Midyear Checkup: Broad-Line Retailers

Now that we're into July, it's a good time to check on how the year is shaping up for retailers. Spring has sprung. The major early-season holidays are over. We're into the dog days of summer, when retailers typically clear out early-season merchandise and get prepared for fall and the holidays -- where the real action is.

Let's start with the broad-line retailers, who sell virtually all merchandise categories out of cavernous stores. Once upon a time, this was a larger group of companies, but today, I see only five real players in this field: Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Costco (NYSE:COST), BJ's (NYSE:BJ), and Sears Holdings (NASDAQ:SHLD), which also owns K-Mart.

The big picture
It's virtually impossible to compare these five companies on exactly the same basis. Costco has a different year-end, Sears Holdings only reports quarterly, we have four months of sales but only three months of earnings, etc. Despite these limitations, I think the chart below does a pretty good job of showing the big picture year-to-date.

Target and Costco appear to have the best jump on fiscal 2007. They're both running mid-single-digit comp sales growth and around 10% total sales growth. EPS growth for these two is solid (Costco EPS includes sales return reserve adjustments). BJ's has the best stock appreciation so far this year. Wal-Mart continues to trudge along. Sears Holdings has a lot of minus signs in front of its numbers.

Wal-Mart
The big news for the "smiley face" this year was the announcement at its shareholders' meeting that the company would dial back domestic Supercenter growth by about one-third for the next several years, in an effort to improve returns on capital. The stock took a major leap on the news, but has subsequently fallen back.

The market seems uncertain whether this is a meaningful fix for the flagship division, or just a holding action while the company figures out how to be relevant to consumers beyond low-priced consumables. In the meantime, its Sam's Club and international divisions are performing solidly, both chalking up operating earnings growth around 20% year to date. I expect Wal-Mart to deliver sluggish comparable-store sales but improved earnings growth in the back half of this year.

Target
For the past few years, Target has demonstrated that being No. 2 has some advantages. The company has avoided battling Wal-Mart on opening price points, preferring to stake its claim on being more trendy, more fashion-forward, and ultimately more relevant than its (much) bigger brother. The strategy is working like a charm.

Comparable-store sales have been consistently solid. Margins are improving on a differentiated product mix that resonates with the consumer. Expenses are leveraging downward, and credit card profitability is soaring despite a challenging credit environment. Inventory ended the first quarter up less than 6%. All in all, it's somewhat surprising the stock has not performed as solidly as the financial results behind it. I expect Target to deliver strong second-half results, even in a choppy consumer spending environment.

Costco
Foolish investors know I favor Costco as the best pure retailer in the world. So far this year, the company has continued to deliver impressive results. Yes, its most recent quarterly financials looked a little shaky on the surface, as the company booked a large reserve for returns of electronic items. I don't fault a retailer for having a liberal return policy, but Costco recognized that customers were gaming the system and made the appropriate adjustments.

The retail game is not won or lost in a single quarter. With Costco, you get the highest-average-volume retail stores in the U.S., combined with consistently high comparable sales growth -- an incredibly potent combination. I look for Costco to deliver 5%-10% comps in the back half, the highest in the broad-line retail group, with some margin growth and expense leverage. As always, the company's shares command a premium multiple. I favor averaging in or buying on inevitable dips when the market catches a short-term cold.

BJ's
While BJ's ranks third out of three in the wholesale club business in sales per store, the stock is on a nice run this year. First-quarter earnings were below the prior year's after adjusting for one-time events. I see signs of life as comparable sales are beginning to trend up, and first-quarter free cash flow was impressive on the strength of significantly improved inventory management.

I can't justify the current share price for BJ's on financials alone. At the current $36.60 a stub, BJ's would need to deliver about $2 in EPS to be in a market-average P/E multiple range of 18. That's nearly double last year's earnings, better than any of the past five years, and even then I question BJ's growth potential. There's been on-and-off speculation that private equity is eyeing the company, a likely reason the shares are trading at a high multiple. I think the company is showing some improvement in key operating metrics, but is overpriced based on fundamentals.

Sears Holdings
I have to admit I don't get the hype around this stock. Combining two also-rans leaves you with exactly that, albeit with some synergies from the marriage. Despite this personal view, shareholders were richly rewarded for holding SHLD last year as the stock advanced about 40%.

Now, the question is: Can the retail portion of the business perform? First-quarter results were not impressive. Domestic comparable sales declined 3.9%; Sears was down 3.4%, while Kmart lost 4.4%. The earnings release blames the usual suspects: competition, energy costs, the housing market, and the weather. My view is that it's a long, hard road to change consumer perceptions of a retailer, which Wal-Mart has learned over the past few years. Until I see some sign of sales vitality from Sears Holdings, this stock is not on my short list. For the other side of the story, check out an incisive review of the company by fellow Fool Matt Koppenheffer.

Summary
The year has not been kind so far to the retail sector as a whole, but there are companies in each category that are delivering the goods. In broad-line retail, I see Target and Costco as the best-positioned firms to make a solid run in the back half of the year.

For more news on the retailers that sell everything, check out:

• Fool on the Street: Wal-Mart Speaks
• A Bigger Target
• All Aboard: Costco

Wal-Mart is a Motley Fool Inside Value recommendation. Costco is a Motley Fool Stock Advisor selection. You can try either, or both, market-beating newsletters free for 30 days by clicking the links above.

Motley Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, and owns shares of Wal-Mart, but none of the other companies mentioned in this article. The Fool's disclosure policy treats its workers fairly.