A Retailer With Growth In Its Sights

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I know that there are investors that believe that Walmart (NYSE: WMT) is the best retail stock that money can buy. Walmart has been impressive, as the company has been able to continue to grow in light of increased competition from both Target (NYSE: TGT), Amazon.com (NASDAQ: AMZN), and companies like Kohl's (NYSE: KSS) in the fashion segment. Though Amazon is certainly a huge challenger, the company has yet to prove that they can produce significant free cash flow from their massive sales growth. Walmart competes in nearly every department with Target, and Kohl's has a better fashion selection. The difference is, only Target offers their type of shopping experience. As a one stop shop, I would actually make the argument that investors should look at Target as the best retail stock.

If you need proof that physical retail is a challenging business, consider that partially due to companies like Amazon.com and eBay, certain retailers no longer exist. Companies like Borders and Circuit City are no longer, and even their seemingly stronger competitors like Barnes & Noble and Best Buy have fallen on hard times. This is what makes it even more amazing that Target has been able to continue growing, and maintaining its margins. How has Target been able to stay competitive? The company understands that their stores are a convenience stop for millions, and if they offer competitive values, this convenience will win them additional business.

If you look at Target's last earnings report, you can see results that were very good. The company saw overall revenue increase by 3.2%, and EPS increased by 4.3%. This doesn't sound like much, but the company's earnings before taxes were up over 10%. The company had some expenses and tax adjustments that lowered EPS, but core earnings growth was there. This is the opposite of what happened recently at Walmart. In Walmart's case, they saw low single-digit sales growth, but turned in over 11% EPS growth. The difference was, Walmart's EPS growth came mainly from a lower tax provision, whereas Target's lower EPS came from a higher tax provision. All things being equal, when taxes become more normalized for both companies, Target should win out. In addition, Target is getting prepared to enter the Canadian market, and this is creating a drag on results in the short-term.

Target's U.S. business showed okay results with sales up 3.4% and comparable store sales up 2.9%. For a company with just under 1,800 stores these are pretty good numbers. The company expects to enter Canada in 2013 and these investments reduced EPS by about $0.13 in the quarter. As investors have seen with other retailers, I expect Target's international expansion opportunities to give new life to the company's growth prospects. The fact that the company is taking a slow and steady approach to expansion is a positive, and likely increases the company's chance of success. What really sets Target apart is the company has developed a niche business model that seems to resonate with customers.

The biggest difference between shopping at Target versus shopping at their competition really comes down to what customers go to Target to buy. Customers who shop at Walmart are looking for the lowest prices. The bad news at least for Walmart is, Amazon has been effective at undercutting Walmart on price. The fact that customers don't pay sales tax through Amazon in the majority of states is yet another advantage to going through the online retailer. Where Kohl's is concerned, their target (sorry for the bad pun) audience is a shopper looking for clothes and home furnishings. One reason Target has been so successful is the company offers what their competition offers, but in one store. Target has exclusive items that you can't find on Amazon or that Amazon doesn't want to sell. The company offers groceries at the majority of its locations. Target offers enough fashion and home furnishings to appeal to most customers, and though the prices aren't necessarily the lowest, convenience plays a major role.

If you want proof that convenience is a major selling point for customers, look at Target's gross margins. Walmart and Amazon both pride themselves on low prices, and their gross margin is right around 25% because of it. Kohl's, on the other end of the spectrum, has a gross margin of just over 38%, but the company may have priced itself out of some growth, as analysts are calling for just 7.5% EPS growth in the next few years. By comparison, Target falls right in the middle with a gross margin of 30.03%. The company's higher margin fashion and household merchandise helps offer lower margin electronics and grocery items. I've made the argument before and it still holds true, if Target can maintain competitive prices and a good mix of merchandise they will do fine against the threat of online competition.

In the end, shoppers still have to go somewhere to buy grocery items. Though some companies offer online grocery ordering, most customers still prefer to see what they are buying rather than have someone else pick it out for them. After all, how can you see if the strawberries you buy are ripe if you don't pick them out yourself. This business is well insulated from online competition, and if customers have to go to a store to buy their groceries, why not go to a place like Target where they can get so much more? The market seems to be unimpressed with Target, and that gives long-term investors a good buying opportunity.

Target is just at the beginning of what should be a multi-decade expansion internationally. The company is expected to grow earnings by about 11.7%, yet trades at a forward P/E ratio of about 12. Target management consistently buys back shares as well. By comparison, Walmart and Kohl's are both expected to grow slower than Target in the next five years. Amazon is expected to grow much faster, but the stock is priced for more than perfection. I know that some would say you can't look just at Amazon's P/E ratio, but with a PEG north of 4 compared to a PEG of 1.02 at Target, Amazon has some extreme expectations built into the stock already. Target's yield of 2.46% is better than most bonds, and is consistently raised each year. A good yield, good growth, reasonable price, and good margins, make Target arguably the best retail investment available at the current time.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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