2 Retail Stocks To Buy, 1 To Sell

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

Retailing has struggled over the last few years for obvious reasons. The result has been a general undervaluation of many businesses and, in some instances, the creation of takeover targets. But even in this tough sector, some companeis manage to turn into a bubble. The goal in value investing is to navigate around those bubbles and towards the takeover targets and undervalued suitors.

Staples: An Obvious Takeover Target

Over the past 12 months, Staples (NASDAQ: SPLS), has been on an inexplicable decline. At a time when the NASDAQ has soared 29%, Staples is down 13.4%. Earnings were very weak in 2Q12 with a 18.2% miss on EPS of $0.18, but the three quarters before the miss were either in-line with or better than estimates. Perhaps the main reason why the company's stock price has been falling is because of its "negative growth story," which can be seen in the way it's slashing the number of domestic and European stores.

However, the company still generates significant free cash flow and is trading well below historical levels. It now trades at a respective 8.7x and 8.2x past and forward earnings while paying out an impressive 3.8% dividend yield. Free cash flow has gone up slowly from $909 million for the TTM ending July 31, 2008 to $1.2 billion in July 31, 2012. Given that the entire market cap of the firm is at $7.9 billion, Staples is an attractive takeover target. Analysts forecast 9.7% annual EPS growth over the next 5 years, and this is more than enough to finance the probable acquisition costs.

However, many claim that Staples is becoming increasingly unattractive, given how desperate its internal turnaround strategy to increase retail square footage by 15% has been. My own view, however, is that this is one of the few instances of a restructuring amidst few signs of bankruptcy.

Target Also Undervalued; Costco Overvalued

As the second largest retailer in the US, Target (NYSE: TGT) is one of the most under-appreciated stocks on the Street. While management is aiming for just 3% comparable store growth in this half of the year, the company remains on track for strong performance, given how cautious consumers have been. Share gains in REDCard and PFresh position Target for long-term cross-selling opportunities.

Some have lamented the company's capital expenditures, but these are ultimately investments in the future and are being used primarily to finance store expansions, particularly in Canada. If anything, Target is the reverse of Staples-it is thriving and looking to expand because business is doing so well. Investors have been myopically focused on the expenses, however, and this sets up new investors for an attractive return when the economy hits full employment. According to Morgan Stanley, Canada can add $0.80 to EPS by 2017. This is worth $0.50  in present terms, which translates to a stock value of $7.50 - more than what the market is currently pricing it at.

As attractive as Target and Staples are for two very different reasons, investors need to be very careful in generalizing. While the retail sector may very well be undervalued as a whole, there are numerous instances when stocks are overpriced. Costco (NASDAQ: COST) is, ironically, quite expensive. It trades at a respective 28x and 22.6x past and forward earnings with a low dividend yield of 1.1%. Even the annual EPS forecast of 13.5% over the next 5 years is not enough to justify the current stock price.

Assuming the company meets expectations, 2016 EPS would come out to $6.48. At a multiple of 16x, the stock should be worth just about what it is priced at today. Discounting backwards by 10%, the stock's future growth is worth $64.19, implying that the business is roughly 36% overvalued. Accordingly, if there ever was a time to sell, it's now.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale and Staples. Motley Fool newsletter services recommend Costco Wholesale and Staples. 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure