Aggressively Buy Wal-Mart, Target As Dollar General Underperforms

 |  Includes: DG, TGT, WMT
by: Takeover Analyst

With the economy recovering at a painfully sluggish rate, many retailers are trading cheaply. While the S&P 500 trades at 20.8x past earnings, Walmart (NYSE:WMT) and Target (NYSE:TGT) trade at just a respective 13.4x and 12.8x past earnings. Dollar General (NYSE:DG) is one of the few retailers to be valued at a similar multiple to that of the S&P 500. In this article, I will run you through my DCF model on Dollar General and then triangulate the result against a review of the fundamentals of Walmart and Target. I expect these two cheaper retailers to outperform Dollar General as the economy advances towards full employment.

First, let's begin with an assumption about the top-line. Dollar General finished FY2011 with $14.8B in revenue, which represented a 13.6% gain off of the preceding year. I model a 16.3% per annum growth over the next half decade or so.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold to eat 68% of revenue versus 22% for SG&A, and 2.5% for capex. Taxes are estimated at 37% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)

We then need to subtract out net increases in working capital. I estimate this figure hovering around 0.8% of revenue over the explicitly projected time period.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $41.50, implying that the stock is around 9% overvalued.

All of this falls within the context of overall strong operating performance:

"[W]e had a great year and we had very strong financial performance in the fourth quarter, with sales above our expectations.

Fourth quarter sales were again driven by consumables, which generally have a lower gross margin than non-consumables. Our fourth quarter gross profit rate was 32.2%, a decrease of 25 basis points from the 2010 fourth quarter, which as a reminder was the highest gross margin performance we have ever achieved. Purchase costs were up year-over-year, particularly on some of our food items such as sugar, coffee and nuts, resulting in a likely charge of $22 million for the quarter, much higher than we had anticipated at the end of Q3 as inflation continued at a higher rate than expected. Overall though, we are pleased with our gross margin results for the quarter".

From a multiples perspective, the stock is expensive relative to peers. It trades at a respective 20.1x and 14.1x past and forward earnings versus 13.8x and 11.8x for Walmart and 12.9x and 11.4x for Target.

Consensus estimates forecast Walmart's EPS growing by 8.2% to $4.86 in 2013 and then by 8.8% and 9.5% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $5.22, the stock would hit $73.08 for 17.1% upside. For a stock that offers a 2.7% dividend yield and a beta of 0.4, Walmart is an attractive defensive company. It is currently rated a "buy" on the Street (source: NASDAQ).

Consensus estimates forecast Target's EPS growing by 0.9% to $4.31 in 2013 and then by 13% and 19.1% in the following two years. Of the last 18 revisions to EPS, 16 have gone up for a net change of 0.8%. This retailer also is rated a "buy" on the Street (source: NASDAQ) and has excellent expansion potential. Assuming a multiple of 14x and a conservative 2013 EPS of $4.84, the stock would hit $67.76 for 22.2% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.