the variables OPM, AT, and RONOA, leaving 29 companies in the middle category (neither relatively high nor relatively low).

The identification categories for OPM, AT, and RONOA were sorted such that the 50 highest relative RONOA and the 50 lowest relative RONOA retail firms could be analyzed to determine the number of firms in the high/low/middle relative OPM categories versus those in the high/low/middle relative AT categories. The findings of this analysis can be found in the results section of this paper.

The next step in the research process was to run ANOVA statistics on those retail firms in the relative high OPM and low AT category (differentiation strategy) and those in the relative high AT and low OPM category (cost leadership strategy) to test if there was a statistically significant difference in the RONOA performance of the two different categories.

RESEARCH RESULTS

The data presented below reveal nine categories of relative OPM and relative AT performance measures for the 50 retail firms with the highest relative RONOA and the 50 retail firms with the lowest relative RONOA.

Interestingly, of the 23 retail firms in the differentiation strategy category (high OPM and low AT), 21 of the firms are in the high relative RONOA category and only two firms are in the low category. However, all of the 18 retail firms in the cost leadership strategy category (high AT and low OPM) are in the low relative RONOA category. There are an additional 8 firms in the differentiation strategy category (high OPM and low AT) and an additional 9 firms in the cost leadership strategy category (high AT and low OPM) that are in the middle relative RONOA category. The differentiation category then contains 31 (23 plus 8) firms and the cost leadership category contains 27 (21 plus 8) firms. See Appendices A and B for a complete list of the companies in each category.

The 31 retail firms in the differentiation strategy category (high OPM and low AT) and 27 retail firms in the cost leadership strategy category (high AT and low OPM) were used in one way ANOVA models to test if there is a statistically significant difference in the RONOA performance of the two different strategy categories and to test for any statistically significant firm size difference between the two categories. The natural log of sales was used to represent the size variable.

The data reported below show sample statistics for the variables used in the one way ANOVAs models for each of the strategy categories:

Differentiation Strategy Category

 Variable       Firms         Mean       Std. Dev.     Max.

RONOA             31         0.292        0.099       0.582
LOGSALES          31         3.208        0.871       4.888

Cost Leader Strategy Category
RONOA             27         0.073        0.174       0.237
LOGSALES          27         3.318        0.726       4.812

 Variable        Min.

RONOA           0.135
LOGSALES        1.328

Cost Leader Strategy Category
RONOA          -0.464
LOGSALES        1.696

The RONOA for the sample of 31 firms in the differentiation strategy category (high OPM and low AT) ranges from a low of 13.5 percent to a high of about 58 percent with a mean of about 29 percent. Alternatively, the RONOA for the sample of 27 firms in the cost leadership strategy category (high AT and low OPM) are considerably lower, ranging from a low of about minus 46 percent to a high of about 24 percent with a mean of about 7 percent. The size variable (LOGSALES) does not differ in a significant way between the two strategy categories.

An ANOVA procedure was run using a categorical variable for the independent variable representing the strategy categories as the high OPM and low AT differentiation strategy and the high AT and low OPM cost leadership strategy. The dependent variable is RONOA. The results of the ANOVA shown below indicate a statistically significant difference in the mean values for RONOA in the two strategy categories. As expected, the size variable represented by LOGSALES is not statistically significant different between the two strategy categories.

CONCLUSIONS

The results of this study suggest that retail firms that pursue a differentiation strategy (high OPM and low AT) outperform those retail firms that use a cost leadership strategy (high AT and low OPM) as measured by the performance variable RONOA. The mean values for RONOA for the 31 firms in the differentiation strategy category are much higher that the values for the 27 firms in the cost leadership category and the differences are statistically significant. In addition, 21 of the 31 retail firms in the differentiation strategy category show up in the high relative RONOA performance category while none of the retail firms in the cost leadership strategy show up in the high relative RONOA performance category and 18 of the firms are in the low RONOA performance category.

These results indicate that the premise that either strategy can be successful is not true for this sample of retail firms. Only those firms with a relatively high level of OPM were able to generate high levels of RONOA. How generalizable these results are is difficult to say. The data used were for one fiscal year. Recreating the study with other years when economic conditions were different would address the issue of generalizability. In addition, alternative performance measures, such as price/market valuations or cash flow measures could be used to test the outcomes of this study.

A key finding of this study suggests, however, that all strategies are not created equal. The pursuit of a cost leadership strategy, depending on asset turnover for results, is not as effective as the pursuit of a differentiation strategy (charging premium pricing) when effectiveness is measured by RONOA.

APPENDIX A

High Net Profit Margin & Low Asset Turnover Firms (Differentiation Strategy)

Abercrombie & Fitch

bebe stores, Inc.

Buckle (The), Inc.

Chico's FAS

Coach, Inc.

Escalade, Inc.

Fossil, Inc.

Gymboree Corp.

Inergy, L.P.

Inter Parfums, Inc.

Joseph A. Bank

Merisel, Inc.

Movado Group

NBTY, Inc.

Ocean Bio-Chem, Inc.

Sotheby's

Tiffany & Co.

Tween Brands

Urban Outfitters

Winmark Corp.

Copart, Inc.

Munro Muffler Brake

O'Reilly Automotive

Fastenal Co.

Home Depot

Lowe's Cos.

Kohl's Corp

Macy's. Inc.

Nordstrom, Inc.

Penney (J.C.)

Target Corp.

Appendix B High Asset Turnover & Low Profit Margin Firms (Cost Leadership Strategy)

Charming Shoppes

Children's Place

Circuit City Stores

drugstore.com

Emerging Vision, Inc.

Insight Enterprises

Jo-Ann stores

Joe's Jeans, Inc.

Nautilus, Inc.

Pantry (The), Inc.

Pier 1 Imports

PriceSmart, Inc.

Sharper Image

Sport Chalet

Trans World Entertainment

Value Vision Media

Asbury Automotive

Autonation, Inc.

CarMax, Inc.

Group 1 Automotive

Penske Auto

Sonic Automotive

BJ's Wholesale Club

Costco Wholesale

Duckwall-ALCO Stores

Fred's Inc 'A"

Steinmart

REFERENCES

Gooderham, G. (1998). Debunking the myths of strategic planning. CMA Magazine, 72(4), 22-26.

Johnson, G. & K. Scholes (2002). Exploring corporate strategy (Sixth Edition). London, English: Prentice-Hall.

Liesz, T. (2002). Really modified Du Pont analysis: Five ways to improve return on equity. Proceedings of the SBIDA Conference. n.p.

Nissim, D. & S. Penman (2001). Ratio analysis and valuation: From research to practice. Review of Accounting Studies, 6, 109-154.

Palepu, K. & P. Healy (2008). Business analysis and valuation: Using financial statements (Fourth edition). Mason, OH: Thomson Southwestern.

Porter, M.E. (1998). Competitive advantage: Creating and sustaining superior performance. New York, NY: Free Press.

Pratt, J. & D. Hirst. (2008). Financial Reporting for Managers: A Value-Creation Perspective. New York, NY, Wiley.

Price, A. & E. Newson (2003). Strategic management: Consideration of paradoxes, processes, and associated concepts as applied to construction. Journal of Management in Engineering 19(4), 193-192.

Soliman, M. (2004). Using industry-adjusted Du Pont analysis to predict future profitability and returns. Ph.D. dissertation, University of Michigan.

Soliman, M. (2008). The use of Du Pont Analysis by market participants. The Accounting Review 83(3), 823-853.

Value Screen III. (2008). Value Line Publishing, New York, NY.

Philip L. Little, Coastal Carolina University

Beverly L. Little, Horry Georgetown Technical College

David Coffee, Western Carolina University

                   Relative    Relative    Relative
                     OPM          AT        RONOA

   Category
      1.             HIGH        HIGH        HIGH
      2.             HIGH        LOW         HIGH
      3.             LOW         HIGH        HIGH
      4.             HIGH        LOW         LOW
      5.             LOW         HIGH        LOW
      6.             LOW         LOW         LOW

             Relative      Relative      Relative
               RONOA          OPM            AT
Category
   1.           HIGH          HIGH          HIGH
   2.           HIGH          HIGH          LOW
   3.           HIGH          HIGH          MID
   4.           HIGH          MID           HIGH
   5.           LOW           HIGH          LOW
   6.           LOW           LOW           HIGH
   7.           LOW           LOW           LOW
   8.           LOW           LOW           MID
   9.           LOW           MID           LOW

             Number of Firms

Category
   1.               8
   2.              21
   3.              11
   4.              10
   5.               2
   6.              18
   7.              13
   8.              10
   9.               7

Variables                               Pr > F
Dependent:                               RONOA
Independent: Strategy Categories        <0.0001

[R.sup.2] = 0.389