Retail stocks have incurred a brutal sell-off lately, primarily due to the impact of 40-year high inflation on their business. Inflation in freight and labor costs is pressuring the margins of retailers while inflation in essential goods is taking its toll on consumer spending.
As the effect of inflation on the earnings of retailers has exceeded analysts’ expectations in the latest earnings reports of some retailers, the entire retail sector has gone through a massive sell-off lately.
Notably, some high-quality retailers, which have strong business models and are very likely to recover from the current crisis, have been punished to the extreme by the market. In this article, we will discuss the prospects of three undervalued retail stocks, which are likely to offer high total returns to patient investors.
Walgreens Boots Alliance (WBA)
Walgreens Boots Alliance is the largest retail pharmacy in both the U.S. and Europe. Through its flagship Walgreens business and other business ventures, the company has more than 13,000 stores in the U.S., Europe and Latin America.
Walgreens has grown its earnings per share at an average annual rate of 7.2% over the last decade. However, this growth rate is somewhat misleading, as the company has hardly grown its bottom line during the last four years, mostly due to razor-thin margins, as the topic of the margins of the pharmaceutical business has attracted political and public interest.
Walgreens currently enjoys positive business momentum. In the second quarter of its fiscal year, Walgreens grew its sales from continuing operations 3% over the prior year’s quarter thanks to COVID-19 vaccinations and testing. Its U.S. retail comparable sales grew 15%, which is a 20-year high growth rate, while its adjusted earnings per share grew 26%, from $1.26 to $1.59, and exceeded analyst consensus estimates by $0.19. The company has beaten analyst consensus estimates for 7 consecutive quarters.
Walgreens reaffirmed its guidance for low-single digit growth of its annual earnings-per-share in 2022. Despite strong performance, the stock dipped 6% after the company’s earnings release, as the market was alarmed by the fading tailwind from the pandemic (11.8 million vaccinations in Q2 vs. 15.6 million in Q1), which resulted in a deceleration of sales growth (3% in Q2 vs. 8% in Q1).
On one hand, investors are justified to be concerned over the fading tailwind from the pandemic and the stagnation of Walgreens in recent years. On the other hand, the aging population and the focus of Walgreens on becoming a health destination are likely to help the company grow its earnings-per-share at a decent rate. We expect Walgreens to grow its earnings-per-share by 5% per year on average over the next five years.
It is also important to note that Walgreens has grown its dividend for 46 consecutive years and it is offering an above-average yield of 4.5% with a wide margin of safety, given the resilient business model of the company and the payout ratio of only 36%.
In addition, the stock is trading at a nearly 10-year low price-to-earnings ratio of 7.9, which is much lower than the 3-year average of 10.0. If the stock trades at its historical valuation level in five years, it will enjoy a 5.0% annualized valuation gain in its returns. Adding in our expectations for 5% annual earnings-per-share growth, the stock can offer a total average return of 13.6% per year over the next five years.
Lowe’s Companies (LOW)
Lowe’s Companies is the second-largest home improvement retailer in the U.S., behind Home Depot (HD). The company operates or services approximately 2,200 home improvement and hardware stores in the U.S. and Canada.
Not only has Lowe’s proved resilient throughout the coronavirus crisis, but it has also greatly benefited from this crisis. Thanks to a surge in the demand for home improvement, Lowe’s grew its earnings-per-share by 54% in 2020 and by another 36% in 2021, to a new all-time high.
Lowe’s has also proved resilient to the inflationary environment that has prevailed in recent months. In its latest earnings report, it grew its earnings-per-share 9% over last year’s quarter, from $3.21 to $3.51, and thus exceeded the analyst consensus by an impressive $0.29. The company has exceeded the analyst consensus estimate for 13 consecutive quarters. In addition, it reaffirmed its guidance for record earnings-per-share of $13.10-$13.60 this year. At the mid-point, this guidance implies 11% growth vs. the record earnings per share of $12.04 achieved last year.
Unfortunately for Lowe’s, the Fed has begun to raise interest rates aggressively in an effort to keep inflation under control. Higher interest rates are likely to reduce the demand for new houses at some point and hence they may provide a headwind to the business of Lowe’s. Nevertheless, given the outstanding performance record of Lowe’s, which has grown its earnings-per-share at a double-digit rate every single year in the last decade, we conservatively expect the company to grow its earnings per share by 6% per year on average over the next five years.
The stock is currently offering a 1.7% dividend yield and is trading at a forward price-to-earnings ratio of 13.9, which is much lower than its historical 5-year average of 19.5 and our assumed fair price-to-earnings ratio of 20.5. If the stock trades at its fair valuation level in five years, it will enjoy an 8.1% annualized valuation gain in its returns. Given also our expectations for 6% annual growth of earnings per share, the stock can offer a total average return of 15.8% per year over the next five years.
The Gap (GPS)
The Gap is an American clothing and accessories retailer. It was founded in 1982 and currently has 3,399 store locations in over 40 countries, of which 2,835 are company operated.
In contrast to Walgreens and Lowe’s, Gap has a relatively poor performance record. Its earnings-per-share have significantly declined over the last decade, primarily due to intense competition in its business, which has exerted great pressure on the company’s margins.
Moreover, Gap has negative business momentum right now. In its latest investor update, the company lowered its guidance for 2022 due to supply chain disruptions and probably the impact of inflation on tis business. As a result, Gap now expects its sales in the first quarter of its fiscal year to decrease at a low- to mid-teens rate vs. prior guidance for a mid- to high-single-digit rate decline.
As long as high inflation and supply chain disruptions due to the pandemic remain in place, the business performance of Gap is likely to remain under pressure. With that said, we expect these headwinds to subside at some point in the upcoming years and hence we expect the retailer to grow its earnings-per-share at a 4% average annual rate over the next five years off this year’s low comparison base.
Moreover, the 71% plunge of the stock over the last 12 months is probably exaggerated, especially from a long-term point of view. The stock is currently offering a 6.3% forward dividend yield and is trading at a forward price-to-earnings ratio of 6.7, which is much lower than its historical 10-year average of 14.2. Due to the volatile performance record of Gap, we assume a fair price-to-earnings ratio of 10.0 for the stock. If Gap trades at its fair valuation level in five years, it will enjoy an 8.2% annualized valuation gain. Adding in our expectations for 4% earnings-per-share growth, the stock can offer a total average annual return of 16.7% per year over the next five years.
The above three retail stocks have become remarkably cheaply valued due to the sell-off of the entire retail sector. We expect inflation to eventually subside in the upcoming years and thus we expect these three retailers to highly reward those who purchase them around their current stock prices.
Investors who want to have a wider margin of safety will likely prefer Walgreens and Lowe’s, which both have a much more reliable track record over the last decade as compared to Gap. But, investors with higher risk tolerances may prefer Gap, as it has the highest expected total returns of the three.
Bob Ciura has worked at Sure Dividend since October 2016. He oversees all content for Sure Dividend and its partner sites. Bob received a Bachelor’s degree in Finance from DePaul University, and an MBA with a concentration in Investments from the University of Notre Dame.
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