This week has seen a barrage of earnings reports from retailers. There might not have been a better received report than that of Target Corp. (TGT, Financial). The company reported results before the opening bell on Wednesday. By the end of the trading session, the stock had gained nearly 13% compared to the previous day's close.
Target's stock has increased 81% over the last 12 months, an incredible climb that dwarfs the 16.7% return of the S&P 500 Index. After this rally, Target is now the third-largest position in my portfolio. Shares of the company sit very close to an all-time high as I write.
Quarterly results and valuation analysis
Target released earnings results for the second quarter on Wednesday. Revenue increased 24.7% to $23 billion. The company's revenue total was $2.9 billion above what Wall Street analysts had anticipated. Adjusted earnings per share increased $1.56, or 86%, to $3.38. Analysts had actually expected the company to show a decrease for earnings, but Target topped estimates by $1.73.
To put it another way, Target's beat of analysts' predictions was larger than what the market had expected the company to earn per share for the quarter.
The average share count was down 2.3%, but nearly all of the gains in adjusted earnings per share were due to significant growth in sales.
Second-quarter comparable sales increased 24.3%, which was a company record. This result was much better than consensus estimates of growth of 7.6%. The number of transactions increased 4.6%, but the average transaction size was the real story as this metric grew nearly 19%. Consumers were shopping more than usual, but they were also spending a considerably higher amount each time they shopped.
Target's results were excellent even as consumers faced stay-at-home directives throughout the second quarter. Despite this, in-store comparable sales were up 10.9%. This was impressive in its own right, but digital sales were very strong as they contributed 13.4% of comparable sales growth.
Digital sales were higher by 195% year over year. For the quarter, stores fulfilled more than 90% of sales. Same-day services, which includes order pick up, drive up and Shipt, were 273% higher. While consumers were stuck at home for various portions of the quarter, they still shopped at Target. Digital fulfillment costs declined 30% from second-quarter 2019 as the company has gotten a better handle on the cost of these services.
Both in-store and digital growth contributed to gains in market share in all of the company's core merchandising categories. Total market share capture was nearly $5 billion in the first half of 2020.
Gross margins improved 30 basis points to 30.9%, while operating margins grew 280 basis points to 10%. Expenses were up 14% to $4.5 billion due to higher compensation costs, but accounted for just 19.4% of total sales. This was an improvement from 21.2% in the previous year.
Target's balance sheet remains in pristine condition. As of Aug.1, the company has $17.6 billion in current assets, including $7.3 billion in cash and cash equivalents. The company had just $1.7 billion in cash and cash equivalents at the same time last year. Current assets also include $8.9 billion in inventory, which is down 3% from the second quarter of 2019. Target has $15.9 billion in current liabilities, but just $109 million of long-term debt and other borrowings are due within one year. Long-term debt stands at $15.9 billion. Target appears well able to handle any difficulties that may come from Covid-19 due to its liquidity. The company is also operating a bit leaner in terms of inventory than the previous year.
The company's free cash flow was $3.7 billion for the first half of the year, which more than covered $706 million of share repurchases and $662 million of dividend payments. Target paused its share repurchases after March, but does have $4.5 billion, or 5.8% of its current market capitalization, remaining on its authorization.
Target pulled its guidance following the first quarter due to the uncertain impact of Covid-19 on the economy.
An excellent quarter overall for Target, one that the market recognized and sent the share price surging to a new high. But what about valuation?
According to Seeking Alpha, all 21 Wall Street analysts that cover Target raised their estimates for the current year following the earnings announcement. On average, they expect that Target will earn $7.19 per share in 2020.
Using the current share price of $155, Target's stock has a forward price-earnings ratio of 21.6. This is cheaper than the average multiple of 29.1, but higher than its historical valuation.
The stock has averaged a price-earnings ratio of 14.6 and 14.8 since 2015 and 2010, respectively. The valuation has been rather consistent over both the medium and long term. This would mean that Target is currently overvalued by at least 31% using current earnings per share estimates and the 10-year average earnings multiple.
Final thoughts
Shares of Target have had an excellent performance over the last year. The company's performance in the second quarter showed the strength of consumer demand for products. A comparable sales record speaks for itself and were driven largely by digital sales. The company's digital performance is a key point as this quarter showed consumers are more than willing to adapt how they shop at Target.
Compared to peer Walmart Inc (WMT, Financial), which had an excellent quarter itself and has a forward price-earnings ratio of 25.3, Target is the much cheaper of the two discount retailers.
Target also offers a dividend growth streak of 53 years and pays a 1.8% dividend yield, though this would be the lowest average yield since 2010 if the stock were to average the current yield for the entire year.
Based on Target's second-quarter performance, I am willing to pay a higher-than-average multiple for the stock. I believe a price-earnings ratio range of 17 to 19 takes the stock's historical performance and recent business results into account. With an already large position in the company, shares of Target would need to fall to at least $137 before I would consider adding more of the stock.
I don't believe Target is a sell based on the strength of results and dividend growth streak, but I do consider the name to be a hold due to the stock trading near its all-time high.
Disclosure: the author has a long position in Target and has no plans to sell in the next 72 hours.
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