The major story of inflation affecting corporate costs and reducing margins is commonplace now, but one of the highest-profile cases occurred this week with Target Corp. (TGT, Financial). The company’s stock fell almost 25% on Wednesday after reporting difficult first-quarter earnings, its largest one-day decline in many decades.
Target is a general merchandise retailer operating predominantly in the U.S. The company offers grocery items, apparel, accessories, home décor products, electronics, toys, beauty and household essentials and seasonal offerings. The company sells its products through brick-and-mortar stores and digital channels, including Target.com. The company operates approximately 2,000 stores. Target was incorporated in 1902 and is headquartered in Minneapolis. The company currently has a market capitalization of $70.5 billion and generated $106 billion in revenue last year.
Recent success
The company has shown very strong growth results in the past two fiscal years. This was in part due to a strong omni-channel presence. This means Target customers can choose between online purchase and delivery, online purchase and pick up in store, or the traditional method of visiting one of their large physical stores with average approximately 170,000 square feet. The retailer has stated that over 10 million customers can be considered “multi-channel,” meaning they utilize more than one of those three shopping options. According to the company, multi-channel consumers spend four times more than a physical store-only shopper and approximately 10 times more than a digital-only shopper.
Owned brands
In order to enhance its margin profile, Target has had good success developing its own brands. The company owns almost 50 different private label brands, which now represent close to one-third of total sales. Some of these private label brands include Archer Farms, Cat & Jack, Simply Balanced and Market Pantry. These higher-margin products may help offset some of the pricing pressure imposed by large competitors such as Walmart Inc. (WMT, Financial).
First-quarter earnings review
The company ran head-on into the higher cost trifecta affecting so many companies today, which include higher input costs, wage increases and supply chain and logistics issues. Target had additional negative issues, including higher markdown rates that were largely driven by inventory impairments and other actions necessary to address lower-than-expected sales in discretionary categories, particularly large-ticket items.
The sales growth was reasonable as comp sales increased 3.3% for the quarter, which was up against a very strong comp of 22.9% in the prior period. Online and mobile comparable sales increased 3.2%, but also against a tough comp of 50.2% in the prior period. Due to the issues mentioned above, margins were hit hard. The gross margin declined to 25.7% from 30% last year and operating margins decreased to 5.3% from 9.8%. Adjusted earnings per share decreased a stunning 40.7% from a year earlier.
This created a large reversal of operating cash flow in the quarter, which showed a use of cash totaling $1.4 billion compared to positive operating cash flow of $1.1 billion last year. This negative cash flow combined with a $2.75 billion related to previous share repurchases reduced cash levels from $5.9 billion to $1.1 billion. This significantly increased the company's net debt leverage ratios.
Valuation
Analysts have been busy ratcheting down earnings estimates for 2022 after this week's quarterly release. Most earnings per share estimates had been in the $14 to $15 range and are coming down to the $10 to $11 range. This means Target is selling at approximately 15 times this fiscal year's earnings. If these cost issues go away next year, a resumption of normal earnings power could be realized and the company could earn back into the $14 range, which would make Target a cheap stock.
The recent price swoon has brought the dividend yield up to a reasonable 2.23% based on an annualized dividend payment of $3.60 per share.
Guru trades
Gurus who purchased or added to their Target positions recently include Joel Greenblatt (Trades, Portfolio) and Ray Dalio (Trades, Portfolio). Gurus who have reduced or closed out their positions include Ken Heebner (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio).
Conclusion
Target appears to be deeply undervalued when taking a long-term investing approach. If one assumes that wage pressures, higher fuel costs and supply chain issues will return to normal in the near future, then Target is trading at low valuation levels. The company has survived many difficulties in its 100-year history, and will likely survive this one as well.
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