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Cash-Strapped Customers and Strong Competition: Retail and Wholesale
Posted by: Damian Illia (IP Logged)
Date: September 16, 2013 10:00AM

With food inflation around the corner and cash-strapped consumers being extra careful with their shopping, the retail and wholesale business right now looks particularly competitive. Is it good time to invest in the industry? We’ll take a look at Safeway (SWY), Wal-Mart Stores (WMT) and Costco (COST), three prominent firms in their respective markets, and see if they fit your portfolio.

Is It a Safe Way?

Counting over 1,400 stores across the U.S., Safeway is one of the country’s major grocery chains. The firm operates another 213 stores in Canada, which it has recently agreed to sell to Sobeys for $5.8 billion. This deal will allow Safeway to sharpen its focus on the domestic market. Having gained over 45% during this year, Safeway trades at $28, or 10.5 times its earnings, a massive discount to the industry average — 21 x — while projected to yield about 2.8% of the current stock price in the form of dividends.

Valuation appears tempting, but is it a buy? I’m not convinced, and I'm not the only one: Legendary fund manager Ken Heebner and Gotham Capital's Joel Greenblatt have sold out their shares recently.

The firm faces tough competition from discount retailers, dollar stores and higher-end groceries alike, which continue to gain market share and pressure Safeway’s profit margins. Safeway has undertaken several successful initiatives, like the profitable “Just for U” loyalty program, but the company’s growth remains slow, and its competitors remain forceful. Moreover, new unlikely players are stepping into the market — for instance, Amazon, with its online grocery delivery service — which could make things tougher for Safeway.

On the bright side, I should mention that Safeway’s upcoming Wellness initiative is expected to tackle the fast-growing U.S. health care market and will likely open new growth opportunities for the firm. In addition, the firm’s Blackhawk unit, a major gift-card provider, has gone public recently, and after the spin-off it’s expected that Safeway will increase its focus on the retail business, hopefully improving the company’s performance.

Big Guy

Wal-Mart Stores, present in Bill Gates and Jeremy Grantham's portfolios, is an international retail store operator which runs large department stores and warehouse chains. The firm benefits from operating on a massive scale: With over 8,500 stores distributed in 15 countries, it is the world’s largest private employer. After delivering non-impressive second quarter results, which brought the stock down, Wal-Mart trades at $74 or 14.4 times its earnings, a slight discount to the industry average, while offering above-average margins.

The firm hasn’t been in a particularly good run, as its previous quarterly results also turned out to be weaker than expected, due to lower consumer spending in the domestic market. Yet, first quarter results also showed interesting productivity improvements and a strong 30% increase in e-commerce sales.

In fiscal 2013 Wal-Mart has developed diverse initiatives that should expand its online sales internationally in the near term, like improving its mobile apps, developing a new search engine and increasing its investment in Newheight Holdings Ltd., which owns China’s Internet retailer Yihaodian. Although Wal-Mart’s opportunities in the e-commerce market look promising, it’s still uncertain how an increase in online sales may affect the company’s core business, store sales, in the long term.

Also, the firm has been shifting its capital from international new-store openings to higher-return small stores in the domestic market, as it seeks to expand sharply the number of Neighborhood Market stores. Investors may be interested in this move, as it could certainly reduce the competitive threats that rising dollar stores represent for Wal-Mart’s low-end customers.

Not Cheap

Costco is the leading warehouse club operator in the U.S. The firm showed strong third quarter results with revenues up 8% year-to-year and has been consistently expanding its market share thanks to its loss leader capabilities. Having gained over 17% this year, Costco trades at $117 or 25.6 times its earnings, at a 28% premium to the industry average.

The firm’s position as the dominant warehouse retailer looks unchallenged as it holds a positive growth record and a strong membership renewal rate. Making the most of its operating profit out of membership fees, Costco can manage to sell basic inelastic consumer needs (for instance: food or fuel) at wholesale rather than retail prices, or even at a loss. As a price leader, Costco looks a difficult firm to compete with.

Costco has also been exercising a strong domestic and international expansion, and has plans for 28 new openings for fiscal 2013. With domestic and international comparable-store sales growth healthy year after year, Costco’s expansion strategy looks appealing for shareholders. Moreover, contrary to many of its peers, the firm’s international operations have generated returns above their cost of capital.

On the down side, it should be noted that the company’s customers are extremely sensitive to changes in macroeconomic factors that alter spending levels, therefore hurting Costco’s sales. Also, as a direct consequence of Costco’s international expansion, the firm is now more sensitive to possible currency fluctuations, which would affect its top and bottom-line results. These might be some of the reasons several finance gurus, like Paul Tudor Jones, have recently sold out their shares.

Bottom Line

While all the three companies analyzed here exhibit compelling growth opportunities ahead, none looks as a strong buy right now. Costco looks like a particularly strong firm, yet its premium valuation may put off many investors. I would wait for a lower entry point to come available before chipping in. On the other hand, Wal-Mart hasn’t been on a run, but at current valuation it certainly looks tempting.

Disclosure: Damian Illia holds no position in any stocks mentioned.

Guru Discussed: Bill Gates: Current Portfolio, Stock Picks
Jeremy Grantham: Current Portfolio, Stock Picks
Stocks Discussed: SWY, WMT, COST,
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