Which Discount Retailer has the Best Business Model?

A company that has more gross profit can push more profit to the bottom line, which is why investors look for value in companies with high gross margins. For discount retail the marketplace has become so competitive that value is created for the customer through lower and lower prices. This trend is eroding gross margins, especially for traditional large-box retailers like Wal-MartStores and Target .

On the other hand, close-out retailers like Big Lots and Tuesday Morning have some of the highest gross margins in the industry. Analyzing the three companies that have the highest gross margins may provide some insights about which discount retailers provide the best investment opportunities.

WMT Gross Profit (% of Annual Revenues) data by YCharts

Gross margin: a measure of business model efficiency
Gross profit margin is calculated by subtracting the cost of inventory sold from sales and then dividing this figure by sales. It represents how much of each dollar the company keeps after it makes the sale. So, the ideal gross profit margin for discount retail means the highest sales for the lowest costs, which gives investors more profit for the same amount of invested dollars. For this reason, investment analysts use gross margin to measure business model efficiency, especially when comparing companies within the same industry.

In a comparison of seven discount retailers, Tuesday Morning, Dollar Tree Stores , and Big Lots had the highest gross profit margins while Family Dollar, Dollar General , Target and Wal-Mart Stores had the lowest gross profit margins. Let's look at the top three retailers to see if any trends emerge that can help determine which discount retail companies are worthy of your investment dollars in 2014.

Top 3 discount retailers by gross margin
Tuesday Morning has the third-highest gross margin in the comparison at 34.5%. That means for every $1 of sales at Tuesday Morning, $0.65 goes to paying for inventory sold and the other $0.35 becomes gross profit. Like Big Lots, Tuesday Morning is a closeout discount retailer which accounts for the company's higher-than-average gross margin.

Gross profit actually decreased 2.3% for Tuesday Morning from 37.6% last year. The company attributes the decrease to lower initial mark-ups and higher markdowns -- in other words Tuesday Morning offered sales promotions to move inventory.

According to the company's most recent quarterly report, Dollar Tree has a gross margin of 35%, which increased slightly from 34.9% in the prior year. Dollar Tree does not have a traditional retail business model. In the 2012 Annual Report, Dollar Tree explains its purchasing process: "We buy products on an order-by-order basis and have no material long-term purchase contracts or other assurances of continued product supply or guaranteed product cost." That's definitely more like the close-out business model than the traditional Wal-Mart supplier model.

Finally Big Lots, North America's largest close-out retailer, had the highest gross profit margin of the group at 38.5%. The company also had the lowest same-store sales growth; the intuitive mind may have a difficult time linking those two scenarios together, but the link is transaction volume. Big Lots sells more furniture than it does consumables like food. While furniture is purchased less often than food, it also has a much higher margin.

The Foolish bottom line
"No institution can possibly survive if it needs geniuses or supermen to manage it. It must be organized in such a way as to be able to get along under a leadership composed of average human beings." --Peter Drucker

In other words, company executives have more room for error when gross margins are higher, which is needed in those organizations that aren't run by geniuses. Peter Drucker studied business models and he is perhaps most well known for his insights on helping managers determine who the customer is, what the customer values, and how to best deliver that value in the most efficient way possible.

Tuesday Morning, Dollar Tree, and Big Lots have advantages and disadvantages as investment opportunities, but Dollar Tree and Big Lots likely have the most potential. This analysis also provided the following insights:

• For the discount retail industry, it appears that the close-out inventory business model is more efficient than the traditional, long-term supplier contract model.

• Tuesday Morning has a higher than average gross margin, but it also has negative earnings making it unattractive from a long term investment perspective.

• Dollar Tree may have traditional storefronts, but its business model is more like a close-out retailer.

• Big Lots has the highest gross margin, but its traffic is waning. If the company can increase traffic it may be a good investment in 2014.

We'll have to wait until fourth-quarter earnings calls to see if these companies were able to maintain high gross margins over the holiday season.

If big box stores are going down, Wal-Mart stands to lose the most
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The article Which Discount Retailer has the Best Business Model? originally appeared on Fool.com.

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