3 Retail Stocks With Different Risk/Reward

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By virtue of being the direct beneficiary of rising consumer expenditures, retail offers a strong way to profit off of an optimistic outlook on GDP. Fortunately, the sector offers various risk/reward. There are defensive investments, high reward investments, and volatile investments. Below, I consider 3 stocks that are likely to appreciate in value from an improving economy but have diverging upside and downside scenarios to offer investors.

Why You Should Be Optimistic About Target (NYSE: TGT)

Investors all too often forget that Target is the second largest retailer. I find that it has a large economic moat with strong growth potential and excellent current momentum. Greater use of the REDCard and store remodeling has driven domestic top-line results. Although comps have fallen from 4.3% to 2.1% in June, it is still tracking towards 3% for the second half of 2012. And, in Canada, investors are getting overworked about spending being higher than originally expected. But capital expenditures have been higher only because the company is looking to expand with even more stores. Actually, this understates the extent to which bears are misunderstanding Target's international growth strategy, because capex has been actually made more efficient from greater, and more generous, landlord concessions. 

According to Morgan Stanley, Target is valued at a trough EPS because of the Canadian startup. They argue further that "investors have myopically focused on near-term earnings." This will reverse when Canada drives an estimated mid-teens annual EPS growth over the next 2 years. I see tremendous value creation from the strategy, since it positioned the company to better target a middle and upper income base. This double-pronged market strategy will help the company better sustain a retail advantage against competitors. In this market environment, retailers that focus exclusively on a low-income market may be victim to a "race to the bottom" while those that focus exclusively on the upper-income market are vulnerable to macro uncertainty and consumer unpredictability.

Going forward, there are several metrics that you should closely follow. Most important is same-store sales. The second is how unemployment tracks. I believe that RedCard will continue to penetrate and help expand operating margins in the process. When you factor in improving consumer confidence and better-than-expected performance in Canada (the bar has been set too low), it is hard to not being optimistic about Target.

Walmart (NYSE: WMT) Vs. Dollar General (NYSE: DG)

If you are looking for a more defensive retail investment, Walmart is the obvious choice. It's ROE consistently stays above 20% and Buckingham Research Group expects earnings to rise 9% in 2013. With greater employment and gas prices decelerating, consumer confidence will provide a steady stream of business to drive up the stock price. Meanwhile, profitability is improving abroad.

However, with low risk often comes low reward. One should not expect terrific returns over the next few years as free cash flow yield declines to around 5.8% and overall operating margins decline to 5.9%. Total debt is also expected to rise to around $56 billion. I am further concerned about how investors have gotten "hooked" on the company's growth strategy without looking at the ramifications. One major ramification is that it could cannibalize same-store sales and result in weakened productivity. Comps have also been more volatile than what you would expect: 2.1% in 2006; 1.4% in 2007; 2.8% in 2008; -0.8% in 2009; and -1.1% in 2010, for example.

If the risk/reward is not too compelling at Walmart, you may be tempted to consider other low-income retailers, such as Dollar General. I find, however, that this business is not proving itself to be a strong turnaround play like many had expected. Free cash flow over the last two years has only improved by $30 million to $430 million. This represents a yield of only ~2.5% against the market cap and, as such, spells an overvalued business. Even if analysts are right, and the company's EPS grows by 17.6% annually over the next half decade (which I believe is too optimistic), it will be hard for the firm to outperform. Dollar Tree has already seen forecasts revised downwards--I expect ditto for Dollar General.

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