The Long & Short Of Retail Stocks

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 are bullish on the long-term health of the global macroeconomy, it's tempting to bullish on retail. However, investors should bear in mind that some of the largest retailers also have the smallest betas, which means that their market reaction to a global recovery will, based on past data, be less pronounced than what is experienced by most other companies. That said, there are multiple reasons to be optimistic. This article attempts to look at both sides--the long and the short--of the retail sector.

Pros & Cons Of A Wal-Mart (NYSE: WMT) Investment

As the largest retailer in the world, Wal-Mart commands an economic moat like none other. It's hard to even fathom, but the company experienced 5,000 transactions per second during the peak time of Black Friday. It's shares have appreciated by 25% in the last 12 months, outperforming the S&P 500 by 950 bps. It is also creating value in the process with a return on invested capital of 13.7%, which is 123 bps greater than the industry average. Fortunately, it is also making growth investments. 8.7% annual EPS growth is forecasted over the next 3-5 years--around 160 below the broadline retail average. All things considered, Wal-Mart is an ideal investment for the defensive investor who is bullish on a macro recovery.

There are several other factors to look at. I believe the threat of Amazon is absurd--a belief I expect the market to embrace within the next year when the e-commerce business fails to live up to its potential. Sure, consumers are in the hunt for bargains, but the kind of low-income consumers Wal-Mart is targeting would probably rather go to the local store to pick up goods than waiting for the mailman. Pricing is important, but at Wal-Mart's level, it comes down to a matter of convenience. With a variety of options and the convenience of picking it up in one go, the lead is not changing any time soon. My one main concern with Wal-Mart is its growth strategy. Reports have emerged that the retailer will close 100 unprofitable stores in China. While management neither confirmed nor rejected the reports, they have suggested that they will stop expanding as aggressively.

I also like the company's appropriate handling of shareholder cash. During the last 5 years, SG&A expenses went up 23.9% to $87.9 billion, while free cash flow soared by 124.1% to $14.9 billion on a TTM-basis. Total expenses have risen by only 22.9%. For some that argue Dollar General is a threat to Wal-Mart, consider that the discount retailers's expenses rose 42.4% versus a 14.8% growth in FCF.

Buy Target (NYSE: TGT), Avoid Costco (NASDAQ: COST)

Target has done better than Wal-Mart--growing FCF by 710% versus 12.3% growth in expenses. Then again, Target has much more room to expand than Wal-Mart does. Costco, on the other hand, has done worse--growing expenses by 46% versus a 117.3% growth in FCF--the worst among the three. What does the future hold for Target and Costco?

As evidenced by Wal-Mart's declining market share in the domestic consumer goods market, smaller discount retailers are cutting into the retail pie. Customer Growth Research shows that Target's prices have fallen to 0.7% less than Wal-Mart's. This is a remarkable comeback that I believe few on the Street have reported on. Wal-Mart was long considered to be invincible due to its top bargaining power with suppliers and leading position in China sourcing. At only 14x past earnings versus Wal-Mart's 14.8x, Target is at an unreasonable discount for its growth trajectory.

In addition to weak trends in free cash flow against corporate expenses, Costco is expensive. It trades at a respective 26.7x and 20.7x past and forward earnings. Analysts expect it to grow EPS by 13.2% annually over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $7.30. At a multiple of 16x, this translates to a future stock value of $109.50--nominally higher than the current market assessment. At a 10% discount rate, Costco would be overvalued by around 35%. For this reason, I recommend avoiding the retailer and buying Target and Wal-Mart instead.

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