Target (NYSE:TGT) is one of the companies that reminds me of the old Peter Lynch quote “buy what you know”. When I first invested in the company in 2016, much of retail was left for dead due to the rapid expansion of e-commerce. My thesis was easy – every time I went to a Target it was almost annoyingly slammed, it had a long and profitable operating history, and people still wanted to shop in stores. It worked out. Target was considerably undervalued then, and the best retailers made it through that time of uncertainty and regained their rightful valuations. However, the future is a little murkier from here. I’ve covered many retailers I see as pretty obvious long-term winners. There’s a recipe for success, and it revolves around either finding a profitable niche like TJX (NYSE:TJX), Tractor Supply (NYSE:TSCO), or Dollar General (NYSE:DG), or building out omnichannel at sufficient scale as to face up to the Amazons (NYSE:AMZN) of the world head-on, like Walmart (NYSE:WMT), Williams-Sonoma (NYSE:WSM), Lowe’s (NYSE:LOW), and Home Depot (NYSE:HD).
If anything, Target is definitely in the latter group. The stores do have differentiated brand offerings, but these are unlikely to be sufficient in a vacuum to drive the next decade of profitable growth for the company. Target’s customer base is relatively loyal, in some regards, but the winds could easily shift with management missteps. Target’s position in the market is not nearly as insulated as the companies I mentioned above, but it does seem like management is taking the right steps to set the company up for success. However, the next few years will tell the story of whether Target will be able to maintain its competitive position and remain among the elite retailers in the market.
Over the past two decades, Target has maintained its 55-year streak of dividend increases, and compounded the dividend at around 15% a year. With that, total returns have beaten the market with a CAGR of 10% against 8.8% from the SPY. It’s not necessarily worth writing home about, but Target offered those market-beating results in a relatively low-risk and long-term profitable company.
The last year was rough for the company. Free cash flow swung negative for the first time in many years on the back of an unexpected decline in profitability and outsized capex. Management is expending considerable effort and capital into sortation centers for delivery, the launch of drive-up returns later this year, and continued remodeling and new store layout initiatives. Brian Cornell has done a good job, in my view, of steering the ship since he took over. Starting with the acquisition of Shipt several years ago, Target has rapidly transformed itself into an omnichannel retailer using its installed store base as hubs. 95% of all sales are facilitated by stores, and although the store count has increased only slightly since 2019, sales have increased 40% in the past four years. Q4 comparable store sales were up .7% on the back of 9% gains the year before, and 2022 was up 2.2% on the back of 13% gains. Traffic increased 2.1%, and management discussed 3 of the top 10 fastest growing private label brands in 2022 were owned by Target.
Target’s secret sauce today doesn’t give me enough confidence to assign a premium to the company. There is a very specific customer who likes to shop at Target, and I assess there’s solid brand loyalty. Young middle-class mom’s swarm the stores on the weekends, resulting in 170M Starbucks beverages sold last year. There’s a ritual to it, and the company’s investments into Target Circle and its digital advertising initiative should help continue to foster that loyalty. The new initiative with Ulta Beauty (NYSE:ULTA) seems like a logical move in-line with the decision decades ago to partner with Starbucks. Ulta has significant brand loyalty and caters to a similar customer cohort as Target and could assist the company in bringing in traffic for consumable beauty items.
The company’s omnichannel investments have driven average cost of fulfillment per unit down 40% over the past 4 years, and the full embrace of the concept was a necessary move for Target to remain relevant over the long-term. In a perfect world for retailers, they wouldn’t have had to make these moves, as they are likely somewhat value-destructive. Customers are more likely to purchase additional items, browse, and spend more money if they come in the store than just placing an order online. However, as customer behavior has changed, Target could have gone the way of the dinosaurs without making the shift with them. Despite the recent operating weakness, I believe the success of the company’s initiatives and the shrewd decisions made by Brian Cornell should keep Target marching forward as a GDP-plus business.
However, SG&A to revenue ticked back up and is projected to increase further this next year on anemic sales growth. Management is projecting a low single digit decline to low single digit increase in comp’s for 2023, and overall is maintaining wide bands on projections in the face of weak discretionary demand from customers. Target differs significantly from Walmart in its core offerings. Although food and beverage has grown double digits for three consecutive years and now accounts for around 20% of revenues, it’s not at the core of the store’s offering like it is for Walmart. This has historically resulted in higher operating margins for Target, since the discretionary purchases are higher margin than food items, but it drives less predictable traffic to stores.
SG&A to revenue has declined meaningfully since 2019 on the back of strong revenue growth, so some increase isn’t worrisome at this juncture. The metric is still in a solid spot compared to peers.
Operating margins were crimped pretty significantly this past year. Management is projecting a return to 6%+ as early as 2024 as discretionary demand resumes, but for now we should expect a small recovery in 2023 until the picture becomes clearer. The past year quickly closed the gap between Target and Walmart, and if this continues and margin expansion doesn’t appear, it would be cause for concern.
Excess inventory, capex investments, supply chain issues, and poor margins resulted in negative free cash flow this past year. I don’t expect that to continue. Target has long been able to consistently cover its dividend and increase it every year, so I consider 2022 to be an outlier. However, this does paint a good picture for investors looking out at the long-term. Due to the more discretionary purchases Target relies on, it’s less shielded from recessionary pressures than Wal-Mart and some other retailers, like Dollar General.
The debt load is creeping up, but its serviceable. Management has halted share buybacks, which seems appropriate, and are projecting $4-5B in capex in 2023. If the company’s investments pan out, when the recessionary pressures abate the company’s financial position should meaningfully improve.
Looking at earnings over time, it’s pretty obvious 2022 was rough for the company, coming on the back of a banner year in 2021. The company was excessively bid up like many in the market, so I hope not too many Seeking Alpha readers were chasing it up near $300. The P/E ratio today is above long-term multiple on depressed earnings, which are projected to bounce back this next year.
Based on a return to average long-term multiples, which seems appropriate, and analyst estimates for earnings growth, an investment today could yield around 11.5% annualized total returns over the next three years.
In all, I’m not excited to invest in Target stock today, but it’s a buy looking to economic recovery, margin expansion, and some small level of top-line growth as the company’s initiatives play out. You’re getting a Dividend Aristocrat that has a long and storied history of returning capital to shareholders. I’d personally wait for a little more margin of safety, or for a little more clarity in the economic recovery, but you likely won’t get both. Target management is making the right moves, but this investment would require a little more homework and observation than some of the long-term compounders I like to hold.
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