Monday, October 1, 2012

Wal-Mart, Costco and Target are Set to Flourish

With recent US retail sales data coming in better than expected it’s a good time to turn attention to some domestic plays. I think the big box retailers have good prospects but after strong run in the markets which of them looks like good value?

Why Big Box and Discount Retailers are Set to Flourish

I’m going to list the key arguments in bullet form

  • A moderation in global growth will see lower gasoline prices which should see more discretionary income filter into lower income households
  • Lower commodity prices should increase margins for mass retailers
  • Despite the doom and gloom, US employment is improving
  • Customers continue to be price conscious and want to trade down
  • Big box retailers can grow profitability through online sales and expansion of their existing sales lines
  • House Prices and Household Net Worth are both improving in the US

In fact, I would argue that many of these growth drivers are already in play. A word of caution though; when looking at overall revenue growth it is important to remember that when gasoline prices are high revenues tend to get a boost but as gasoline is relatively low margin, this will tend to reduce the overall gross margin. In addition high gasoline prices tend to crimp lower income discretionary spending.

We can see a graphical description of this below.  Here are how revenues are trending for the big three, Wal-Mart $WMT, Costco Wholesale $COST and Target $TGT.

Growth appears to be moderating (partly due to gasoline prices falling) but gross margins appear to be trending towards the positive.

As the world watches the euro zone deal with ever more complex and taxing issues, it is clear that the European growth outlook is set to weaken. I can report anecdotal evidence of sales falling sharply in Spain and I believe Italy is following suit. Similarly, in Asia there is a lot of uncertainty surrounding a housing market crash in China and the difficulty of stimulus spending to filter down into the economy through the obstacles of corruption and a local banking system with questionable exposure to housing loans.

As a consequence the US looks like a pretty good place to be in the short to mid-term. Moreover, consider that things like food and commodity prices have been rising in recent years thanks to the marginal increase in demand coming from emerging markets. If that growth is moderating than the US could see many of its input prices falling. Again this would cause margins to go up at the US big box retailers.

It's always interesting to compare these business with Best Buy $BBY, which has had significant difficulties because much of its merchandise can also be bought online. On the other hand, Wal-Mart and co have always been good at diversifying and expanding upon winning categories.

Consumers are Still Cost Conscious

Whilst all of the above is good news, it is hard to get away from the fact that slow economic growth has been with the US for a while now. Consumers are used to cost cutting and shopping around. As a consequence, the off-price retailers like TJX Companies $TGT and Ross Stores $ROST have been doing a roaring trade. The trouble here –at least from an investment perspective- is that the evaluations of these two companies are well up with events.

Every fund manager going wants to own them or at least say he/she has been overweight in them. Both companies are aggressively rolling out expansions and I think the macro outlook remains good for them. However, if the US economy continues to improve, the higher end retailers are likely to get better at managing inventory so the likes of TJX and Ross may not find it so easy to acquire stock to sell.  They both trade on PE’s in excess of 20x and free cash flow yields in low single digits. Hardly cheap.

Evaluation Premium?

Turning to the big box retailers, Wal-Mart and Target trade on mid teens PE ratios, and despite Costco’s mid twenties PE ratio the stock generates very good cash flow. It looks expensive thanks to relatively high depreciation over the last few years.

The relative evaluation premium of the off-price retailers (TJX & Ross) to the discount retailers seems to be an anomaly. The former do have higher growth rates and sexier growth stories but as discussed above, their inventory is subject to more uncertainty. I think their evaluations should be at a discount rather than a premium. In addition, the growth drivers described above play more into the big box retailers' hands.

The Bottom Line

Wal-Mart, Target and Costco are all attractive stocks but their evaluations are not screamingly cheap right now. Costco is the cheapest on a cash flow basis but Wal-Mart generates far better return on assets. That said, these stocks have been flavor of the month (or rather the quarter) and it is probably better to wait for a pull back, even given the decent ‘upside surprise’ potential.