1. Is the company undervalued?
EV/EBIT: 10.9
EV/Sales: 0.82
Price/Book: 6.62
Tarjay is the #1 big box retailer for middle class women across the United States. The company is also extremely durable with a 120-year history. Notwithstanding $TGT just reported a huge miss and investors are worried this could be a precursor for more pain ahead. However Target is priced quite reasonably and returning a sizeable amount of capital back to shareholders. Additionally topline growth remains strong, so if profitability concerns abate investors could hit a bullseye by buying at today’s prices!
2. Can I easily explain what the company does?
Yes, they’re a general merchandise retailer. Selling; groceries, apparel, décor, electronics, etc…
3. Does the cash flow statement line up with income statement?
Yes, cashflows have been consistently higher than reported earnings:
Most of their cash went towards; share buybacks, inventories, capital expenditures, dividends paid out, and debt repayment. The obvious issue here is the build up of inventories which is up ~43% YOY. Additionally the CEO flat out said they screwed up by ordering too much of the wrong product. While this is obviously bad, I give $TGT credit for owning the mistake and taking full accountability. This reminds me a lot of infamous presser given by legendary coach Jim Calhoun:
Replace Emeka Okafor with bulky discretionary items and the message is virtually identical!
4. Is the Balance Sheet Healthy?
Total Cash: $1.1B
Total Debt: $16.7B
Current Ratio: 0.99
$TGT does hold some debt relative to their market cap. Although they’re only paying ~$420M annually in net interest on the outstanding debt. Even if you assume a much lower 6% EBIT margin in 2022, that’s over 15X coverage. Because of this Target’s balance sheet is sound.
5. How profitable is the business?
Gross Margins: 28.3%
Operating Margins: 7.5%
Net Margins: 5.5%
Being a retailer who sell groceries, it shouldn’t surprise anyone to see a lower margin profile. Moreover inflation is having a severe impact on margins for $TGT as they’re eating some input costs. To further exacerbate the problem $TGT has higher shipping expenses, increased labor costs, and had to mark down inventory. The ending result was a 5.3% EBIT margin in Q1, which is well below the guidance they gave of 8% or higher back a few months ago. The good news is that macro is causing these headwinds and there’s nothing structurally wrong with the business. On the other hand these issues maybe stickier than bulls think, and a 25% drop in margin guidance is certainly not a good omen.
6. What is the company’s growth potential?
10-yr Revenue Growth: 4.3%
10-yr Operating Income Growth: 4.84%
10-yr FCF Growth: 5.31%
The trailing data is probably understating Target’s growth. For example, if we use 2017 as a start date operating income has grown at 10.69% annually. With that said the business is much more mature and therefore harder to grow. Management thinks they can hit mid-single digit growth long term, which to me seems reasonable. Facing tough comps last quarter; same store sales and e-commerce still grew at ~3.3% YOY. Demand doesn’t seem to be an issue, so the long-term thesis remains intact.
7. Is management rewarding shareholders?
Target currently offers investors a 2.3% dividend and have $2.75B remaining on their share repurchase program. Management also hinted they plan on raising their dividend by a mid-teens % next quarter. Conversely they stated share repurchases will likely be clawed back due to lower profitability.
This is gonna piss off some dividend growth dipshits, but that makes zero fucking sense! $TGT bought back over $7.3B worth of stock last year at a ~16.5X EBIT multiple, but don’t want to repurchase shares at 11X EBIT?!?!?!?! It’s remarkable how many CFO’s suck at capital allocation, the only time dividends are preferred is if the company is trading above intrinsic value! If you want a dividend check in the mail every month, go buy an annuity from some idiot sales guy who claims to be a “fiduciary”.
Getting back on track here, operating income should come in around $6.6B this year if you assume 5% topline growth and a 6% EBIT margin. With ~$4.5B in CAPEX spending, that leaves investors with a ~2.8% expected shareholder yield (net of SBC). That’s really not that great for a low growth company, but could be significantly improved if margins expand.
8. How does the company stack up against their peers?
Target’s closest competitor is Walmart Inc $WMT:
$WMT EV/Sales:0.67
EV/EBIT: 16.47
Operating Margins: 4.2%
$WMT is objectively a lower quality business, which trades at a hefty premium to $TGT. Additionally they return about the same amount of capital back to shareholders and have a similar balance sheet. Furthermore Walmart focuses on lower end consumers, who are more affected by inflation. For these reasons, $TGT seems like the more attractive risk adjusted bet.
9. What’s the counter argument?
The counter argument is that consumer spending is about to fall off a cliff and so will Target’s earnings.
I do think margins will certainly be lower near term, but the consumer demand argument doesn’t make much sense to me. Target is clearly getting customers in the door, it’s execution were they’re falling short. For instance, grocery and beauty sales were up double digits YOY. Simply put management purchased merchandise that customers were unwilling to buy. I don’t think this problem persists for more than a quarter or two and by that time inflation will likely be lower.
10. Is there something I think the market may be missing?
Mr. Market appears to be over extrapolating this recent quarter out into the future. However I would contend that management is playing the long game. While shareholders would prefer higher margins, management is doing everything in their power to reward customers. This builds loyalty and will potentially lead to market share gains as $TGT under cuts competition. Eventually margins will improve and Target will be well positioned when that occurs.
Final Thoughts:
My base case would be 5% revenue growth long term, EBIT margins normalizing around 7.5%, and a 3% shareholder yield annually. If you apply a 15X EV/EBIT exit multiple, that works out to a ~14% expected return. This is pretty solid for a durable name like $TGT, but there are better opportunities elsewhere IMO. Additionally there’s probably near term pressure on the stock and I don’t think Mr. Market is going to reward shareholder until margins improve. For that reason it’s a pass, but something worth monitoring as $TGT has traded down to a single digit multiple in the not so distant past.
***Disclosure: I have no position in the security mentioned above, nor do I have any plans to purchase within the next 72 hours. This article is intended for educational purposes only and in no way should be interpreted as investment advice