Target sold off 15% last week even though the company’s comps were better than Walmart.
Target has some sales catalysts in digital and toys.
Margins are structurally lower, but this was expected.
Shares look undervalued, and I’ll initiate below $65.
Shares of Target (TGT) dropped a whopping 15% over the last week when the company posted lighter than expected revenue growth for its third quarter. On a two-year stacked basis, however, the company has outperformed rival Walmart (WMT), which also posted disappointing numbers. While shares are not trading at the bargain basement levels seen in the summer of 2017 (could also be named: the summer of Amazon (NASDAQ:AMZN)), I believe the market is overly punishing the company for structural issues that are lowering the operating margin profiles of multiple companies. As a result, I believe shares of the retailer are worth $85, and I would be interested in initiating a position at the $65 level, which I believe provides a sufficient margin of safety.
Comp Growth Strong Driven by Traffic
Among the most positive aspects of Target’s Q3 was its traffic comp. Although total same-store sales were up 5.1%, traffic was up 5.3% y/y, suggesting that store remodels and continued investments in demand generation are attracting visitors more frequently. Though a 0.2% decline in average spending is not ideal, I am much more encouraged by the offsetting growth in customer traffic. On a two-year stacked basis, Target now sits at 6%, which is just slightly below Walmart’s 6.1% increase. Importantly, Walmart’s comps in Q3 were up a more modest 3.4%, suggesting that some momentum may be swinging in favor of Target. With revenue up at existing stores and some additions to the store base, total revenue was up 5.7% y/y to $17.6 billion.
There were some particularly impressive aspects of the quarter that I believe portend good growth in upcoming quarters. Digital sales were up a whopping 49% y/y, and Target has materially improved its digital offering by shipping from stores, adding subscription services, and better order fulfillment times. Although Amazon is far and away the leader in e-commerce, Target and Walmart are clearly catching up. Both are successfully able to leverage their existing brands to attract customers online, and it is possible that both are gaining some market share. Walmart’s digital sales in the US were up 43% y/y, while Amazon’s product growth was likely somewhere in the mid-to-high 20% range.
In addition to strong online sales, Target is doing a great job of capturing the toy sales that leaked into the marketplace with the Toys «R» Us closure. Q4 is undoubtedly the biggest season of the year for toys, and I think Target is going to see a material uplift. Toys comped up more than 20% in Q3, and I think this number could accelerate, especially as the company has increased its toy square footage in 500 stores and completely recreated its toy department in 100 stores. As customers become more familiar with Target as a toy destination, I think the momentum will pickup.
Margin Compression – A Known Issue
As has been the theme throughout Q3 earnings, Target lost gross margin due to increased freight and fulfillment costs. Gross margin was down 90 basis points y/y to 28.7% of sales. After reviewing the majority of earnings reports from retailers, unless there was a merchandise margin uplift in Q3 ’18 from comping against heavily discounted product in Q3 ’17, then gross margin fell with higher freight costs. Such is simply the dynamic in retail at the moment, and a company like Target with high China exposure will also have to mitigate tariffs.
Overall, operating margin was down just 40 basis points y/y to 4.6% of sales. SG&A was roughly flat at 22.1% of sales. I consider this performance admirable, particularly in light of higher labor costs across all of retail. In fact, Target is one of the companies that best mitigated this increase. Target is on a path to $15 minimum wages by 2020, and because of this known increase in labor cost, I suspect Target is somewhat ahead of the game in planning spending to keep margins flat or up by focusing on cost reduction elsewhere.
Ultimately, operating margin will likely be in the 4-6% range on a sustainable basis. Although Target has posted numbers above this range fairly consistently, I think the nature of the business is changing, and the retailer will have to settle for a lower level of profitability. However, this will ensure the long-term survival and success of the business.
Capital Allocation: Not Exactly Savvy in Q3
I love to look at the quarterly cadence of buybacks for different companies. Foot Locker (FL) is a prime example of a company that times buybacks relatively well. Target does not. The company bought back a whopping $526 million worth of stock at $84 per share. This price looks terrible considering that shares are now trading at $67.35. Even worse, Target spent $305 million on buybacks in Q1 ’17 at $61.68, $296 million on buybacks at an average price of $52.45 in Q2 ’17, and $171 million on buybacks at an average price of $57.58 in Q3 ’17. Target deploys a classic animal spirits mentality, and the company does not seem poised to execute buybacks at the most desirable time.
In addition, the company raised its dividend in 2018. It was just a modest 3.2%, but I do not believe increasing the dividend does anything to improve shareholder value. I’d rather the company keep its coffers full so it could repurchase its stock when its cheap. Admittedly, this does not seem to be management’s strong suit.
Shares Still Look Cheap on a Multiple and DCF basis
Target should comfortably be able to earn $5.40 per share, which would equate to about 12.5x, which looks relatively cheap for a company that can generate a mid-teens ROIC and $2-4 billion in free cash flow. There are certainly some near-term capital expenditures that weigh on near-term free cash flow, but over the long haul, the company will be generating $4 billion in cash annually, in my view. I can easily derive a DCF valuation in the $80-90 range, which leaves me with a midpoint target of $85.
Management is not the savviest when it comes to capital allocation, but the team has demonstrated the ability to drive traffic growth and adapt to e-commerce. I will purchase shares if they fall below $65.
Disclosure: I am/we are long FL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
