Retail shares have been hot performers in 2013. The SPDR S&P 500 Retail ETF (XRT) was up over 30% year to date at writing. The sector has performed strongly on the back of pent up demand, the impact of wealth creation generated by higher stock and housing prices, and refinance activity. Improved home sales may also be providing some spill over support, as consumer buy items related to improvement and remodel. The sector has posted a hot return despite lackluster wage growth and unexciting labor demand trends.
Macro headwinds:
Looking forward, the retail sector faces a number of macro headwinds. Although home sales are still increasing, refinance activity has slowed materially, real disposable income growth is anemic, and the savings rate has been falling. Refinance activity is down over 55% from its December peak, real disposable income rose only 0.6% y/y in June, and the savings rate is depressed near a cycle low at 4.4%. Increases in the savings rate tend to coincide with slower retail sales.
Macro headwinds may get some play given American Eagle (AEO) recently guided its profit outlook lower. The strong rally in the sector does not leave a lot of room for disappointment. Given the macro headwinds and strong performance, it may be worth reviewing valuation and opportunities in the retail sector.
12 month forward PE ratio:
The retail space is extremely large, so this article will focus on a handful of retailers across the apparel, department store, wholesale, and electronic space.
A company’s PE ratio can be used as one measure of valuation. Generally speaking, a high PE ratio can imply the stock is richly valued, while low PE ratios can suggest the stock is cheap. The PE ratio measures how much the market is willing to pay for a company’s earnings. Examining forward 12 month PE multiples, Kohls (KSS) and Wal Mart (WMT) have the largest discounts to their averages and electronics retailers Conn's (CONN) and HH Gregg (HGG) recorded the biggest premiums to their averages, although CONN and HGG have been public for a short period of time. WMT and KSS appear cheap, while CONN and HGG seem expensive. CONN and HGG are also Zacks Rank #1 (Strong Buy) stocks and the market may be paying up for their strong upward trend in earnings revisions.
PEG Ratio:
Since investors seem very willing to price retailers with PE ratios ahead of their average, it might be worth looking at the PE ratio in relationship to the growth in earnings per share – the PEG ratio. If growth in earnings is strong, a higher PE ratio could be justified. The table following displays the PEG ratio for each firm.
All of the companies are trading at a PE ratio above their growth rate or with a PEG ratio over 1.0, although Macys (M) and Gap (GPS) are trading below their average PEG ratios. M looks cheap against its history and its peer group. The same can be said for GPS which is trading at a slight discount to its average PEG ratio and has a PEG ratio below the average retailer in the table.
Best Buy (BBY) looks most expensive. However, the company has struggled in recent years and the PEG ratio may reflect the market pricing a turnaround. Besides BBY, HGG and Fred’s (FRED) had the largest premiums to average, and FRED and Costco (COST) had the largest PEG ratios relative to the peer group. The market seems willing to pay a premium for COST given its track record.
Gross Margin:
One of the reasons investors may be willing to pay up for retailers rests gross margins. Expanding gross margin could suggest improved profitability and warrant a higher PE ratio. CONN and HGG have shown the ability to expand their margins dramatically. Ross Stores (ROST) and L Brands (LTD) have also been able to show strong gross margin to average, but their gross margin levels are less dramatic. Target (TGT) and GPS have gross margins which are below their average.
Earnings Estimate Revisions:
Analyst earnings revisions have been the most bullish for GPS and HGG. The upward to downward revision numbers have been strongest for these names. FRED would be next, and LTD has shown disagreement among analysts.
Sales growth outlook:
The table shows that CONN by far has the strongest sales growth outlook. COST and JWN display the next best levels of sales growth. It is noteworthy that sales growth is expected to accelerate next year for most of the companies. Is this too optimistic given macro headwinds?
Conclusions:
Based on the universe of retailers above, it is hard to clearly find a retail stock which is trading at an inexpensive valuation and showing strong upward momentum to earnings estimates. GPS and CONN look most attractive sorting through the names, but M could be a value play given its low PE ratio and low PEG ratio.
GPS has a PEG ratio which is at a discount to its 10 year average and below the average of its peer group. It has also seen strong upward revisions to its fiscal 2014 and fiscal 2015 earnings estimates. The downside may rest in narrow gross margin to average.
CONN has a PEG ratio which is premium to its average, but the PEG ratio appears relatively low compared to the peer group. It is showing quick sales growth and robust gross margin expansion. It seems to be a stronger value than HGG and the best pick in the electronics and appliance space.
Bottom line: there does not appear to be much for sale in the retail sector.
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