What To Look At Before Buying These 3 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 seeking to gain exposure to the retail market, I encourage not being lured into companies where the conventional wisdom is that the growth curve ahead is strong. In many instances, a hungry media can overhype a company's prospects and cause all upside to be factored into the stock price. In other instances, a growth curve could just be overblown. The best investments in retail right now are those that have produced steady growth and are taking meaningful strategies to intelligently penetrate international markets. Below, I present this outlook through three retailers.

Wal-Mart (NYSE: WMT): Amazon Threat Overblown

It was reported that, at peak time during Black Friday, Wal-Mart was receiving 5,000 transactions per second. That is hard to fathom and ultimately reflects the company's large economic moat, which exceeds 174 countries’ GDPs. But could this large giant tumble? CEO Mike Duke recently came out and explained how he should have done more on the eCommerce front, where large online retailers are undercutting profits. Amazon (NASDAQ: AMZN), in particular, has been cited as the main threat. 

The secular transition towards more mobile Internet use--which is elected to overtake desktop Internet use by 2014--poses a major long-term headwind. This is because more smartphone owners are using their discounts as they shop, which enables them to become more aware of phony discounts. We have all been in a department store or diversified retail store and found bizarre discounts like "50% off!" or "Special Holiday sale!" It's so common; it's hard to not find these "discounts" any more. In my view, the amount of advertised discounts has past the point of being helpful and is now clearly disingenuous. In any event, mobile is enabling consumers to see that, hence the greatest number of sales have come from those with the highest sell-through rates. Trade groups have also forecasted for a 15% rise in Cyber Monday online sales versus only a 3-4% rise in Black Friday brick-and-mortar sales.

However, I think the threat of Amazon has been greatly exaggerated. This is indicated by how barely profitable the online retailer is relative to its market cap. Free cash flow has actually fallen by around $2 billion over the last two years and a half and now stands at $1.1 billion, or less than 1% of the market cap. By contrast, Wal-Mart is yielding 6.5% and still expected for strong growth.

And I think the company will do better in growth abroad than what the market makes out. Though India is investigating the company for possible bribery, the local government still recently passed legislation that would enable foreign companies, like Wal-Mart, to own majority positions in Indian supermarkets. India is in need of multinational support to jumpstart its slowing economy, and it doesn't want to scare off future entrants by coming down too hard against Wal-Mart. Further, a much to do has been made about the company supposedly closing 100 in China. But, in reality, while the company is certainly decelerating in this emerging market, it still plans on expanding. All things considered, while I don't find the company particularly undervalued, I think it is defensive with less than 70% of the volatility of the broader market. It has grown 9.4% annually over the past half-decade, and I see little reason to expect anything seriously below this amount over the next 5 years.

Costco (NASDAQ: COST): Good Stock, But Upside Factored In

Costco is at a steeper part of its growth curve than Wal-Mart is, but it trades considerably higher at 24.9x past earnings. Is this premium justified, especially since it values the discount retailer at an all-time high? To put it into perspective, consider that Costco has just recently edged out Target (NYSE: TGT) in market cap despite the fact that the latter is the second largest retailer with 1.8x Costco's free cash flow. And Target trades at only 13.4x past earnings.

The market is nevertheless focused on Costco's momentum. First quarter same-store sales grew an impressive 9% in international markets, which beat the pace of competitors. Management is now planning to open an outlet in Korea by December's end in addition to the general strategy of outlet expansion. This growth will be complemented by the company's suggested interested in offering more private label options, such as through a partnership deal with ConAgra. The food marketer has been staging a buyout of Ralcorp with the expressed purpose of gaining greater exposure to private labels.

With consumer confidence rising to its highest in five years and the implementation of a $7 special dividend, Costco shouldn't suffer from any near-term multiple contraction that will cause the stock price to decline. Even though it had to raise $3.5 billion in debt to finance the $3 billion payout, Fitch only downgraded the company's credit rating from AA- to A+. That said, I believe the market is exaggerated the company's growth. Revenue of $23.2 billion still came out a full $500 billion below expectations, and, moreover, analysts are expecting just the same ~13% annual growth from Target over the next 5 years. For this reason, I recommend avoiding Costco and buying cheaper peers.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Costco Wholesale. Motley Fool newsletter services recommend Amazon.com and 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus