Description

Target (TGT)

Intro:

If you’re not in a desert somewhere, you’ve probably read about well-known concerns about Target’s (and many other mass retailers’) inventory issues recently. TGT dropped ~25% in a single day after reporting earnings in May 2022. A few weeks later, they made another announcement, saying they’ll tackle their inventory issues more aggressively and earnings will be lower than expected over the next two quarters. I’ve followed TGT for a while and I see this as another sign of strong management who is long term oriented, willing to take short term pain (again) to continue building customer loyalty and their competitive advantage. With shares trading at about 13.2x PE on FY23 (ending Jan ’24) depressed earnings (consensus modeling 6.6% op margin vs LT target of 8%), we think TGT is a relatively low risk bet on a company that is acting aggressively from a position of strength and could benefit those who are willing to ride out the storm.

Company description:

Target operates general merchandize retail stores. It operates 1,937 stores and has 5 main product categories: beauty + household essentials, apparel + accessories, food + beverage, home furnishings + décor and hardlines (electronics, sporting goods, toys). Sales are evenly split between the 5 categories, with beauty + household doing 26% in FY21. Target generated $106B in sales for FY21 (ending Jan 2022) (vs $94B in FY20, up 13% yoy). It’s worth remembering that sales were <$70B in FY2016, meaning they grew top line 50% in 6 years. Yes, they did benefit from Covid/Stimulus spending, but unlike other covid beneficiaries that elected to raise prices (in the name of supply chain issues) and expanded GM%, TGT actually kept GM in-line with historicals during the pandemic years. Over the same period, AFTER TAX ROIC improved from 15% to >30% last year. They publish this chart on ROIC every quarter https://investors.target.com/static-files/65d09ce5-9869-495d-a60f-2d2fcec0c511

We will discuss the decline and disastrous recent quarters below. Note that FY21 means fiscal year ending Jan 2022, and I use 2021 and FY21 interchangeably below.

81% of sales originated from stores and 19% originated digitally in 2021 – this was 8.8% in 2019. These are the growth rates for digital from 2017 to 2021: 29%, 34%, 28%, 144%, 20%. Despite digital growing rapidly, more than 95% of sales are still fulfilled by stores in 2021.  Sales fulfilled by stores include in-store purchases and digitally originated sales fulfilled by shipping merchandise from stores to guests, Order Pickup (buy online and self-pick up in store), Drive Up (buy online, drive to store and they bring to your car), and Shipt (same day like Instacart). Target stores are really important assets and more on this below. Target’s loyalty program, Target Circle, now has more than 100M members. Circle members get 1% cash back on all purchases. Target credit and debit cards (Redcards) make up 20.5% of sales in 2021. They get 5 percent discount on virtually all purchases immediately.

Strong Merchandizing & Store Brands

One of Target’s biggest competitive advantages that’s not obvious to the casual observer is its product development and merchandizing teams. In fact, Target’s owned brands generated more than $30B in sales in 2021 and they grew 18%. On store brands, management said in FY20: “It represents about 1/3 of our total sales and even more of our gross margin …. They're not just private labels, they're brands our guests trust, they're brands our guests love.” It is worth remembering Target’s tagline since 1994:  "Expect More. Pay Less." Target’s brands deliver on value while being “chic” vs. purely low cost/low quality. “Tar-jay” is back.

If you haven’t seen them, go check it out. It’s definitely not Amazon’s Basics. 11 brands grossed more than $1B while 4 brands grossed more than $2B in FY21. Remember these are all brands that Target developed from scratch using their in-house product development and design teams. And constantly adapting to customer’s desires and needs requires this culture of speed and courage to take risks that is quite unique to Target as a large retailer. This is in their DNA, developed over many decades, revived by current CEO after losing it under prior management. Needless to say, owning brands mitigates against the risk of brands squeezing Target for margins, especially in this inflationary environment where every dollar of margin is fought for. The classic push-pull relationship between retailers and brands that Buffett said a few times. Target branded items are tailored towards value conscious customers who want good-looking and good quality items. Owning these brands also means they can readily adapt to consumer needs much quicker by designing and contract manufacturing what customers want rapidly and stopping what doesn’t work as quickly. For example, they killed 4 brands in 2019 and being ruthless is necessary in retail. The data they gather from the 100M Circle members help with this initiative. Right culture plus scale works.

Target Really Differentiates vs. Competition

When we think mass market retailers, it’s fair to say Target competes with Amazon, Costco, and Walmart. But I’d argue that while there’s strong competition among the four, they all (except Amazon Retail) generate incredibly consistent returns on invested capital and grow steadily as each play in their own niches that differentiates them from one another. The premium Target puts on curation, partnerships, product design and development really differentiates it vs. Walmart, Costco, Amazon etc. Yes, Amazon is still the best for fast shipping of random items but I would argue Amazon’s prioritization for gaining high margin ad dollars means that its marketplace is flooded with dubious quality goods that makes it a very confusing place to buy many things. It’s just not convenient if customers have to spend more time and curate things themselves out of the 500 listings of the same thing and not sure what to make of the “reviews”. Recent WSJ article talks about this exactly https://www.wsj.com/articles/the-surprising-reason-your-amazon-searches-are-returning-more-confusing-results-than-ever-11656129643

Costco focuses more on big families that do not mind large sized items as long as unit cost is low and quality is good. But this doesn’t work for a lot of smaller families because you really do waste more than you save if you buy that huge jug of peanut butter from Costco and there are only 2 adults and 2 kids at home, and smaller family size is where America is heading demographically. Walmart caters more to the lower income group in which price is the top priority. I don’t income discriminate, but given the choice, I believe most Americans will elect to shop at the better atmosphere of Targets.

On the other hand, Target focuses more on middle and upper-income families which highly values the convenience of one stop shop in which one single trip could get you baby goods, high quality toys, electronics, apparel, food, etc. and its omni-channel capability (discussed below). What’s also interesting is Target just keeps driving foot traffic and winning market share across all categories as other weaker physical retailers just fall apart due to lack of investment either in their physical stores or digital. The weak retailers are dying off and in this digital age, scale matters even more and the biggest players are grabbing share.  The big 4 will continue to gain share, including Target.

Valuable Store Spaces

In retail, if you get people in the door, you get a chance of closing a sale. Target foot traffic grew by more than 12% in 2021 on top of nearly 4% in 2020. Since they grew foot traffic during the 2020 covid year, it’s hard to argue the 2021 foot traffic gain results from a declined base. Naturally, all this foot traffic translates to sales per square foot that grew from $304 in FY17 to $436 in FY21 (43% growth), which is also helped by their investment in digital/supply chain capabilities. I believe this has been helped by (1) decline in quality of competition, especially those who failed to invest in upgrading their stores (just go to a suburban Macy’s and you wonder why you even stepped in) and (2) consumers’ desire to one stop shop when they are in a store driven by their online habits – everyone wants everything quick under one roof. It’s just more convenient if we can get most of what we need under the same roof, and that’s why consumers continue to “trip consolidate” their shopping trips and Target’s multi-category strategy means they should be well positioned as consumers one stop shop even more. Add in the desire to save on gas in this inflationary environment, there’s even more reason to shop at somewhere like Target.

Target has also formed partnerships with Ulta, Levi's, Disney and Apple for these brands to have standout sections with more distinct, stand-out floor space to present their products. This should drive even more store traffic as they give shoppers more reason to visit Target stores. Target is in effect renting out their store spaces to brands like Disney, Apple and Ulta Beauty. This quote from 2021 Q4 earnings call said it all when they talked about Ulta:  In stores where we've added an Ulta Beauty experience, guests are buying incremental items from the Ulta Beauty assortment while continuing to shop the beauty brands they've loved at Target for years. In fact, these new spaces average more than 2x the productivity of the rest of the store, and the growth is proving to be incremental. Specifically, in stores that have added an Ulta Beauty section, we're seeing a mid-teens lift across total Beauty and productivity lifts in complementary categories as well. With these incredible results, we remain committed to operating at least 800 Ulta Beauty at Target locations over time with plans to add more than 250 new locations in 2022.

I actually don’t know what their revenue arrangement with Ulta, Apple, Disney are but it’s fair to say if Target traffic continues to drive incremental sales for these companies without the necessity of them having their own stores, Target should benefit somehow by charging some kind of in-store partnerships fees (which would be highly cash flow generative) or Target just get the bump in sales (which isn’t too bad either).

Digital and Omni-channel Capabilities

I leave this for the last because this has been talked about quite often, including in Gavin Baker’s Sohn Australia pitch. You can google it. The bottom line here is Target is reaping the reward of years of investment and improvement in their supply chain and back office technology to make digital and omnichannel buying so seamless. Consumers today demand convenience, whether it’s buying online and getting it shipped same day, next day or getting it within 2hours by picking up or driving up. Target can really do all these and it works! I think too many equity analysts probably live in a large city and just do not appreciate the convenience of tapping a few times on the app, picking up at the store (on your way home from picking up your kid from Karate class anyways), and have an employee load up what you bought in 2 minutes into your car. It could literally be faster than you waiting for your concierge front desk to find your packages (plus waiting for the elevator). And what’s incredible is, driveup and pickup are just so much cheaper than shipping from warehouse. By making consumers do the “shipping”, it is 90% cheaper for Target vs. shipping from their upstream warehouse. Target is also adding returns and Starbucks to driveup, again this should deliver convenience that generates incremental revenue with little incremental cost needs – you are already bringing things to your guests. Drive up grew >70% in 2021 on top of >600% in 2020 (covid beneficiary of course). On top of all these, many customers actually still go into store while they driveup/pickup and buy more random things – generating foot traffic that really matters.

In addition, Target is shipping many online orders directly from their stores. Because their stores are so close to their customers’ homes and their upstream warehouse sub-scale (vs AMZN), ship from store is 40% cheaper than ship from warehouse (according to management). Again, the stores are quite valuable and this has allowed TGT to drive so much incremental sales (and profits) without needing much more incremental capital (chart above).

Bottom Line: Target Sells Convenience and it’s Differentiating and Working

You can argue I cherry picked some rankings to confirmation bias my thesis, but these numbers don’t lie. Target is ranked #1 in this YouGov retail ranking for mass merchandisers, club, value & drug stores. The score is based on: “Index scores are calculated by taking the average of our Impression, Quality, Value, Satisfaction, Recommend and Reputation metrics.” We believe good things happen when your customers are happy.

 Link here: https://business.yougov.com/content/38836-us-yougovs-retail-rankings-2021

Culture, Strong Management & Capital Allocation

Target has an embedded midwestern culture that has proven to be solid, consistent, decisive yet flexible. If you read the transcripts dating back the past 8 years, you will realize they are actually more customer focused than people give them credit for. I’d argue a lot of what they’ve achieved the past few years just came from a management culture that *really* listens to what customers demand, and building out capabilities accordingly and just steadily improving over time to provide goods/services that are better, more convenient, faster and cheaper. The decision to deliver your Starbucks order with your drive-up order is just that.

Since joining in August 2014, Brian Cornell has proven his ability to take decisive actions that sacrifices short term growth but drives long term ROIC and sustainable growth/profitability. The decisions to shed the money losing Canadian business, sell off the pharmacy business, and really focus on its domestic business: the signature categories (style, baby, kids, and wellness) that bring guests in, upgrading stores (when others just let them decline and buyback worthless stock) and building out digital/omni-channel/supply chain capabilities have proven right. It’s easy to look back and think management has made good decisions but they really were not easy decisions/executions when you see Amazon and Walmart breathing down your neck and trying to kill your business in the early/mid 2010s. The uncertainty was immense back then.

If you have read about Bed Bath Beyond’s recent issues (which hired ex TGT Chief Merchandizer to turn around), you’ll understand it’s harder than most people think to execute what Target management did (digital transition, supply chain investment, real strong private brands). Capital is not enough, it takes culture built up over decades (and decades) https://www.wsj.com/articles/bed-bath-beyond-ceo-private-label-brands-11658547084?reflink=share_mobilewebshare

Prior to 2014, ROIC was not a compensation criterion but beginning 2014 right around when the prior CEO was driven out, ROIC began to figure prominently in compensation section of the proxy. From their 2014 proxy: “Along with increasing PSUs from 25% to 75% of annual LTI mix, we also added a third relative metric, return on invested capital (ROIC), to our PSU plan.” Today, management’s Performance share unit awards are driven by adjusted Sales growth, EPS growth, and ROIC. These are all solid metrics that drive long term shareholder performance, in our view, as long as earnings track free cash flow (FCF). In the past 8 years, TGT generated ~$29B in total adjusted net income and $30B in FCF. Meanwhile diluted share count reduced from 644M in 2015 Jan quarter to 464M in 2022 July Quarter (28% decline).

Again, reading the transcripts since present management took over in 2014/2015, it’s pretty consistent how they allocate capital. They were investing $2-3B in capex annually before slowly upping it to $4-5B today (recent inflation means they will invest more than $5B this year which they just announced in 2022 July quarter – not great I know – unless the capex do yield good incremental returns). After that, they grow dividend every year (stock yields ~2.7% at current share price) and buy back as many shares as they can while maintaining their middle A credit ratings. They bought back $7B of stock last year. Of course, I’d prefer them to buyback when the stock is $150 vs $250 last year but I think it’s okay if they generate cash flow and just do it consistently (not ideal, but that’s the best I can hope for when it comes to buyback).

Long term Investment Thesis:

We believe Target’s unique combination of convenient multi-category one-stop shop retail model, experience owning/creating eleven $1B+ revenue brands, highly efficient & developed omni-channel capabilities and valuable store space are harder to replicate than most people think. Target really has generated much more income without needing much incremental capital over the past few years and gained much share from other traditional retailers. We are not betting on hope or big changes here. This is purely investing in a business that has proven itself during the past 3 years and that its digital/store/omnichannel capabilities are efficient (low cost fulfilment), highly scalable and convenient for consumers.

In our view, Target’s retail model is just fundamentally more efficient than competitors and this should win them more customers over time. Sustainably generating high ROIC requires you to generate win-win situations for your customers and yourself and below are three reasons why TGT achieves this. Moreover, we believe these are competitive advantages that can sustain (and even enlarge) as long as management doesn’t screw up and continues to maintain and gain scale.

(1)    High quality products and brands developed at lower cost: the trust that Target customers place on them, scale from 100m customer relationships and their experience creating store brands mean that they can create high quality brands that customers really want/need from scratch at far lower unit costs (low product development cost as they know what customers want and don’t need to trial and error as much [lower risk too], minimal advertising costs as TGT doesn’t need to spend on online/offline ads to kickstart brands, no wholesaler taking margins). This means customers get good products at a lower price but it is also higher margin for TGT. Win-win for both TGT and customers.

(2)    Lower “All-In” Delivery Costs: On top of that, constantly being creative with utilizing their stores as fulfilment assets means they can get products to their customers at continuously faster speeds and lower costs. If all it takes is for customers to conveniently drive-up or self pick-up on the way back from work, there’s very little incremental shipping cost and hence it’s just a cheaper way to get goods last mile to society. Do not believe in “free shipping”, they are just bundled into the costs of what you bought over the long term and hence will result in higher prices or recuperated through selling ads that result in you wasting time scouring from 500 similar items. There really is no free lunch. Only if you can “deliver” in a truly cheaper way do you benefit society. Win-win for both TGT and customers. More recently, I’ve realized that some items on AMZN can be found at the seller’s own DTC website at 20-30% lower price, albeit having to wait a couple more days for the item to arrive at your house – is “free” really fast shipping still real?

(3)    Better utilization of store space: store within store concept helps save on rent for brands, efficient for customers (you get everything under one roof – where do you get toys nowadays?), and TGT could drive incremental sales. Another win-win-win situation for everyone in the situation.

We believe TGT should get stronger in the omni-channel world and they can further gain share both online (trust & differentiate from AMZN for its curation and vetting of vendors) and offline (worst retailers are shutting down, and Target is a very natural place to seek out toys, baby and apparel as a one-stop shop). In our view, TGT basically just needs to do more of the exact same thing and execute growth in a large retail market (they have ~2% of retail today). TGT should be a high probability, multi-year compounder over a multi-year (even decades) timeframe.

What happened in 2022 Q1 (April 2022 quarter)?

On May 18th 2022, TGT reported adjusted EPS that was well below expectations. They did $2.19 vs consensus of $3.07. Gross margin missed big time (reported 25.7% vs consensus of 29%) as they had to markdown and take inventory impairments on discretionary items like electronics and furniture and consumers increasingly adjust their spend as they shift from forced at home to going out more. Q1 earnings release: “Operating margin rate of 5.3 percent was well below expectations, driven primarily by gross margin pressure reflecting actions to reduce excess inventory as well as higher freight and transportation costs.”

Then in June, TGT announced they will take actions including “additional markdowns, removing excess inventory and canceling orders” and downgraded their EBIT% outlook to 2% vs 5.3% previously for Q2 2022. I think what caught most of us by surprise was the speed in which the tones of management changed. When they reported Q4 FY21 at their annual analyst meeting on March 1st 2022, all seemed well and they didn’t show a hint of weakness. Then in about 10 weeks, it all changed. Given their track record, over the past 8 years, I think it’s okay to give them the benefit of the doubt that they just didn’t anticipate the speed in which reopening and inflation will change consumers’ spending patterns. While incredibly painful short term, we believe this is the right move for TGT as they try to remove bulky inventory (kitchen appliances, TVs and outdoor furniture) that are costly to store, bulky to display and devalue quickly. We think it’s foolish to hang on to these inventories and hoping to sell at a higher price later while incurring the storage costs. These items devalue quickly and even more so if multiple retailers unload them simultaneously. Better to take one time pain in our view. This is TGT’s explanation from Q1 earnings call: “ In addition, as supply grew and demand shifted away from bigger, bulkier products like furniture, TVs and more, we needed to make difficult trade-off decisions. We could keep this product knowing it would sell over time or we can make room for fast-growing categories like Food & Beverage, Beauty, and personal care and Household Essentials. To preserve the quality of on-shelf presentations and support the guest experience, we chose the latter, leading to incremental markdowns that reduced our gross margin. While these were difficult decisions, we believe they'll pay off in the long term, given that building long-term loyalty remains our top priority.”

Q2 2022 (July Q) update: Comparable sales grew 2.6%, traffic grew 2.7%, digital comp grew 9%. Op margin was 1.2%, so worse than expected and almost exclusively due to GM% hit. GM was 21.5% vs 30.4% prior year quarter and as expected was due to higher markdown rates, driven by inventory impairments to deal with lower demand in discretionary categories. Obviously, there’s also inflationary factors like higher comp/headcount in distribution centers, higher freight/transportation costs, etc. Longer term, we still believe the business and efficiency of the system is intact and they can bring their GM% up to historicals (as explained below).

Valuation

TGT is trading at 13.2x FY23 (ends Jan 2024) consensus earnings on op margin expectation of 6.6% (Bloomberg has FY23/24 wrong). In March 2022 when management updated their Long-Term Financial Algorithm, they guided to MSD growth in top line, MSD growth in EBIT, HSD in EPS and after tax ROIC in the high-20% to 30% range. Most of the setback this year is due to the GM% miss (21.5% in 2022 Q2, 25.7% in 2022 Q1 vs around 30% in prior year quarters) that naturally flows through to EBIT% and net income miss. I strongly believe their GM% is not permanently impaired. . If you look back the past 10 years, when they had much less scale and were less of a force in retail, their annual GM% was range bound between 28.3% and 29.7%. This is just an incredibly stable business at scale. Yes, inflation is real and misjudging consumer desires and inventory was a mistake, but inflation affects all retailers and inventory mistakes can and will be corrected. Target’s business will continue to grow over the long term and is not permanently impaired. And if over the long term, a company of TGT’s scale cannot maintain decent margins and efficiency because of inflation, you can imagine where the smaller retailers are headed and that means more room for TGT (and Costco, WMT) to capture. I’m quite optimistic that gross margins, operating margins and hence ROIC should be quite stable over the long term (as they always had been). And growth will come at the expense of smaller and much weaker retailers. Inflation is real, the bottom 10% is hurt but nobody wants to shop at a Dollar General or Dollar Tree forever, not even the bottom 10% and that’s just human nature. America’s economy will keep going, and I’d rather bet on it recovering and that nobody wants to shop at a Dollar General or Dollar Tree forever.

In terms of valuation, we think they can still grow revenue at MSD through 2026, and that operating margin will slowly improve by 2026 to below what they achieved in 2020 when revenue was smaller (they did 7.0% EBIT margin in 2020). This means gross margin will only recover slowly and by that time they will have even more SG&A leverage (which I am not giving them credit for). Retail at scale just do not change overnight as long as management keeps executing and stay focused on serving customers what they want (regardless of online, offline or omnichannel – TGT has it all). Past 8 years suggest this management team can deliver exactly that.

The recovery should take place sooner because most of the margin problem came from GM contraction in 2022. And assuming they buy back 2.5 to 3% of shares each year (costs less than $2B a year of FCF at current share price and more than covered by FCF), EPS should grow to ~$16.5 in 2026. Applying a 15x forward PE based on where they traded the last 10 years (when the business was facing much higher uncertainty because market was doubting their ability to build digital capabilities and wasn’t sure if it would become a JCP or an omnichannel winner), we arrive at a target share price of $248 in 3 years (share price is $159 on 9/20/2022), returning 56% in 3 years on ~16% IRR (and you collect the 2.7% dividend each year for 19% total annual return). In our view, this is not a bad outcome given how beaten down the stock is, minimizing downside risk as business and management remains strong. In fact, we view this as a multi-year (even decade) holding that will keep growing steadily on strong returns on invested capital.

In addition, if we forget about market dynamics for a second and just think about TGT purely from a business perspective, we think ROIC and FCF growth should be maintained because mgt expects increasing productivity from existing store footprint as they utilize even more of their existing stores to fulfil more digital sales. This means more Operating Cash Flow will turn into dividends/buyback instead of capex despite inflation. In FY20, their top quartile stores generate $499 per sq ft vs $372 for the average store, meaning much capacity to fulfil digital sales is still untapped.

Risks

Retail is super competitive (especially for the tier 2, tier 3 players), and there are always lots of choices for consumers and no switching cost, albeit the loyalty and habits of some customers. Who knows where the next SHEIN will come from? However, it’s quite incredible how stable Walmart, Costco and even Target have been the last 10 years (even with AMZN coming into picture). Gross margin decline could be more permanent than expected but with $100B in sales and margins that have held up for a decade, it is just so hard to imagine this being the case. It’s almost all about scale in retail and being a top 4 retailer that’s growing and has business momentum should help mitigate against this. The layer below Brian Cornell (CEO) turned over a bit recently but I take comfort in both him and John Mulligan (COO) who has been at TGT for 26 years. Mulligan was made CFO in 2012, served as interim CEO before Cornell came in and then made COO in 2015. CFO has been at TGT 18 years, Chief Growth Office 19 years and Chief Merchandising Officer 25 years. This is despite prior CFO retiring in Jan 2019 and prior Chief Merchant leaving for BBBY Oct 2019. Inflation is top of mind for investors but if a retailer of Target’s scale cannot maintain their margins, you can imagine smaller, less efficient ones dying off and benefitting Target (and Costco and Walmart). They just need to not screw up too much for this business (and hence stock) to turn up okay. And I believe their scale and relationship with customers (via stores and the app) could spring up a few positive surprises (3P marketplace revenue, selling more ads to brands, collecting “rent” from brands, Roundel ad business, etc.). Other revenue (while very tiny today) grew 15% in 2022 Q2, driven by the Roundel ad business.

Catalyst

Revenue consistently outperforming expectations as Target becomes one of the easiest places for Americans to shop online, offline, omnichannel and consumers consolidate trips further to get high quality high value items.

Gross margin (and hence earnings) recovery that comes sooner than expected.