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Patricio Kehoe
Patricio Kehoe
Articles (164) 

Gurus Shed These Two Stocks

October 18, 2013 | About:

In times of economic hardship, those willing to sell goods at a reduced price may find a great growth opportunity. Over the past years, discount stores such as Costco Wholesale Corporation (NASDAQ:COST) and Target Corp (NYSE:TGT) have been able to increase their market share, largely due to a rise in low income consumers. As both firms seem to follow similar roads, including the incursion into the food business and expansion outside the U.S., Target seems to be merely following in Costco’s footsteps.

Global Presence and Membership Fee

Costco operates a membership warehouse club in the U.S., Canada, Mexico, UK, Japan, Taiwan, Korea and Australia. Apart from selling food, fuel and general merchandise, the firm generates large profits from its membership fees. Only consumers willing to pay the annual fee can take advantage of the company’s wholesale prices. Its well-planned business model has landed Costco a narrow economic moat, derived from its loss-leader capabilities in the food and fuel sectors, and its increasing buying power.

In an unfavorable macroeconomic scenario for retailers, Costco’s business model has several advantages. By selling food and fuel at zero profit, or at an economic loss, the company attracts consumers to its stores. This generates larger sales opportunities for discretionary products, which enjoy larger margins. The firm is only able to maintain this business model through its membership fees, which are paid at the beginning of a member’s annual contract. In addition, austere warehouses and an absolute lack of advertising help to keep costs down. Turning its merchandise quickly is another important factor in Costco’s business model. By acquiring only specific and fast selling items, the company is able to sell of its entire inventory in less than 30 days.

Despite the positive returns on investments the firm has to offer, investment gurus of the likes of George Soros and Ray Dalio are not fans of this stock. At least, that is what their recent sale of shares seems to indicate. First, trading at 25.6 times its trailing earnings, Costco entails a considerable price premium of 58% relative to the industry average. Second, there is not much room for further market penetration.. Hence, the company is expected to continue delivering positive results, but growth is not expected to reach previous levels. The sale of stock by investment gurus is thus understandable, and I would recommend holding on this stock.

Following the Leader

As one of the largest retailers in North America, Target operates 1,800 large-format stores. Originally, the firm only offered general merchandise, but following Costco’s and Wal-Mart (WMT)’s example, it has recently entered the food business. The company is also set to enter the Canadian market, in an attempt to expand outside of the U.S. However, John Hussman of Hussman Economtrics Advisors doesn’t seem too thrilled about the company’s initiatives. In consequence, the guru has unloaded a significant amount of shares over the course of the year.

Target reported weak second-quarter results, and in the current macroeconomic environment, growth opportunities are limited. Near term growth will be difficult, since cost-cutting and scale will not be able to counteract the effects of high unemployment levels and limited income growth. In the longer term, however, competing with larger rivals will not be easy. The entry into the low return food business, with the introduction of PFresh, is an attempt to follow in Costco’s footprints. But, with Wal-Mart already capturing excess profits from the grocery business there is little room for fresh competition. The low returns from the food business, along with the expansion into the Canadian market are bound to reduce the firm’s cash flow drastically. Nevertheless, management is expecting higher sales in general, from the increase in customer traffic generated by food shoppers. Whether Target will be able to achieve the same degree of success as Wal-Mart is doubtful, but additional market share is expected to be taken from smaller rivals.

With returns on invested capital declining as a result of the entrance to the lower-return food business, Target is bound to face headwinds in the short-term. Entering the already mature Canadian market is also seen as an overestimation of the market’s growth potential. Furthermore, since the firm is already trading at 15.6 times its trailing earnings, only slightly below the industry average of 16.2, the price discount is not significant enough to favor entry. Hence, I agree with John Hussman’s bearish stance towards Target.

Low Risk, But Low Growth

Despite their differences, neither of these two firms are worth investing in at this moment. Nevertheless, Costco seems to have the edge over rival Target, which is just now entering the food business and expanding outside the U.S. The Costco membership strategy generates a steady stream of income, and with an 86% global renewal rate, profits are bound to continue rising. Nevertheless, the high price premium of 58% and limited growth opportunities the company faces mean that shareholders cannot expect share value to rise considerably.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

Rating: 4.0/5 (5 votes)


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