Grab This Cheap Retail Stock

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September sales were nothing to brag about for the retail industry. And to some extent I believe that the market was already well aware of the tough set-up, including a challenging year ago comparison and unfavorably warm weather. Retailers reported September same store sales growth of 3.6% (excluding drug stores) against last year's difficult comparison of 6.4% and consensus expectations of 3% growth. Trends at the beginning of the month were very strong, but they tailed off as September progressed. I think more favorable weather pulled forward some demand from September into August, and it is worth noting that the August-September combined period was roughly in line with strong spring numbers.  The Gap (NYSE: GPS) was the clear winner in September whereas Kohl's Corporation (NYSE: KSS) & Macy's (NYSE: M) both reported weaker than expected results. The following table provides September same store sales results of these companies with respect to consensus estimates and prior year growth.

 

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Gap</p> </td> <td> <p>Kohl's</p> </td> <td> <p>Macy's</p> </td> </tr> <tr> <td> <p>Sep-12 SSS</p> </td> <td> <p>6.00%</p> </td> <td> <p>-2.70%</p> </td> <td> <p>2.50%</p> </td> </tr> <tr> <td> <p>Sep-12 Cons. Estimates</p> </td> <td> <p>5.30%</p> </td> <td> <p>0.10%</p> </td> <td> <p>3.30%</p> </td> </tr> <tr> <td> <p>Sep-11 SSS</p> </td> <td> <p>-4.00%</p> </td> <td> <p>4.10%</p> </td> <td> <p>4.90%</p> </td> </tr> </tbody> </table>

As a result of strong year to date sales trends, the Gap has seen a staggering 115% run up and is trading at all-time highs. Let's analyze the valuation multiple, future growth rate and dividend yield of these retailers.

 

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Gap</p> </td> <td> <p>Kohl's</p> </td> <td> <p>Macy's</p> </td> </tr> <tr> <td> <p>Forward PE</p> </td> <td> <p>15.34</p> </td> <td> <p>9.99</p> </td> <td> <p>10.34</p> </td> </tr> <tr> <td> <p>Next 5 Year Growth (per annum)</p> </td> <td> <p>10.03%</p> </td> <td> <p>8.02%</p> </td> <td> <p>12.90%</p> </td> </tr> <tr> <td> <p>Dividend Yield</p> </td> <td> <p>1.30% (payout ratio=27%)</p> </td> <td> <p>2.50% (payout ratio=27%)</p> </td> <td> <p>2.00% (payout ratio=19%)</p> </td> </tr> </tbody> </table>

Source: Yahoo Finance

We can see that Gap is trading at a healthy premium to both Kohl's as well as Macy's. However, the premium valuation seems unjustified if we go by dividend yield and consensus estimates for the five year forward growth rate. So, I don't think it would be wise to chase this stock following such a strong year to date performance. On the other hand, Macy's looks highly attractive at the current levels as it has the highest growth rate among these companies. Although the company's share price has appreciated more than 46% over the last twelve months, but the PEG ratio has actually decreased 35% (from 1.40x to 0.90x) over the same period. In addition, it also offers a good dividend yield at a lower payout ratio (on both earnings and free cash flow basis) which suggests that there is ample room for dividend hikes in the future.

Despite being modestly light of expectations in September, the combined August/September same store sales growth came in a very respectable at +3.6%, consistent with year-to-date trends. Recall that the company guided for 2H12 same store sales (SSS) of 3.7% with 3Q below and 4Q above that average, so investors need not to panic as the quarter to date SSS are running above the company guidance and the company looks well positioned going into October, particularly as cooler weather approaches.

Macy's has been a consistent performer over the last 3-4 years and I believe the company has enough growth drivers to post consistent results in the future as well. Macy’s is finding opportunities to study markets in more refined ways (e.g. southern living strategy, cold summer strategy) and My Macy’s 2.0 is helping to take complexity out of processes and drive faster decisions. In addition, Macy’s has best in class omni-channel capabilities, within the mid-tier dept store space. Omni-channel initiatives like Search & Send program, Store-to-door fulfillment and Site-to-store to door fulfillment will gain further traction among customers.

Thus, Macy's looks cheap on the PEG basis. In addition, the company has the potential to raise the dividend in the future. The company's M.O.M strategy ensures consistent long term growth. I believe Macy's is a safe bet in the retail sector and recommend buying this stock at the current levels.


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