Top 3 Retailers for a Tough 2009

Retail stocks have had a rough year that just keeps getting worse with last month’s drop in consumer spending being the largest since the data began to be tracked in 1947. Unfortunately, things do not look much better for 2009 with some 44 percent of consumers saying that they would further cut spending after the holidays, according to a study conducted by America’s Research Group. However, some investors see opportunity for strong retailers that can weather the storm…

Many investors looking at the retail sector will find no shortage of value in the form of low multiples, but relative value is no longer a valid measure in today’s environment. Investors should instead look at brand strength, asset valuation, cash flow generation and debt load to find retails that will be able to not only survive but thrive in the economic crisis. So, without further ado, here are our top three retail stock picks for 2009:

Wal-Mart Corporation (NYSE: WMT)

Wal-Mart’s stock has continued to perform well throughout the economic crisis as consumer sought lower prices. The discount retailer has also attempted to reinvent its image to include quality along with price while expanding its presence internationally. Combined, these changes have resulted in a 9.4 percent jump in third quarter net sales with the international segment leading growth.

Despite a modestly lower guidance for the full year, Wal-Mart continues to be one of the strongest retailers in the United States given its strong value proposition to customers. Meanwhile, the retailer’s efforts to reinvent itself as a quality retailer may end up paying dividends down the road when the economy recovers and consumers open up their billfolds, especially against rival discount retailers like Target Corporation (NYSE: TGT) and Macy’s (NYSE: M).

Investors interested in taking advantage of Wal-Mart shares over the long-term may want to consider purchasing long-term options called LEAPS (or long-term equity anticipation securities). Currently, investors can purchase $55 January 2011 LEAPS calls for $12.95 per contract. This means that investors can buy the right to 100 shares at $55 anytime over the next 764 days for only $1,295 compared to $5,519 by purchasing the underlying stock.

Target Corporation (NYSE: TGT)

Target has recently been the target of activist investor William Ackman’s Pershing Square. The hedge fund noted the fact that the retailer owns the real estate under the vast majority of its stores and estimates that it could be worth roughly as much as the company’s current market capitalization. As a result, Pershing Square recommended that the firm spin-off the land portion of the real estate into an REIT that would lease-back the property to the stores via a ground-lease.

Theoretically, this plan would unlock tremendous value for Target shareholders. The new REIT would be forced to trade at a reasonable valuation given its massive size and security (having Target stores as collateral in the unlikely case of default). Meanwhile, Target’s strong cash flows and balance sheet make it one of the best tenants that any real estate owner could desire. Finally, Target would be unencumbered with many of the costs associated with purchasing land for new stores (now covered by the REIT.

Investors looking to take advantage of this situation may want to consider a pair trade between Target and the retail ETF (NYSE: XRT). One Target LEAPS call and one retail ETF LEAPS put with the same dollar amounts will create a situation where investors will only profit when Target outperforms the retail sector. This means that no losses will be incurred when the retail sector declines, only when Target sees its value unlocked or comes to value.

Aeropostale Inc. (NYSE: ARO)

Warren Buffett chose to invest in this specialty retailer for a good reason: Aeropostale has no debt, strong cash flows, and an easy to understand business. Shares may be down some 32 percent over the past year, but the firm’s fundamentals remain very strong. Return on equity stands at a huge 54 percent while operating and profit margins remain strong despite the uncertain economy. Finally, the firm’s $100 million in free cash flow generation certainly has many investors interested.

Investors looking to make a bet on this stock may also want to take a look at long-term LEAPS options. Currently, investors can purchase $20 January 2011 LEAPS calls for just $6.60 per contract. This means that investors can have the right to 100 shares at $20 per share anytime during the next 764 days for just $660 down compared to $1,747 for the underlying stock.

See “Using LEAPS as a Stock Substitute” for more information.

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