Description

Situation Overview

Target was an early pandemic winner:  as people were stuck at home, they scooped up its general merchandise by the fistful, sending comps up 20% in the period from May 2020 to April 2021.  Online sales, which had been 12% of revenue pre-pandemic, soared more than 100% to 22% of sales.  EBIT margin, which was 6% in FY19, grew to nearly 10% for several quarters.  Despite the big increases, Target was able to comp positively in FY22 (ended Jan. 2023), however the complexion of the growth was very different, and the quarterly trend decelerated meaningfully.  High-margin categories like apparel and Home Furnishings turned negative, but were offset by gains in Beauty & Household and Grocery.  In 2022, Target had to contend with the double-whammy of 1) too much of the wrong inventory – partially caused by over-extrapolating earlier successes, and partly due to supply chain delays resulting in seasonal goods arriving too late to be useful; and 2) inflation-induced shifts in consumer behavior away from discretionary goods and toward necessities like groceries and household consumables.  Rather than sit on lots of high-value and physically large merchandise for an indefinite amount of time, management opted to fire-sale the excess merchandise to make room for faster turning in-demand categories.  The result was gross and operating margins falling by 500bps in 2022.  2023 was also plagued with issues.  Though margins started to rebound, traffic turned negative in 2Q and 3Q as Target lapped the prior year’s heavy discounting and faced acute customer push-back over its Pride merchandise.  And shrinkage, a growing industry-wide issue, has kept a lid on margins, despite sales per sq. ft. and operating income that are 30% higher than pre-pandemic levels.  We expect same-store sales (“SSS”) and margins should rebound over the coming quarters as these idiosyncratic issues fade and merchandise mix normalizes.  Beyond that, any pick-up in industry-wide discretionary spending should accrue to Target’s benefit.  Our base case assumptions lead us to 2025 EPS estimates ~14% above consensus levels without baking in much of any benefit from announced efficiency measures which could yield another 100bps+ (16% to EPS).  With shares currently trading at a reasonable 16.5x consensus, we see the 14% - 30% earnings revision opportunity as sufficiently compelling in its own right, but think shares could also re-rate higher if the fundamental story plays out as we expect.

Business Description

With 1,956 stores and 246m sq. ft. of selling space, TGT is the 6th largest U.S. retailer by revenue and third largest general merchandise merchant behind Walmart and Amazon.  In contrast to Walmart, for whom grocery comprises 60% of revenue, grocery accounts for just 22% of TGT’s revenue.  As a result, TGT stores are more levered to discretionary spend than non-discretionary.  The chart below lays out the full breakdown of categories as well as their recent growth trend.  Per the company, approximately 53% of goods are discretionary.

Thesis

Negative traffic is transitory and will inflect positively as Target laps the inventory fire sale of 2022 and pride merchandise issue of May 2023.  The chart below lays out Target’s traffic, pricing, and total comp trend going back to 2013.  The duration of the chart makes it clear just how disruptive COVID was to the business, first driving average ticket higher as shoppers consolidated trips into fewer, bigger shopping sessions, and later as transaction count soared as consumers flocked to all manner of home goods, sports equipment, apparel, etc.  The excess traffic growth of the pandemic has been subsiding for the last two years but turned negative for the first time in 2Q23.  We believe there are two reasons for this negative inflection:  1) Target began to lap the extraordinary discounting implemented in 2022 to clear excess inventory; and 2) (likely more impactful) the conservative backlash to Target’s Pride month merchandise assortment.  Outside of the first months of the pandemic, there have only been three points in the last decade in which TGT’s traffic dipped negative (circled below).  In each case, there was some proximate cause that led to a portion of customers “going on strike”:  1) a 2013 credit card breach affecting 40m customers; 2) Target’s decision in 2016 to allow transgender customers to use a bathroom of their choosing, which prompted a conservative boycott; and 3) the May 2023 boycott over Target’s extensive Pride month merchandise assortment.  In the first two examples, traffic was depressed for 3 or 4 quarters and then bounced back nicely.  We expect the same will be true of the present situation. 

Examining the recent data more closely, traffic in 1Q23 was +0.9%.  It then fell to -3% in May, -7% in June, and -5% in July, and then was -4.1% for 3Q and -1.7% in 4Q.  Our expectation is that traffic will continue to improve sequentially, returning to positive territory sometime in the second quarter of 2023 and leveling out around 2%, its long-term rate, thereafter.

To provide context to Target’s recent traffic woes, in the charts below we compare its traffic performance to that of Walmart’s (WMT) domestic Walmart stores.  Despite the recent declines, Target has outgrown Walmart’s same-store traffic by approximately 16% in aggregate since 2019.  In fact, Walmart traffic levels today remain below pre-pandemic levels while Target’s are materially above.  Looking specifically at the last few quarters, we can see the sharp contrast in performance beginning in 2Q23 when the Pride merchandise issues began to make headlines, providing evidence that the issues at play are Target-specific rather than industry-wide.

Census retail sales data in key discretionary categories are showing early signs of inflection.  Recent industry-wide retail sales data indicates we may be at the start of a reacceleration in spending in key discretionary categories.  In the chart below, which maps out U.S. Census Retail Sales data, we can see a clear first quarter acceleration in Clothing and Electronics & Appliances, despite weather-induced softness in January.  In Furniture & Home, the second derivative is improving but the category continues to remain negative.  The industry data matters because TGT has historically been a share gainer across many of these categories, so to the extent the industry returns to growth, TGT should as well.

Gross Margins are currently depressed by transitory and fixable issues; we see 150bps of upside as they normalize, 60bps above consensus (as of the time of our investment).  As mentioned above, in response to supply-chain issues and easing pandemic demand, Target found itself with unusually high inventory levels at the start of 2022 (55 days-of-sales vs. 48 pre-pandemic).  More concerning still, the inventory was skewed toward discretionary seasonal categories for which demand was falling.  Management made the decision to aggressively promote/discount this merchandise to make room for more in-demand non-discretionary goods.  The effect was that low-margin categories were growing while higher margin categories were declining.  At the same time, input cost inflation and freight expenses surged.  While Target made the difficult choice to raise prices across a number of categories, margins were decimated nevertheless, declining 500bps in 1Q22, 900bps in 2Q22, and ~300bps in 3Q22 and 4Q22.  The charts below lay out the y/y change in Target’s gross margins (as well as Walmart U.S.’s which were far more stable) along with the cumulative change in margins since 2019.  As we can see in the first chart, margins rebounded quite a bit in 2023 (up 550bps in 2Q, +275bps in 3Q, and +291bps in 4Q) but remain approximately 200bps below 2019 levels.  Part of this delta is a result of elevated shrinkage, which has become an issue across the retail sector.  On their last earnings call, TGT called out Shrinkage having had a 120bps negative impact on margins since 2019.

While it is difficult to precisely quantify the impact of various items on margins, there are reasons to believe we should see continued improvement in overall margins, specifically:

Elevated discounting is over now that inventory levels are back to normal.  As we can see in the chart below, the acute inventory issues of 2022 are now behind the company.  As of the last few quarters, Days of Sales were ±5% from 2019 levels.  With excess inventory no longer a headwind, merchandise margins have been and will continue to rebound.

Merchandise mix should normalize:  As a result of the cascading effects of the pandemic on consumer spending patterns, TGT’s category mix today is markedly different than prior to the pandemic.  The chart below lays out the changes:  high-margin categories such as apparel and home furnishings remain depressed while lower margin ones such as food & beverage are elevated.  But all of this is ultimately cyclical.  Even the most durable home goods ultimately need to be replaced as they age.  My expectation is that these will normalize over time, and that as they do, they will push gross margins higher.  On our math – informed by category margin data gleamed from channel checks – there are approximately 190bps of margin upside from mix normalization alone should mix return to 2019 levels.

Shrink normalization:  As mentioned above, shrink has hit margins to the tune of 120bps since 2019.  Management has taken steps to get this under wraps, including 1) the Oct. 2023 closing of 9 stores with exceptionally high theft and crime rates; 2) reducing the hours of self-checkout areas so that they can be better monitored by employees; and 3) installing anti-theft prevention measures in high-risk stores.  4Q was likely a peak in shrinkage and should begin to improve in 2024 with the closure of certain problem stores, the inclusion of new anti-theft measures, and reducing self-checkout hours of operation.

Freight:  From 2Q22 through 4Q23, lower freight costs have provided a significant tailwind to margins, with cost down 50% - 90% in certain quarters.  That is likely to reverse to some extent later in 2024 given the recent spike in shipping rates.  Even at today’s recently elevated levels, freight costs are still down nearly 75% from where they peaked in 2021.  Freight costs are just one factor that contributes to merchandise margins – AUR/price increases, mark-down/promotions, freight & transportation, and inventory carry costs all contributed – however as we can see in the charts below, for the last several years, there has been a strong correlation between changes in freight rates and the inverse of merchandise margins, lagged 3 quarters.  If this relationship holds, merchandise margins should remain favorable for the next four quarters or so before becoming a headwind.

1. The Freightos Baltic Index measures the cost of a 40’ container shipped from China to the West Coast of the United States.  Source:  Bloomberg. 

Management has announced a $2bn to $3bn cost savings initiative to be implemented over the next 2 years.  Thus far, only $500m have been realized, leaving an additional $1.5bn to $2.5bn to be realized over the next two years.  This represents 140bps to 230bps of margin opportunity relative to 2023 revenue levels.  Management has said these savings would be incremental to any margin recaptured from the normalization in their assortment and promotional cadence.  While there are plenty of unanswered questions regarding this savings plans, it could drive another 100bps to 200bps of up upside to my 2025 numbers.  Each 100bps of incremental margin would add $1.90/share of EPS to FY25 (16% of current consensus estimates).

Moderating macro headwinds should become tailwinds for Target, fundamentally and from a stock perspective.  With persistent fears of the consumer being under pressure, particularly at the low end, a narrative developed in 2023 that Target was a loser in an environment that favors recipients of non-discretionary spending, Walmart in particular.  For several months now, it has become increasingly clear that the hard landing the market had feared is not happening - unemployment is low, consumer spending has held up, credit quality isn't deteriorating except among the lowest-end consumers, and corporate earnings are beating at an above average rate.  To the extent the consumer outlook marginally improves from here, Target should see a benefit both to revenue and margins, as well as in investor sentiment.  The market is clearly warming to this narrative (as evidenced by Target's recent share movement), but it is still early days with much more upside to come as revenue growth reaccelerates and margins expand.

Earnings Differentiation:  We model base case earnings of $11.87 in FY25 (vs. consensus $10.40), based on Target achieving a gross margin of 28.0% in FY25 (40bps below 2019 levels) and an EBIT margin of 6.4% (vs. 2019 of 6.0%).  With the business 30% bigger on a sales per sq. ft. basis than it was pre-pandemic, we think it is reasonable to assume operating margins get back to above pre-pandemic levels over the next two years.   While it is hard to be explicit in this regard, we don’t view our Base Case model as baking in much of any benefit from the $2bn to $3bn efficiency program.  To the extent we layer on even half of the contemplated savings not yet realized, it could increase 2025 EPS by an additional 16% to $13.77.

Valuation

In the five years prior to the pandemic, the stock averaged 14.2x earnings, with the multiple expanding in 2018/’19 as traffic growth accelerated to then all-time high levels.  It now trades at 16.5x consensus.   We think this is reasonable given our expectation of accelerating revenue and expanding margins.  At this multiple Target still trades at a discount to its more non-discretionary focused peers such as Walmart (23x), club stores such as CostCo Wholesale (42x) and BJ’s Wholesale Club (17x), hardline retailers such as Home Depot (23x) and Lowe’s (18x), or even off-price merchants such as TJX Companies (22x), Ross Stores (22x), and Burlington Stores (24x).  Assuming no change in multiple, investors in TGT should capture the 14% - 30% of positive earnings revisions over the next year.  In our experience, such revisions often result in some degree of multiple expansion, though we need not assume that for this to be a compelling investment.

Risks

Moderating consumer spending:  Implicit in our assumptions around a reacceleration in traffic growth is that underlying consumer spending is stable to improving over the next few years.  To the extent that consumers tighten their wallets or continue to prioritize spending on non-discretionary goods and services over discretionary ones, Target is likely to see a more muted growth outlook. 

Margin expansion doesn’t materialize.  Should freight costs continue to climb or shrink continue to worsen, it could offset some of the margin gains Target realizes over the coming years.  Given the $2bn to $3bn efficiency plan Target has in place, we would be very surprised if the company did not see some degree of margin expansion over our forecast period, but it is possible margins top out at a level below pre-pandemic levels.

Disclaimer:

This presentation is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate. At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information.

This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

No hard catalyst.  Traffic turning positive will likely be the biggest catalyst for upward earnings revisions and a revaluation of the stock.  We expect this happens in 2Q24.