Target (NYSE: TGT) has struggled in recent months. Indeed, in their Publication of the results for the 1st quarter of 2022 we learned that they were filling the shelves with pandemic-era inventory that no one wanted. The target was forced to reduce inventory and increase promotional activities to clear shelves and make room for in-demand products such as food and household essentials. Target’s operating margin fell from 9.8% to 5.3%. Stocks did even worse, falling 25% in a single day. Investors should not expect Q2 2022 to be better. The company has already hit a 2% operating margin due to ongoing inventory headaches and inflationary pressures.
But if you take a long-term perspective and ask yourself, “What really changed in Target’s business between May 17 and May 18?” the answer is: not much. Yes, Target has some short-term headwinds to overcome, but with an impressive long-term track record, I believe they will manage to overcome these issues and get back to business as usual. They have already guided operating margins of 6% for the second half of 2022.
The only thing May 18 did for investors was to offer a discount on Target stock. Long-term investors can take advantage of Mr. Market’s offer for this iconic company.
Inventory optimization plan
The market was taken aback by Target’s missed Q1 2022 results, as evidenced by the 25% drop in share price, but management is taking the inventory issue very seriously. On June 7, Target announced a “Plan focused on inventory optimization.” Some investors don’t like companies providing long-term financial goals (i.e. perceived unrealistic expectations) or post-earnings PR (to save face), but I’m not not one of them.I appreciate the openness of management to resolve issues, but even more so, I appreciate the accountability that these kinds of announcements create.
An unprecedented economic situation
Investors are upset with Target for not predicting the future correctly, but is that fair? In December 2019, how many of us predicted a global pandemic, lockdowns, flash crashes, free money giveaways, historic rebound, crazy inflation, recession and war? For my part, I had not planned any of this.
Over the past 2 years, Target has had to evolve and stay nimble to meet ever-changing consumer demand. With record profitability of $6.9 billion in 2021, I say they’ve done a pretty good job. Maybe Target got a little complacent late last year and fell into the Fed’s “transitional” inflation trap, but who can really blame them for that? A short-term memory will help the investor at this stage.
Tear off the bandage
Target has taken and continues to take quick and decisive action to turn the inventory ship around. They could have dragged things out by refusing to reduce inventory or increase promotions, allowing margins and profits to slowly deteriorate, but they didn’t. This indicates that Target means businesses and other retailers, such as Walmart (WMT), could learn a thing or two from this approach.
Target’s Q2 will be even more painful than Q1. Management has already guided to operating margins of 2% due to continued inventory markdowns, removal of excess inventory and order cancellations. Investors should consider this more of a blessing than a curse.
Brian Cornell, President and CEO, had this to say in the Plan a targeted inventory Press release:
While these decisions will result in additional costs in the second quarter, we are confident that this rapid response will pay off for our business and our shareholders over time, resulting in improved profitability in the second half and beyond.
Target strives to re-establish a solid foundation to build for the long term, which includes:
- Focus on food and drink and household essentials and beauty and be very conservative in discretionary categories such as home
- Work with vendor partners to reduce costs and increase operational efficiency
- Increase supply chain capacity to meet demand by adding five new distribution centers over the next two years
lest you forget
Target is an iconic brand with an enviable long-term track record. This investment thesis is based on the assumption that Target will continue to do what it has done for the past 100 years – grow EPS organically and through stock buybacks and return excess cash to shareholders in the form of dividends.
As noted above, Target has grown EPS at an enviable 12.7% CAGR over the past 10 years. Much of this growth was supported by share buybacks which served to reduce the total number of shares outstanding. The target reduced the total number of shares outstanding from 663 million in 2013 to 493 million in 2021. This is a reduction of 2.9% per year. Shareholders reap the benefits as they end up with a bigger slice of the pie.
Target gave no indication that it would not continue to repurchase shares at a similar pace in the future, enabling similar EPS growth even with slow or stagnant earnings.
In addition to stock buybacks, Target also has a long history of paying dividends and increasing those dividends over time. Target has increased its dividend at a CAGR of 10.2% over the past 10 years. More recently, Target announced a 20% increase to their quarterly dividend, which shows further confidence in their ability to navigate short-term stock headwinds.
I performed a DCF analysis as well as a multiple market valuation for Target. Conclusion: Target’s current stock price of $157.50 is undervalued no matter how I slice it.
Using the DCF, I arrive at an intrinsic value of $223 which provides a 29% margin of safety at current prices. I used a discount rate of 8% and a terminal growth rate of 2.1%. I assumed that Target would continue to reduce total shares outstanding by 2.5% per year and increase FCF by 6% per year (well below the 10-year CAGR of 16.6%).
Using the market multiple approach, I arrive at a fair value of $280, which includes share buybacks but excludes dividends. I assumed revenue growth of 4%, net margins of 4.7% and a long-term P/E of 16, close to its 5-year average.
To be honest, it’s hard to find a bearish case for Target because they have such a long history of success. They have been around for over 100 years for goodness sake! Nevertheless, I will do my best.
My bearish case is that it takes Target much longer to resolve its inventory issues, driving subprime operating margins and profitability beyond 2022. This, coupled with demand destruction caused by an impending recession, could pose a risk to this investment thesis. Indeed, a difficult economic environment could lead to a halt in share buybacks and a reduction in the dividend, which would make my valuations too optimistic. I don’t think that negates the thesis, but it would certainly extend the time it takes for it to unfold.
Target is an iconic brand with strong fundamentals. And while past performance isn’t indicative of future results, it certainly lends credibility to Target’s ability to pull itself out of this hole. They tackle problems head-on, take quick and decisive action while holding themselves accountable to shareholders.
Tearing off the bandage is painful, but it’s the first step to healing. With a 30% Intrinsic Value discount, I’m ready to take a chance on Target and its ability to right the ship.