Target the tanks, but there’s room for optimism (NYSE:TGT)

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By the Valuentum team

Target Corporation Shares (NYSE: TGT) was beaten on May 18 after the retailer released a disappointing earnings update and lowered its guidance for fiscal 2022 (for reference, its fiscal year ends in January). The company has its work cut out in the wake of major headwinds, namely inflationary pressures, supply chain hurdles and labor shortages.

At the low end of our fair value estimate range (derived from the company’s cash flow analysis process that we’ll discuss in this article), we assign Target an intrinsic value of $176 per share, which indicates that the May 18 sale might be a bit of a stretch. . Target is a dividend aristocrat with a strong cash flow profile and improved digital operations. TGT shares are yielding around 2.2% at the time of this writing.

Investment Highlights

Target sells basic necessities and differentiated items at discounted prices. In recent years, its e-commerce business has exploded. A significant portion of its total sales is tied to its own (Archer Farms, Circo, etc.) and proprietary (Fieldcrest, Nick & Nora, etc.) brands. The company has increased its payouts for the past ~50 consecutive years, earning Target the coveted status of a dividend aristocrat.

Over the past decade, Target has made great strides. It sold its consumer credit card portfolio in the United States in March 2013 and its pharmacy/clinic business in December 2015. Additionally, Target announced that it would abandon its Canadian expansion efforts altogether. in calendar year 2015. We believe such moves could also make the retail giant dependent on the US consumer as these are long-term organic growth opportunities.

Target’s digital initiatives have borne fruit, helped by its acquisition of Shipt which was announced in December 2017. Consumers are increasingly using its options for home delivery, curbside pickup, online ordering and in-store pickup. However, online competition remains fierce. As the United States puts the worst of the coronavirus (“COVID-19”) pandemic behind it, Target’s digital sales will face near-term headwinds as consumers resume in-person shopping activities .

Going forward, Target is rolling out store-in-store concepts in select locations. Additionally, Target is steadily rolling out smaller store formats and intends to continue to do so in the future. These efforts are aimed at boosting its organic sales while improving its profitability levels. It is also looking to increase the profitability of its digital operations and is investing in its distribution and sorting operations to contribute to this.

Economic profit analysis

The best measure of a company’s ability to create value for its shareholders is expressed by comparing its return on invested capital [‘ROIC’] with its weighted average cost of capital [‘WACC’]. The gap or difference between ROIC and WACC is called the economic profit gap of the firm. Target’s historical 3-year return on invested capital (excluding goodwill) is 31.1%, which is higher than its cost of capital estimate of 8.6%.

In the upcoming chart below, we show the likely trajectory of ROIC over the coming years based on the estimated volatility of the key drivers of the metric. The solid gray line reflects the most likely outcome (our “base” scenario for Target), in our view, and represents the scenario that results in our estimate of fair value. Additionally, the blue dots represent our “bullish” case scenario and the green dots represent our “bearish” case scenario for Target. Even in our downside scenario, Target would still be a good driver of shareholder value.

Chart of Target's historical and forecasted ROIC, as derived by Valuentum Securities.

Target is a strong shareholder value generator. (Valuen Titles)

The upcoming chart below shows how we calculated Target’s estimated WACC.

Calculation of Target's estimated WACC, as derived by Valuentum Securities.

How we calculated Target’s estimated WACC. (Valuen Titles)

Financial analysis

Target is a tremendous cash flow generator, although the strength of its balance sheet needs to be watched. From fiscal year 2019 to 2021, Target generated approximately $5.7 billion in free cash flow on average per year, defining free cash flow as net operating cash flow less capital expenditures. Its annual dividend obligations were $1.5 billion in fiscal 2021, and Target has historically spent lavishly on stock buybacks.

On May 18, Target announced first quarter results for fiscal year 2022 (period ended April 30, 2022) that exceeded broad consensus estimates, but missed broad consensus estimates. Target was only able to pass on some of the inflationary pressures it faced via price increases to its customers.

While Target’s GAAP revenue grew 4% year over year last fiscal quarter, helped by its comparable sales up 3%, its GAAP operating profit fell 43%, its margins gross having been hit by inflationary pressures and its operation, spending has exploded. Target’s digital sales grew 3% year-over-year in the fiscal first quarter, down from the dizzying growth rates seen in the same period last year, but still decent given the high base to which this measure was compared. The company’s GAAP diluted EPS was down 48% year over year to $2.16 in the last fiscal quarter.

Target came out in April 2022 with $13.4 billion of net debt on the books (including short-term debt). Its short-term liquidity includes its available cash and cash equivalents, which amounted to $1.1 billion at the end of April 2022, and its $3.0 billion unsecured revolving credit facility which matures in October 2026. Target remains one of the industry’s leading retailers. and has an excellent A-rated (A2/A/A) credit rating. In light of the pressures Target faces and its large net indebtedness, management may reduce the pace of the retailer’s share buybacks going forward (which totaled $9.7 billion from fiscal 2019 to the end of the year). 2021 financial year).

Table of Target's historical cash flow profile.

Target is a strong cash flow generator, although the strength of its balance sheet needs to be watched. (Valuentum Securities, with data from Target)

Target released a sharply reduced guidance for fiscal 2022 on May 18 from the guidance it issued in March 2022. Target now expects to post an operating margin of approximately ~6.0% over the course of the year. fiscal 2022 (vs. ~8.0% previously) and that its revenue will grow in the low to mid-single digits in that fiscal year on an annualized basis (same as its previous guidance). In fiscal 2021, Target’s GAAP operating margin was 8.4%. Target’s guidance for the second fiscal quarter was also lackluster, underscoring the immense headwinds the company faces.

Evaluation analysis

Our discounted cash flow process values ​​each business based on the present value of all future free cash flows, while taking into account its net balance sheet considerations. We think Target is worth $220 per share with a fair value range of $176 to $264. Please note that in the current environment, the lower end of our fair value estimate range is a more useful benchmark given the pressures the retail space is facing. The short-term operating forecasts that we have used in our business cash flow models, including revenue and earnings, do not differ significantly from consensus estimates or management guidance.

Our valuation model reflects a revenue compound annual growth rate of 3.7% over the next five years, a pace below Target’s historical 3-year compound annual growth rate of 12%. Our valuation model reflects a projected 5-year average operating margin of 8.4%, which is above Target’s 3-year average, although the lower end of our fair value assumes a significantly reduced average operating margin over this period. Beyond year 5, we assume that free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For Target, we use a weighted average cost of capital of 8.6% to discount future free cash flow.

Table of key valuation assumptions used by Valuentum Securities to arrive at Target's fair value estimate.

An overview of the key valuation assumptions we used to arrive at Target’s fair value estimate of $220 per share. (Valuen Titles)

Although we estimate the company’s fair value at approximately $220 per share, each company has a range of likely fair values ​​that is created by the uncertainty of key valuation factors (such as future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets, as stocks would trade precisely at their known fair values. In the upcoming chart below, we show this likely range of fair values ​​for Target. We think the company is attractive below $176 per share (the green line), but quite expensive above $264 per share (the red line). Prices that fall along the yellow line, which includes our estimate of fair value, represent a reasonable valuation for the business, in our view.

Chart of Target's fair value estimate range, as derived by Valuentum Securities.

Fair value estimate range of the target. (Valuen Titles)

Final Thoughts

Target faces many hurdles, even though the retailer remains one of the best in the industry. Management will likely do whatever it takes to preserve Target’s coveted dividend aristocrat status. Target has several initiatives underway that aim to improve its organic sales growth trajectory and underlying long-term profitability, and its free cash flow generation capabilities are impressive. We remain on the sidelines for now, but if Target’s technical performance improves as selling pressures ease, TGT shares could recoup some of the lost ground.

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