What follows is a list of discount retailers that are well positioned both in a recovery and a mild recession. While increased consumer expenditures is an obvious plus for retailers, a mild recession may be a long-term blessing disguise for discount retailers. This is because it attracts middle income consumers and possibly builds loyalty for long-term sustainable streams of free cash flow. Walmart (WMT) and Target (TGT) are cheaper than Dollar General (DG) on a multiples basis, but Dollar General has more room for penetration in international markets. Even still, I find that Walmart and Target's brand name and sustainability make them worthy of a "strong buy" compared to Dollar General, which is a much more speculative investment.
In my DCF model on Dollar General, I make several assumptions: (1) 16.3% per annum growth over the next six years and (2) 2.5% into perpetuity, (3) consistent operating metrics, and (4) a 9% discount rate. Based on these multiples, I find that the stock is overvalued by around 10%. 2011 may have been a great year in terms of greater-than-expected sales, but the retailer faces considerable competition and margin pressures.
The stock is also more expensive the peers at a PE multiple of 22.9x. Input inflation is also worrisome for food items like sugar, coffee, and nuts. The company is planning to ramp up store-specific merchandising, which to me appears like a desperate tactic to gain media attention. It is as if the company is attempting to shake things up but failing at beating the competition.
Walmart is a more attractive pick than Dollar General in light of its sustainability, impressive global presence, and excellent management (although Dollar General is good in this last respect). 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.
The Street is also optimistic about the world's largest retailer and rates the firm close to a "buy". My one concern with Walmart is that it will lose consumers to both the higher income stores, like Target, and the very low income stores, like Dollar General. In light of the more than $10B worth of free cash flow that the firm generates, it should consider raising the dividend yield or buying back more shares.
Consensus estimates for Target's EPS forecast that it will hold flat at $4.27 in 2013 and then grow by 13.6% and 19.8% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $4.81, the stock would hit $62.53.
Target may be considered a discount retailer; but, in my view, it strikes a happy medium in "targeting" both middle-income and lower-income consumers. Advertising doesn't extol everyday low prices like Walmart and Dollar General's does; but, rather focuses on value. Target is also relatively safe at 13.3x past earnings (lower than that of the S&P 500) and a beta of 0.9.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.