Retail stocks worth adding to investors' wish list

This may be a sweet spot for the retail industry with the markets on the comeback trail after favourable midterm election results and bright prospects for leading retailers as they count down to the festive shopping jamboree. Moreover, the current market volatility has knocked down valuations and may have placed select blue-chip retail stocks in the shopping carts of some investors.

One of the highest-grossing online retailers globally,  Amazon (AMZN) rang up US$178 billion in net sales in 2017.

The retail giant has an almost unrivalled global reach, scale, logistics capabilities and brand equity, all of which continue to grow year after year. "Amazon is the most disruptive force to emerge in retail in several decades," says a Morningstar report. "Its operational efficiency, network effect, and a brand intangible asset built on customer service provide it with sustainable competitive advantages that few, if any, traditional retailers can match."

With more than 410 million global active users, the company is particularly aggressive on the online retail side. "Amazon will maintain its consumer proposition through the convenience of Amazon Prime's expedited shipping, expanding digital content library and new partnerships from its Whole Foods acquisition," says Morningstar sector strategist R.J. Hottovy, asserting that Amazon has built one of the widest moats in the consumer sectors and "is likely to reshape retail, digital media, enterprise software and other categories for years to come."

The e-commerce behemoth has continued to outpace global online retail trends with 14% annual growth in active users, 25% annual growth in total physical and digital units sold, and 31% annual growth for third-party units sold, says Hottovy who puts the stock's fair value at US$2,200.

The premium valuation, he argues, is supported by solid competitive advantages, growth prospects and longer-term margin expansion potential. Stressing that Amazon's competitive position and compelling value proposition should lead to additional share gains in 2018, Hottovy projects revenue growth of 31% for 2018 and 22% annually through 2022, including contribution from Whole Foods and international expansion.

The largest retailer in the world with around US$500 billion in annual revenue,  Walmart (WMT) has 11,700 stores worldwide and has been aggressively pushing into online retail, as evidenced by its recent acquisition of a 77% stake in Indian e-commerce titan Flipkart.

A demonstrated value proposition for its customers and a cost advantage enabled by its vast size differentiate Walmart in a highly competitive retail landscape. "Walmart's position as a low-price leader supports its brand strength, one of the factors contributing to our wide moat rating," says a Morningstar report, which identifies the retailer's significant perishable selection (60% of sales) as a key driver of store traffic and another source of its competitive strength.

Investments in in-store initiatives to leverage its physical footprint, and improve its fresh food offering, should continue to bolster its competitive edge.

Walmart owns roughly 10% of JD.com and has bumped up its e-commerce game by splurging US$3 billion to scoop up Jet.com in 2016 and another US$16 billion to buy a 77% stake in India's Flipkart earlier this year. "Together, these give insights into the channel and close the gap with Walmart's biggest foe, Amazon," says Morningstar equity analyst Zain Akbari, who recently lifted the stock's fair value estimate from US$90 to US$96. "Its 11,700 locations allow it to play offense in winning these online sales by leveraging its locations close to the end consumer, also potentially positioning it to win out in fresh food delivery over time."

As a result of its vigorous thrust into e-commerce, Walmart can increase online sales by more than 30% annually (including Flipkart) over the next five years to more than 15% of overall sales, up from 5% in fiscal 2018, forecasts Akbari.

The third-largest retailer in the United States,  Costco (COST) is a leading operator of warehouse clubs with a strong presence in North America and a meaningful footprint across Europe and Asia. The membership-based company that sells food, fuel and general merchandise clocked more than US$140 billion in revenue in 2017.

Despite intense competition throughout retail, Costco's differentiated business model will keep its ability to generate outsize returns intact for the foreseeable future. "Costco operates a warehouse club model, deriving about 70% of its operating income from membership fees and the rest from below-average markups on merchandise, including fuel," says a Morningstar equity report.

With membership renewal and retention rates close to 90% globally, Costco currently serves 90 million loyal members from 760 one-stop-shop warehouses. "The high renewal rates suggest Costco benefits from a strong brand that stands for high quality and low cost," says the report.

This self-reinforcing business model prompts customers to shop frequently to justify the fees they pay to access Costco's low-price products. As a result, annual fees drive nearly three-quarters of the firm's operating profit annually.

Akbari says sticky membership and exceptional productivity generate strong returns on invested capital (18% in fiscal 2018), more than double its 7% cost of capital, and he notes that the trend will continue over the next 20 years.

Costco's enviable competitive advantage stems from cost efficiencies and a strong brand. "Costco boasts a minimalist warehouse structure and an efficient distribution system that allows it to sell merchandise at virtually zero economic profit," says Akbari, who recently raised the stock's fair value from US$175 to US$191, prompted by strong fourth-quarter results, incorporating 2019 price/earnings ratio of 25 times and a 5% free cash flow yield.