Summary

Retail is dead.  Long live retail!  In times like these, it helps to stand back and see which companies will be around 20-years from now.  Enter Target, a seemingly yesteryear company whose market has moved onto buying online.  Yet despite negative optics and relatively weak comps, the company has been the star of a remarkable self-help story.

Over the past-3 years, management at Target have been making meaningful changes to the company.  From eliminating pizza huts from newer stores (and with it, the smell of burnt cheese) to rolling out smaller-format stores, management has shown willingness to take the long-view.  The short-term result has been a gut-wrenching stream of poor financial results over the same time-period.

Sell-side analysts have thus been conditioned to expect poor numbers from Target.  As shown below, Target’s estimated EBIT margins are far more negative than other companies in its peer group.  I believe this is too negative an outlook.

Target investors will need to be patient; although Target is a reasonably run company, its industry is going through major shakedown.  Those worried about the industry’s future should also consider an equivalent short in Walmart.  Walmart is a stronger company, but one that has grown decidedly short-term in their quest to make quarterly numbers.

Company Description

Target Corporation is a mass-market retailer based in Minneapolis, MN.  The company operates 1,800 stores across the 50 US states.  Most stores are big-box with footprints larger than 50k sqft.  The company has recently began rolling out smaller “city” stores with store footprints of 40-50k sqft, and had 22 operational as of January 2017.  E-commerce made up 4.4% of company sales in 2016, up from 3.4% in the prior year

Target has retrenched in recent years.  The company sold its pharmacy segment in 2015 for $1.9 billion and now retains a perpetual operating agreement with CVS Pharmacy.  Target also exited the Canadian market in 2015.

Sales are evenly split between five key categories.

The share of revenue from food and beverage has steadily increased at the expense of other categories, causing gross margin compression

Yet operating profits have remained somewhat stable thanks to corporate cost-cutting and the sale of the low-margin pharmacy business.  

Why This Opportunity Exists

Target is undergoing an enormous self-help story.  The company has been quietly investing in store and merchandising changes, e-commerce capabilities and smaller-format stores.  Each of which has the potential to reasonably improve the company’s bottom line.  2016 may be the low-point in the company’s margins.

How did the company get here though? In the early-to-mid 2000’s, Target bucked the big-box trend by appealing to a younger demographic.  Its apparel lineup became known as the “Tarjhay” brand.  The company had unexpectedly stumbled upon a magic formula that fast-fashion retailers would later co-opt: mass-market fashion at accessible prices.

The 2007-2008 recession changed much of Target’s fortunes.  Broadly, it turned out that even “cheap chic” wasn’t cheap enough once the recession hit.  Instead, the company found itself stuck in the middle between Walmart and Amazon’s rock-bottom prices and the nimbleness of smaller specialty stores such as Zara/H&M in apparel, CVS/Walgreens in drug stores and Whole Foods/Trader Joes in groceries.

A decent Time article summarizes the reversal.

http://time.com/money/3148576/target-walmart-tarjhay/

The company hired Brian Cornell in 2014 in response to flagging sales.  Since then, the company has embarked on cost-cutting and shedding assets deemed non-core such as Target Canada and its pharmacy business.

Currently, there are four major changes happening at Target.

1. Store changes

Target has been testing major store changes in its grocery department.   The company’s Minnetonka superstore has been used as a test site, and the company appears to be gearing up launch of this new concept.  In March 2017, the company both issued an official press release of its next-gen stores and appointed Jeff Burt from Kroger to lead their grocery, fresh food and beverage department.

While it’s difficult to predict the store design’s fiscal impact, my experience as a retail analyst leads me to believe that this concept will help.  Target lost a major segment of its affluent customers to e-commerce; a higher-end grocery store will likely help at the margins to bring them back.  Kroger made similar changes to their store design in the early 2010’s to compete against Whole Foods.

2. Merchandising

Approximately 1/3 of Target’s sales are private-label.  Over the past-two years, the company has been making significant changes that could increase this further.

Clothing: In September 2015, Target announced it would not renew its supply agreement with Cherokee Inc, its outsourced supplier of apparel brands such as Cherokee and Liz Lange.  (Cherokee’s stock promptly dropped from $25 to $15).  Instead, Target would replace these outsourced brands with its own, such as Cat & Jack, and Gilligan & O'Malley.  Target’s motivation for this change is sound.  Margins for these largely undifferentiated clothing brands are surprisingly high.  Cherokee earned 48.3% EBITDA margins and 28.1% net margins in 2015 before its supply agreement with Target was cut short.  In a retail world where net margins hover at 3-8%, this is an incredibly lucrative business if you have the right merchandising team.

Food/soft lines: The company has significantly improved its merchandising design.  Starting in 2016, Target started rolling out redesigned packaging for its low/mid-tier Market Pantry goods.  Changes are striking.

3. E-commerce

It’s difficult to write an article about retail without mentioning e-commerce.

Target was late in e-commerce.  In 2014, only 2.3% of its sales were online, compared to 3.0% at Costco and 9.2% at Best Buy (two earlier adopters of e-commerce).  The company has since changed tack, building up its e-commerce capabilities internally.  The company is now able to ship from over 1,000 of its stores, and offers free standard shipping on orders $35+.  

Investors, however, should temper their expectations.  E-commerce is unlikely to be a major margin driver for Target, but rather is a necessary defense to retain its current customer base.  More importantly to recognize that Target has been doing well in rolling out its e-commerce platform.  Walmart’s e-commerce had a famously rocky start: lack of communication between its San Bruno e-commerce office and its Arkansas headquarters may be much to blame.  Target’s e-commerce rollout has been somewhat better.

4. Small-box stores

Target’s move to smaller-format stores, however, has the potential to be a long-term game-changer.  These stores of less than 50,000 square feet are generally built in cheaper prime shopping areas with large catchment populations (i.e. think basement of a Manhattan office buildings).  The company plans to open around 30-40 per year through 2019, bringing their total to around 130 stores.  

These stores will act as a gateway for Target shopping.

Valuation

Target’s key investment thesis revolves around its long-term margins.  Growth is secondary: big-box retail is arguable saturated and same-store sales growth is likely to track inflation.  (Again, take a step back here.  This is Target, a slow-moving company in a slow-moving segment)

Here is where things get tricky.  How much impact will e-commerce and small-box stores have on margins?  How will mix towards food?  Here, I put together several DCF models to illustrate the range of likely outcomes.  I use a 3-stage DCF model with an explicit forecast period of 3-years, followed by a 20-year “normalization” period and ending with a perpetual series of cashflows.

Other assumptions as follows

As shown, Target’s share price today is relatively undemanding.  Yet much can go wrong…

Risks

Target’s key risk is in continued deterioration in industry-wide profitability.  Big-box retail already runs on razor-thin margins, so even small downward revisions in gross margins or SSSG (same-store sales growth) will severely affect Target’s value.  EBIT margins would have to drop to ~3.0% to see significant value destruction.  A feat that isn’t impossible, as well documented by the constant stream of bankrupt retailers. Of Target’s major peers, Bed Bath and Beyond has more negative expectations, with EBIT margins projected to fall almost 2% over the next-4 years.  

Remember that Target operates in a lousy industry.  Same-store-sales have been weak, reflecting weak industry dynamics.