3 Discount Retailer Stocks To Consider Buying
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you want to buy into retailers to capitalize off of holiday seasons, you need to understand that markets are "forward-thinking." Put differently, companies are valued today based on how they will perform tomorrow. Thus, the important thing to do is to invest on whether you think there will be any positive or negative "surprises" against the market assessment. A good way to gauge the market's outlook is to look at multiples between competitors and see if a discount / premium is justified. Below, I review three stocks with this consideration in mind.
Low-end retailer Dollar General trades at a respective 17.9x and 14x past and forward earnings versus corresponding figures of 19.8x and 14.7x for peer Family Dollar. The former is also expected to grow by a rate ~360 bps at 17.6%, which is justified by the steeper growth curve that the company is already on. The consensus price target for Dollar General is ~$61 with a recent report by FBR Capital calling the stock "outperform". But will the stock necessarily outperform?
Dollar General--newly listed in the S&P 500--generated a return on invested capital of 12%, which is around 50 bps below the industry average. By contrast, Family Dollar generates a 25.2% return on invested capital. This basically means that the latter is creating more value than the former from past investments. However, it doesn't say anything about the future, which is the way companies are valued. Bears have pointed towards online retailers, via mobile devices, undercutting the dollars store as a "secular change". Much has been made about Amazon and smartphone apps giving consumers the ability to find the best deals with a bar code swipe. This form of "real-time pricing" may be cool, but I don't see it replacing the dollar store any time soon. Consumers want prices to be low, but the price is already so low at Dollar General and Family Dollar Stores that the cost savings realized from purchasing online won't, in my view, exceed the benefit derived from the joy of getting items upon demand. In short, I think this supposed "secular change" has been overblown.
A greater problem the company faces is through Wal-Mart’s neighborhood markets stores. These chains have pharmacies attached and thus will draw seniors away from the dollar stores. In the near-term, however, the market will be focused on rising consumer confidence, which is at its highest in five years, and a better-than-expected holiday season.
Why You Should Buy Fred's (NASDAQ: FRED)
But, for even greater upside, I encourage buying small cap stocks. Fred's trades at only a respective 14.9x and 12.6x past and forward earnings and is forecasted for 11% annual EPS growth over the next 5 years. In mid-September, Deutsche Bank, in my view, unreasonably, put out a "sell" report with a $9 price target, which implies Fred's is around 33% overvalued. By contrast, I find that even using analyst expectations, the retailer will outperform.
Assuming Fred's meets analyst expectations, 2016 EPS will come out to $1.44. At a multiple of 15x, this translates to a future stock value of $21.60. Including dividends, this provides an annual average return of ~14.8%. While same-store sales have been on the decline, this has been factored into the stock with already low growth estimates compared to peers. November sales were down 1% and same-store sales were down 3.6%, as opposed to up 1.5% in the same period last year.
The CEO attributed poor November comparable sales to an "intensely competitive advertising and promotional environment". However, if investors can see through the cloud of smoke that is characteristic of a challenging environment, they would see that Fred's is very much focused on the long-term. Layaway sales have risen to record levels and have yet to be recognized for accounting purposes. Marketing programs will become active in this month and January. The decision to implement a special dividend in December also showcases management's confidence over the long-term fundamentals.
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