Despite Wal-Mart Stores, Inc. (NYSE:WMT) and Costco Wholesale Corporation (NASDAQ:COST) rising 14.1% and 19.6%, respectively, over the last 12 months, they both are not a sure bet. Remember that February email exchange between Wal-Mart executives? it was clear then that management was panicking over structural changes. Does this matter in the grand scheme of things? Below, I present an overview on Wal-Mart and Costco Wholesale Corporation (NASDAQ:COST), as well as my take on their stock potential.
One large economic moat
Few companies rival the kind of economic moat that Wal-Mart Stores, Inc. (NYSE:WMT) has. Its total revenue of $447 billion and net income of $15.7 billion dwarfs the size of dozens of economies across the world. The company has a gross margin of 25% and a net profit margin of 3.7%. While its global presence is huge, I actually think the company has plenty of penetrative potential considering that it is only actively dominating “just” 27 countries.
With already such large scale, Wal-Mart Stores, Inc. (NYSE:WMT) is able to offer products at very low prices and yet remain incredibly profitable. What attracts me to the company is that it is supported by winners. More than 50% of the company’s shares are owned by the founder’s family, which means management has a vested interest in creating shareholder value. It should not be surprising then that the company has been very shareholder-friendly and consistently increased dividends–it has been doing so for the last 37 years.
Another important indicator that the company has been doing well is the increase in net income and the concurrent decrease in share count. Since Wal-Mart Stores, Inc. (NYSE:WMT)’s net income has been increasing and will continue to do so, there is a high probability that payout ratio will continue to increase as well and attract more defensive investors.
The company, however, faces challenges, such as being the target (NYSE:TGT) of unions, which will affect operating margins if labor comes out victorious in negotiations. But, again, with the founders in control of the company, I believe management has exceptional bargaining power. A more serious threat comes from undercutting by online retailers, like Amazon.
Shareholder-friendly. but expensive
Costco Wholesale Corporation (NASDAQ:COST) is involved in the wholesale business with 622 warehouses and more than 170,000 employees. It sells various goods, ranging from clothes to pharmacy drugs. The company’s sundries segment, which sells cleaning supplies, alcohol, and snacks, among other things, contributed to 22% of total sales in 2011. The hardlines segment deals with electronics, furniture, and hardware, among others. Its sales accounted for 16% of total sales in 2011. Softline segment deals with clothes, jewelry, housewares among other things. Its sales contributed to 10% of total sales in 2011. The fresh food segment had 13% of sales.
The company’s average dividend growth rate is a stellar 13.3%. For the three years from the start of 2010 to the end of 2012, the company has generated free cash flow of $5.2 billion. Out of this, about $1.2 billion has been used to payout dividends, about $1.8 billion to repurchase shares, and about $1 billion to acquire undervalued businesses. Fortunately, this capital allocation policy is supported by Costco Wholesale Corporation (NASDAQ:COST)’s strong balance sheet, which has a low debt to equity ratio of 11%.
At a respective 26x and 23.4x past and forward earnings, the stock is fairly expensive. The company is forecasted for a 13% annual EPS growth rate over the next 5 years. This is more than 250 bps greater than the rate that was achieved over the past 5 years. Accordingly, I believe there is fairly significant downside risk at current levels despite the low beta of 0.68.
Conclusion
Wal-Mart Stores, Inc. (NYSE:WMT) and Costco Wholesale Corporation (NASDAQ:COST) both have several major headwinds going forward. In my view, however, the world’s largest retailer only stands to gain more ground from further international expansion.
And, for good measure, I would like to close with a tribute to Target Corporation (NYSE:TGT) – my favorite retailer, whose founder recently died. Fortunately, you can also pay tribute to Target Corporation (NYSE:TGT) by buying shares! At 17.1x past earnings, Target Corporation (NYSE:TGT) is cheaper than its peers given the double-digit growth forecast. It has a decent FCF yield of 6.7% and is rated a “buy” on the Street. While Target Corporation (NYSE:TGT) has some international exposure, it is limited to North America. Given that Target Corporation (NYSE:TGT) is really just a higher-end version of Wal-Mart Stores, Inc. (NYSE:WMT), the upside is thus huge from a growth perspective.
The article Is It Time to Buy Retail Stocks? originally appeared on Fool.com and is written by David Gould.
David Gould has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale (NASDAQ:COST). The Motley Fool owns shares of Costco Wholesale. David is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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