Why Wal-Mart, Target's Defensive Upside Will Outperform

Includes: COST, JPM, TGT, WMT
by: Takeover Analyst

With employment figures improving, investors are naturally looking to Wal-Mart (NYSE:WMT) as a way to benefit from increased consumer expenditures. What investors fail to note, however, is that Wal-Mart will struggle to be an outperforming beneficiary of a macro recovery due to its low beta of 0.4. With that said, the company is a strong defensive play against the prospects of a double dip. In light of Costco's (NASDAQ:COST) frightening downside, I expect retail investors to shift over to stronger brands like Target (NYSE:TGT) and Wal-Mart.

From a multiples perspective, Target is the cheapest of the three. It trades at 12.2x past and forward earnings while Wal-Mart and Costco trade at a respective 14x and 25.7x past earnings. Wal-Mart has the highest dividend yield by 2.4% with Target just behind.

At the third quarter earnings call, Wal-Mart's CEO, Mike Duke, noted three key financial highlights and strong cash flow generation:

First, Wal-Mart reported earnings per share from continuing operations of $0.97 within our guidance. Second, both Wal-Mart U.S. and Sam's Club exceeded comp guidance for the third quarter, with Wal-Mart U.S. increasing comp sales 1.3% and Sam's Club posting a comp, without fuel, of 5.7%. Third, the company leveraged operating expenses with each of the 3 operating segments achieving this goal as well. We remain committed to leveraging expenses again this year.

Here are some additional third quarter highlights. Net sales increased 8.2% to $109.5 billion. International reported net sales of more than $32 billion, approximately a 20% increase over last year's third quarter. This includes our acquisitions and currency impact. Consolidated operating income grew 4.8%. Wal-Mart ended the quarter with free cash flow of $3.4 billion. The company returned $2.7 billion to shareholders through dividends and share repurchases for the quarter.

Wal-Mart is further attractive as a hedge against inflation. The company is expanding its real estate holdings while penetrating international markets. Consensus estimates for Wal-Mart's EPS forest that it will grow by 10.3% to $4.49 in 2012 and then by 9.4% and 10.6% in the following two yeas. Modeling a CAGR of 10.1% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $69.21, implying 11.6% upside.

Target similarly had strong recent quarterly results. EPS grew 10% over the same quarter last year as same store sales rose by 4.3%. In order to address Wal-Mart's layaway program, Target slashed prices and hiked up prong advertising. Following the 2008 sale of 47% of loans to JPMorgan (NYSE:JPM), Target attempted to sell off all of its credit card receivables. That process was suspended after management failed to find a suitor. Regrettably, this will kick back the $1B anticipated cash injection to sometime following a recovery when investors are less focused on risk mitigation.

Consensus estimates for Target's EPS forecast that it will grow by 9.5% to $4.25 in 2012 and then by 1.4% and 14.4% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $4.25, the rough intrinsic value of the stock is $55.25, implying 6% upside.

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