The Conference Board reported a slide in Consumer Confidence this week, and the trend matched what we have been tracking in the Bloomberg Consumer Comfort Index. The decline was driven by the recent disruption to the EU and relative threats to global trade, and also on the resulting weakness in U.S. financial markets. If the message consumers are sending via the sentiment surveys translates into more frugal consumer spending over coming months, investors need to know how their favorite retailers might be impacted. For some of these major players the last several years of economic volatility have severely damaged operations, but for others, they have been a Godsend. This report analyzes what the varied impact of a significant change to consumer spending might be for retail players Amazon.com (NASDAQ: AMZN), Wal-Mart (NYSE: WMT), J.C. Penney (NYSE: JCP), Sears (NASDAQ: SHLD), Costco (NASDAQ: COST) and Dollar Tree (NASDAQ: DLTR).
The last several years of economic strife and stumble have driven a bifurcation within the American retail space, which was too saturated to avoid disruption. As a result, there have been winners, losers, and a lot of change in between as store operators have struggled to adjust to a different sort of marketplace.
The most obvious change driven by the economic turmoil and sluggishness has been a shift in the value ladder and consumer preferences. High and stubborn unemployment have shaken up the middle class in America, leading many once more picky shoppers to seek value wherever they could find it. As a result, discounters and deep discounters, as well as super-competitive Internet operators have gained market share. The win has not been missed by capital markets either, with the shares of companies like Amazon.com , Wal-Mart , Costco and Dollar Tree reflecting their rising favor.
The five-year performance record, adjusted for dividends and splits, of our focus list illustrates what we are talking about:
Obviously, past performance does not dictate future performance, but I believe the five-year track record reflects the operational performance of these companies over challenging economic times. Of course, an important shift in capital as money chased results probably exaggerated share performance. We will look at current valuation and growth projections further down the report to assess how the shares of these companies might perform over the next year.
Besides valuation, the two struggling stocks in this group are actively addressing their operational strategies in an attempt to mitigate what has been ailing them. Oftentimes, a value opportunity can be found in a stock valuation that has been penalized for past performance in a company that successfully changes its operating strategy. The key word is "successfully", because they will all try by one means or another.
Let's look at valuation first, and against growth expectations:
TTM = Trailing 12 Months
MRQ = Most Recent Quarter
· * Amazon.com's P/E ratio on its December 2013 fiscal year is 85X, giving it a PEG ratio of 2.8X upon that figure.
· ** Costco's P/E is 21X our estimated forward 12 month EPS estimate of $4.11. The P/E ratio above is based on its August end year, which is just two quarters due.
As you can see, the last few years' high flyers are priced at a premium by each valuation metric, while the poor performers are deeply discounted. Still, past performance is an imperfect predictor of future performance. A premium valuation may put future performance at higher risk should a company misfire. Yet, a discounted valuation may likewise mislead if operational performance continues to deteriorate.
In fundamental analysis, we incorporate qualitative information to make better use of the quantitative data produced by past results. For instance, I recently noted that if the latest action of Target (NYSE: TGT) to stop selling Amazon.com's Kindle branded products becomes a trend among retailers, the game will have been effectively changed on Amazon, which should impact its valuation. I've also recently questioned the projections for J.C. Penney , given what I see as a management strategy that seeks to do too much too soon. Thus, I challenged what past performance says for AMZN and what analysts see for the future of JCP. Reiterating, I would be a seller of both today, though Amazon.com's operating performance would otherwise benefit from a more frugal shopper. For this reason, you might simply reduce your exposure to the story instead of outright selling out of the stock. Still, take note that the company's valuation is not leaving much margin for error.
If the economy deteriorates in the near future, those companies which benefited in the past should again benefit in the future, so names like Dollar Tree and Family Dollar (NYSE: FDO) should continue to produce strong operating results. In the case of Dollar Tree, its price-to-book valuation may be higher than others on the list due to the lower relative value of the real estate and inventory it may own. Its price-to-sales premium to the others here may be inflated because of the low price of the goods it sells. Thus, its valuation does not look excessive to me, but we would need to take a closer look at its operational growth strategy and to analyze its opportunity, in order to prove it could achieve the strong growth forecast analysts have for it. For now, let's trust that Wall Street is doing its homework.
I'm satisfied with the company's management of earnings and analysts over its recent history, as evidenced by several consecutive quarters of beating expectations, and so solid controls seem to be in place. The company just announced it will split its stock two-for-one in mid-June, a move that should support the stock as well. Thus, at first blush, and certainly among this short list, DLTR is one of my favorites. I suggest using technical tools to get your best entry point for this stock trading just off its 52-week high.
That leaves us with Wal-Mart, Costco and Sears to discuss. Wal-Mart is America's most important brick and mortar retailer today, and it has done relatively well through the latest economic turmoil. It remains a killer of mom and pop shops, and is super-competitive against other chain retailers as well. However, with the progression of time, Wal-Mart is sharing its portion of the discount pie at an increasing rate. The first serious competition it faced came from imitators and the warehouse clubs like Costco, but it is now fighting on all fronts. Deep discount dollar stores like Dollar Tree and other bargain locales like pawn shops are pulling in the very poor and the most aggressive bargain seekers, and taking something away from the big box. Meanwhile, Internet penetration and ecommerce adoption is attracting the young and hip bargain seekers as well. Thus, Wal-Mart's historical benefit from market share gain during tough times is diluted today. At the same time, because of its size and maturity, its performance is going to increasingly reflect the general economy; so Wal-Mart ventures overseas. While its growth will largely hinge on that, its Internet presence is probably going to prove more important to the company's performance over the long-term. While WMT's historical P/E ratio seems to say value exists, the trend of the historical P/E ratio is telling me the story is tiring. As a result, I'm neutral on WMT today.
Costco's P/E ratio is approaching its historical high of the last five years, and looks high versus growth expectations as well. My feeling here is that there is limited opportunity, and that the pool Costco can draw from is shrinking. Sears has a brand issue that I believe can only be overcome via aggressive change, creativity and marketing spending. Sears is valued as if it might be liquidated, but I'm not interested yet. In fact, I would prefer my investment capital in livelier stories.
Therefore, in conclusion, given the prospect for a consumer spending struggle based on the latest consumer confidence data, and given the individual aspects of the retailers discussed, I would buy DLTR, hold WMT, skim AMZN and COST, and sell JCP and SHLD.