Before a Full Recovery, Buy this Retail Stock
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the economy continuing to improve (albeit at an aggravatingly slow rate), consumers should consider buying retail stocks before it's too late. The problem is that many investors have already begun to do so, and pushed multiples so high that earnings yields have become less-than compelling. I recommend going for the stable stocks that have a sustainable but under-appreciated foundation.
Okay, sorry for that poor pun. What I mean to say is that Target is a strong company that looks undervalued against the fundamentals. Target has a large and sustainable economic moat, pays a 2.3% dividend yield, and is more than 10% less volatile than the broader market. Despite this stability during macro uncertainty, Target is relatively cheap at 14.1x past earnings. By contrast, Costco trades at 21.9x forward earnings, with a dividend yield of only 1.1%.
Target carries more debt than Costco, with a debt-to-equity ratio of 1.2x and a net debt-to-market cap ratio of 42.4% versus Costco's net cash-to-market cap ratio of 8.2%. However, I believe that Target is merely taking advantage of the low interest rate environment, and it knows full well that it has no problems paying off leverage. The decision to take on debt financing will pay dividends when the economy moves towards full recovery.
My bet is that Target will fare better during a recovery than Costco. The company doesn't goes for a low-income or high-income market, but somewhere in between. By contrast, Costco is just what the name implies: it's mostly for discount shoppers. The idea of discounts is much less appealing during a full recovery, so consumers will likely head towards Target should the economy continue to improve.
Even still, Costco has managed to outperform Target by 590 bps over the past 6 months. However, Target has beaten expectations in all of the last 5 quarters; by contrast, Costco only beat forecast 2 of the times. I expect these stronger returns will become particularly pronounced as the economy improves, making Target the preferable choice.
Dollar General's (NYSE: DG) "Show Me" Story Not Holding Up Well
The dollar store company needs to see free cash flows increase consistently to justify its $16.4 billion price tag. FCF for the TTM ending 2Q 2010 was $400.5 million and, two years later, that figure only improved to $430 million. That is still only a 2.6% yield against market cap, which, coupled with the absence of a dividend yield, is a huge deterrent for otherwise high-growth investors.
In terms of earnings, however, the company is forecasted for 17.6% annual EPS growth over the next five years. While Target may be much closer to maturity, it is forecasted for only 12.6% annual EPS growth, while having only realized 6% in the past five years. Accordingly, I believe analysts have set the bar too high for the retail market, which will cause peer stocks with high multiples to depress a bit. It should not be surprising then that forecasts have been revised downwards for many discount retailers, such as Dollar Tree.
Wells Fargo, on the other hand, takes an opposite viewpoint. It boasts that the company is relatively limited from competition by Amazon. In my view, the Street is daydreaming about Amazon and seeing it for something that it isn't. eCommerce has always been an attractive way to buy goods, especially during uncertain times. However, the convenience of buying from the local store will never dissipate. A website is much more ephemeral to consumers than a brand name brick and mortar stores. As cool as it sounds, somehow I do not see the smartphone craze sending Mom to cyberspace for groceries.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. 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.