Why Wal-Mart, Target, and Costco Are Appealing Investments

As you might already know, retailers have adopted highly promotional strategies recently. This isn't just the case for apparel retailers, it is also true for big-box retailers like Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) as well. While Wal-Mart offers everyday low prices, it adds deals on top of those prices in order to drive more people to its stores. The idea is that those promotions will lead to visitors spending on nonpromotional items as well.

With a profit margin of 3.62%, it might seem as though Wal-Mart's profits could be in danger. However, the company does so much volume (245 million customers per week) that its profit margin isn't a big concern. Contrary to popular belief, Wal-Mart's margin is also higher than Target's profit margin of 3.27%.

Many investors who look at these two companies also consider Costco (NASDAQ: COST  ) . As you will see below, Costco is growing its top line faster than its peers, and it doesn't need to conduct promotions since its club member discount always offers promotional pricing. However, Costco needs its high volume to continue since its profit margin is a thin 1.94%.

There's a concerning trend for all three of these companies, but at the same time they're all excellent at generating cash flow. This makes them different types of investments than what you might be used to, but that's not a bad thing. Actually, given the current economic environment and hesitant consumer, they might be ideal investments. Thanks to their strong cash flow generation, these companies are likely to offer limited downside risk. If one of them gets into trouble, it can simply buy back more shares or increase its dividend. Top-line potential isn't out of the question for any of these companies, either. Let's take a closer look. 

Highly promotional
Wal-Mart recently announced record Black Friday results. Logically, it decided to offer a Black Friday redux. This is the way Wal-Mart management operates, and it's one of the reasons you shouldn't jump on the "I Hate Wal-Mart" bandwagon. Wal-Mart is always going to find ways to win, or at least give itself the best chance to win. In this case, it's offering price drops on select items through the store from Dec. 13 to Dec. 24.

Wal-Mart is also wise to make this move because according to ShopperTrak, four of the 10 busiest shopping days of the year were between Dec. 20 and Dec. 24, with Super Saturday -- that will be December 21 this year -- being the second busiest behind Black Friday.

Wal-Mart also held a Special Super Savings event on Dec. 16, where 300 items throughout the store were discounted further. In addition to that, Wal-Mart will offer free shipping on all items if you spend $35 or more online. You can also pick up your items at the store. Then there's the ad price match. If you bring your Wal-Mart receipt and prove that you found the item cheaper elsewhere, you will get a Wal-Mart gift card for the difference in price.

Promotional impact
All of these promotions will likely lead to increased sales and contracting margins. The latter might affect the bottom line, but remember that Wal-Mart is a massive cash flow generator. In fact, it generated $23 billion in operating cash flow over the past year. Therefore, it can buy back shares with ease, which can offset bottom-line declines. It can also increase its dividend. Currently, Wal-Mart yields 2.40%.

As far as growth potential, keep an eye on Wal-Mart expanding its small-box store count from 300 to 550-plus over the next 18 months. Consider the following quote from Wal-Mart CEO Bill Simon:

Against a dollar store, [Wal-Mart Express stores] have fresh food, pharmacy and gas and perform really, really well and have a pricing advantage. Against drug they have a significant pricing advantage and they have fresh food and gasoline. And then against small grocery stores we have a competitive price advantage.

Target isn't quite as promotional as Wal-Mart, but it lags Wal-Mart in operating cash flow by a wide margin, as it generated $6.73 billion over the past year. This is still a massive number, and Target currently yields a more generous 2.70%. However, Target is likely to use much of its cash flow for Canadian expansion. Imagine Wal-Mart before it expanded across the United States. While not on the same scale, Target has similar potential throughout Canada.

As far as Costco goes, it generated $3.44 billion in operating cash flow over the past year and it currently yields 1%. Furthermore, it's trading at 22 times forward earnings, which makes it more expensive than Wal-Mart and Target, trading at 14 and 13 times earnings, respectively. Also keep in mind the profit margin differences above. All that said, Costco is growing the fastest:

COST Revenue (TTM) Chart

COST Revenue (TTM) data by YCharts.

Costco only has limited international exposure thus far. By keeping its store counts low in Canada, Mexico, the United Kingdom, Japan, Taiwan, Korea, and Australia, it has used a trial-and-error approach before expanding further so it can see what countries and strategies offer the most potential. Costco also has a healthy balance sheet, with $6.12 billion in cash and short-term equivalents versus $5.19 billion in long-term debt. Combine that with $3.44 billion in annual operating cash flow and it opens many doors for reinvestment in the business as well as increased capital returns to shareholders.

The bottom line
If you're looking for safety in an uncertain economic environment where you can reap the benefits of stock buybacks and generous dividends, then Wal-Mart should be considered. If you're looking for more growth potential thanks to international expansion, take a look at Target or Costco. They're likely to present a little more risk since they don't generate as much cash flow, but that's only relatively speaking. 

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