Target, Buyout Targets, and More in Retail
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I am relatively bullish on retailers in the months ahead. Multiples are low, and in many instances either free cash flow generation is high or earnings performance has been consistently strong. I encourage buying a mix of buyout targets to capitalize on the low, as well as firms that have a strong track record relative to analyst expectations. This will reduce downside while exposing you to a strong upside.
Staples (NASDAQ: SPLS): Possible Buyout Target?
Despite renewed takeover interest, Staples' stock has barely budged--sure, it's up 6.4% over the last month, but this is substantially below the returns of OfficeMax (13.1%) and Office Depot (25.4%). At a respective 9x and 8.5x past and forward earnings and a recovering economy, it is now an ideal time to stage a buyout. The firm generates tremendous free cash flow, after all, to finance the deal. Though FCF has fallen from the $1.9 billion high in 2Q 2009, it has started to level out in early 2011 around $1 billion, which provides a 12.3% yield. When you factor in a 3.7% dividend yield, it's hard not to see the potential in buying at a trough.
Meanwhile, even though Staples increased EPS by only 1.2% annually over the past 5 years, it is expected to increase EPS by 9.7% over the next 5 years. This means EPS of $1.86 by 2016. At a multiple of even 13x, this translates to a future stock value of $24.18. Discounting backwards by 10%, the stock should be worth $15 today, or more than 25% above its prevailing price. On the negative side, ROA has slid from 10% to 5% over the last few years. ROE has similarly slid from 20% to 12.5%. Gross margins have been relatively rocky and gone nowhere relative to the historical 5-year average.
Despite a third quarter loss of $569 million due to goodwill impairments and restructuring expenses, the company is still on track to deliver $1 billion in free cash flow this year. And Staples is looking to do around $450 million in stock buybacks in 2012, which will limit whatever downside is left and drive earnings accretion. Overall, expectations have been better-than-expected, and investors are confusing the macro low as an indication of a permanently depressed office market.
The Real "Target" (NYSE: TGT) Is Just Fine
If you are afraid that the office retail market could stay depressed, I recommend considering Target. This is the second largest retailer behind Wal-mart (NYSE: WMT) and is well positioned to gain market share from store expansion. Target has consistently been above EPS targets over the past 5 quarters with an average beat of 6.4%. Free cash flow has, however, been less than strong. It has dipped from a high of $4.5 billion in early 2010 to less than half that amount - $2 billion - today. That's less than a 5% yield and certainly not reflected in the ~30% share rise since January 2010.
Even still, Target is worthy of a "buy" when you consider it relative to Wal-mart. It trades at a respective 14.3x and 12.7x past and forward earnings, roughly in-line with the multiples of Wal-mart. This is not justified given the expectation for a sharper growth curve at the world's 2nd largest retailer. Target is forecasted for 12.7% annual EPS growth over the next 5 years versus 9.4% for Wal-mart. On the other hand, the latter's larger economic moat and faster growth over the past 5 years perhaps explain why investors are cautious on analyst expectations.
But Target's track record of beating analyst expectations should help lift multiples. EPS of $0.90 was $0.09 ahead of consensus as a result of improving margins. Gross margins now stand at 32% - above the 30.6% average, and consistently above 2009 and 2010 levels. Although ROA has started to dip around 50 bps to 6.3% since around April of last year, a full recovery will elevate shares to the 16.6x level seen in January 2008.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Staples. Motley Fool newsletter services recommend 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!