Photo by Maxim Hopman on Unsplash

Retail stocks have incurred a fierce sell-off lately due to the headwinds facing their business. Retailers were severely hurt by the coronavirus crisis, which caused unprecedented lockdowns in 2020. They recovered in recent quarters thanks to the immense fiscal stimulus packages offered by the government, but these packages and the ongoing war in Ukraine have led inflation to soar to a 40-year high. Consequently, cost inflation is pressuring the margins of retailers while inflation is also taking its toll on consumer spending. These headwinds have triggered a sell-off of the entire retail sector and hence some great opportunities have shown up. In this article, we will discuss the prospects of three undervalued retail stocks, which are likely to offer high total returns to patient investors.

Ross Stores (ROST)

Ross Stores operates 1,648 stores with off-price apparel and home fashion in 40 states as well as 303 dd’s DISCOUNTS stores in 21 states. The retailer offers attractive merchandize at a 20%-60% discount compared to the regular prices of department and specialty stores.

Ross Stores has an exceptional performance record. To be sure, the company had grown its earnings every single year for more than a decade, until the pandemic struck in 2020. In that year, due to the lockdowns and other social distancing measures, Ross Stores saw its earnings plunge and suspended its dividend.

However, thanks to the massive vaccine rollout and the fiscal stimulus packages offered by the government, Ross Stores recovered impressively last year, achieving all-time high earnings per share of $4.87, which were 6% higher than the pre-pandemic high of $4.60.

Unfortunately, the retailer is facing another headwind this year, namely a 40-year high inflation, which has greatly increased freight and labor costs while it has also taken its toll on consumer spending.

In the most recent quarter, Ross Stores saw its same-store sales decline 7% due to reduced consumer spending and especially strong sales in last year’s quarter amid fiscal stimulus packages. Given also higher freight and labor costs, earnings per share decreased 28%, from $1.34 to $0.97, and missed the analysts’ consensus by $0.03. Even worse, due to the above headwinds, the company lowered its guidance for its earnings per share this year, from $4.71-$5.12 to $4.34-$4.58. It was only the fourth quarter in the last 33 quarters in which Ross Stores missed the analysts’ estimates. This is a testament to the unusually harsh business environment facing the company right now.

On the bright side, as experience has shown, inflation is likely to revert to normal levels in the upcoming years. The pace of mean reversion is unknown and greatly depends on the developments in the war in Ukraine but one can reasonably expect inflation to subside in the future. As soon as this occurs, Ross Stores will return to more favorable business conditions and thus it will improve its performance.

Ross Stores has grown its earnings per share by 11.9% and 11.5% per year on average in the last 10 and 5 years, respectively. Given the somewhat low comparison base formed due to the stagnation in the last three years amid the pandemic and the resultant inflation, we expect the retailer to grow its earnings per share at a 13.0% average annual rate beyond this year.

The stock is currently offering a 1.6% dividend yield and is trading at a forward price-to-earnings ratio of 17.5, which is lower than its historical 10-year average of 18.8. If the stock trades at its historical valuation level in five years, it will enjoy a 1.4% annualized valuation gain in its returns. Given also our expectations for 13% annual growth of earnings per share, the stock can offer a total average return of 16.0% per year over the next five years.

Target Corporation (TGT)

Target was founded in 1902. A few years ago, it tried to expand in Canada but its attempt failed and thus the retailer has operations solely in the U.S. market. Its business consists of approximately 1,850 big box stores, which offer general merchandise and food, while they also serve as distribution points for the burgeoning e-commerce business of the company.

Target has grown its earnings per share at an average annual rate of nearly 13% over the last decade. Due to intense competition and its failed attempt to expand to Canada, Target stagnated between 2012 and 2017. However, thanks to its major turnaround efforts, Target has greatly improved its performance in recent years. Notably, the company has reduced its share count by 4.8% per year in the last six years, although the pace of share repurchases has slowed lately.

Target is currently facing the same headwinds as Ross Stores due to the surge of inflation to a 40-year high. In the latest earnings report, cost inflation pressured the margins of Target so much that its earnings per share plunged 41%, from $3.69 to $2.19, and missed the analysts’ estimates by an eye-opening $0.87. It was the first quarter after 13 consecutive quarters in which Target had exceeded the analysts’ consensus. The stock plunged 25% on the day of its earnings release.

While the impact of inflation on the results of Target is certainly alarming, we expect this headwind to attenuate in the upcoming years. It is also worth noting that the small-format stores of the company have performed well in recent years and thus they provide an additional growth avenue for the company. We expect Target to grow its earnings per share by 11% per year on average off this year’s suppressed level. This growth rate may seem high on the surface, but it is lower than the analysts’ consensus and reasonable given the abnormally low comparison base of this year.

The stock is currently offering a 2.4% dividend yield and is trading at a forward price-to-earnings ratio of 14.2, which is much lower than our assumed fair earnings multiple of 18.0. If the stock trades at its fair valuation level in five years, it will enjoy a 4.8% annualized valuation gain in its returns. Given also our expectations for 11% annual growth of earnings per share, the stock can offer a total average return of 17.9% per year over the next five years.

Best Buy (BBY)

Best Buy is one the largest consumer electronics retailers in North America, with operations in the U.S. and Canada. It sells consumer electronics, personal computers, software, mobile devices and appliances while it also provides services.

Best Buy has exhibited a somewhat volatile performance record but it has grown its earnings per share tremendously over the last decade. During this period, the company has grown its earnings per share at a 16.4% average annual rate. We expect the company to remain in its growth trajectory in the upcoming years, primarily thanks to its successful shift to online sales and the optimization of its store count. Given also the somewhat low comparison base formed this year due to inflation, we expect Best Buy to grow its earnings per share by 6% per year on average over the next five years.

Best Buy is currently facing the aforementioned headwind from inflation but it has proved slightly more resilient than Ross Stores and Target so far. In its latest earnings report, which was released yesterday, Best Buy reported an 8.7% decrease in its revenue and a 30% decrease in its earnings per share, from $2.23 to $1.57.

On the bright side, it exceeded the analysts’ consensus by $0.01 and provided positive guidance for this year. It expects to achieve earnings per share of $8.40-$9.00, which are only slightly lower than the previous guidance of $8.85-$9.15 and in line with the analysts’ consensus of $8.88.

Best Buy is currently offering a 4.8% dividend yield and is trading at a forward price-to-earnings ratio of 8.4, which is much lower than the historical average of 12.0 of the stock. If the stock trades at its average valuation level in five years, it will enjoy a 7.3% 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 17.1% per year over the next five years.

Final Thoughts

When an entire sector incurs a massive sell-off due to a temporary headwind, some high-quality stocks are usually punished to the extreme and hence great investing opportunities show up. Of course, investors should focus only on the stocks that have a strong business model and are likely to recover from the temporary crisis. We believe that Ross Stores, Target and Best Buy have resilient business models in place and thus they have become deeply undervalued from a long-term point of view.