With the euro-area hitting a record 11.2% unemployment rate and growing concerns over the sluggish economy, investors may be thinking "it's not time to get into retail". But are some retailing markets less vulnerable to a macro decline than others? In my view, electronics will fare better than office and home improvement.
After tumbling more than 33% over the last twelve months, Best Buy (BBY) is looking like a contrarian "buy". By contrast, Home Depot (HD), which has been on a consistent upwards trajectory (52.5% return over the last 12 months), is getting overvalued. I had originally encouraged investors to stay out of Best Buy and invest in Home Depot due to convenient pricing. While that prediction obviously proved helpful; at this point, I see little value potential from Home Depot and more from Best Buy as a turnaround play. Staples (SPLS) similarly is undervalued and would help supplement retail holdings. Below, I review the fundamentals of each company.
Best Buy is admittedly one of the more precarious stocks on the market, but it still offers a high 3.4% dividend yield, 5.4x forward multiple, and strong free cash flow generation. The founder recently put out a bid to buy the company for $8.8B, which should reveal to the market that what doesn't glitter may be gold after all. The now-$6.8B company generated north of $2.5B in free cash flow last year. And while operating cash flow has gone up and down, the positive secular trends in tech should point at least to a 4% annual growth rate. Should the company realize this growth rate and trade at a reasonable 7x multiple, it's future valuation will be $21B by 2016. Aggressively discounting backwards by 12% yields a present value of $11.9B.
About that 4% growth rate: I don't expect the market to factor this in in the near-term. But, within the next five years, I believe that it is possible that the market will let Best Buy's bygones be bygones. If that is the case (and not assumed to be likely in my 12% discount rate), the firm offers a substantial margin of safety. With that said, there is still considerable risk in a Best Buy investment, and, accordingly, I recommend limiting the holding as a percent of your portfolio.
Fundamentally, the company has taken several steps to turnaround the struggling business. The new Reward Zone Silver program offers free expedited shipping, a 60-day return policy, and access to free house calls from Geek Squad, among other benefits. Some have lamented the effect that this will have on margins, but I believe that (1) most of the time consumers don't use the benefits they receive and that (2) the effect this will have on demand more than compensates for lower margins. Over the past, same-store sales and margins have both eroded while SG&A is expected to rise. Rising competition from discount online retailers also strain future demand projections. With that said, the company has an existing eCommerce website and it can leverage the brick-and-mortar stores (struggling ones have been cut) to cross-sell consumer electronic services. The focus on Geek Squad and services has yet to be fully appreciated.
Staples is one of the cheapest stocks on the Street with a respect PE and forward PE multiple of 9.1x and 8x, respectively. More importantly for value investors, growth has not been fully factored into the stock price -- as evidenced by the 0.8 PEG ratio. Analysts forecast 11.4% annual EPS growth over the next 5 years, which translates to a future stock price of $32.93 at a 15x multiple. Discounting backwards by 12% yields a present value of $18.69. It would take a 21% discount rate for Staples' 2016 15x exit multiple calculation to fairly valued today!
Like Best Buy, Staples is also more of a free cash flow machine than what investors appreciate -- it trades at 10.2x free cash flow. The question then is: what is there not to love about Staples? One main problem investors have lamented is that the retailer is very exposed to FX headwinds on the euro, the pound, and the Australian dollar. Currency risks are proving to be more of a drag on shareholder value than anticipated, and international sales are expected to fall. But bear in mind that the firm only generates one-fifth of its business abroad -- generally too low for my own tastes.
There are several steps that Staples has taken to limit the impact of FX headwinds. Aggressive share repurchases and cost-cutting should help with EPS accretion. Advertising should be normalized while store productivity will be improved through closing underperforming units. Management has emphasized that it will focus its product mix on where momentum has been seen and try to increase international profitability. Strength in the Nordics, good exposure to Germany, which is stable compared to the rest of Europe, and limited exposure to PIGS need to be communicated more towards shareholders.
Home Depot has a terrific brand, excellent momentum, top management, and sound fundamentals. The problem is that the stock returns it has generated over the past few years has begun to plateau. I expect this to be an accurate reflection of the limited value discount left. Accordingly, I would not recommend the stock for investors looking to outperform broader indices.
The combination of a weak economy and droughts is expected to strain comps for home improvement store. How could droughts effect sales for Home Depot? The argument is that products, like fertilizers, live goods, and tractors, will be hit. However, it is questionable the extent to which this would be offset by sales in, say, air conditioning. With Lowe's (LOW) near a 10-year high valuation gap against Home Depot, I further anticipate that the latter's multiples will compress from a market correction. Home Depot is forecasted for higher growth and comps, but Lowe's only trades at 12x forward earnings and a much more reasonable 1.09 PEG ratio.
What I like about Home Depot is that management is very committed to the international frontier. They are focused on growth not only in the United States, but in Canada, China, and Mexico. Market share gains abroad will lock out competition and help to assure a strong stream of free cash flow when the economy fully recovers. Even still, the firm has a targeted 50% dividend payout ratio, so I do not anticipate management becoming any more shareholder-friendly in its capital allocation policy.