April 11, 2011 - 10:48am EST by
2011 2012
Price: 49.53 EPS $3.86 $4.29
Shares Out. (in M): 714 P/E 13.0x 12.0x
Market Cap (in $M): 35,000 P/FCF 13.0x 12.0x
Net Debt (in $M): 14,000 EBIT 5,252 5,462
TEV ($): 49,000 TEV/EBIT 9.0x 9.0x

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TGT is the second largest discount retailer in the US. I believe that TGT's business quality is underappreciated by the investment community, and that its growth prospects are undervalued at 12x forward EPS.

TGT occupies a unique niche in American retailing. Its customers are predominantly women, with a median household income of $60,000. While they care about price and convenience, they also care about fashion and shopping experience. This stands in contrast to WMT customers, who generally have lower incomes, are less highly educated, and tend to care only about price. TGT has carefully cultivated its "Expect More. Pay Less." value proposition for decades, having recognized early on that competing directly against WMT is not a good idea.

TGT matches WMT's prices on everyday items, which comprise roughly half of TGT's mix.

The rest of TGT's offering is discretionary and largely appeals to the stylish sensibility of its customer base. The shopping experience is packaged in a clean, attractive store format. Far from the warehouse end of the spectrum, TGT stores incorporate genuine design elements and are, for many customers, fun to go to.

With 1,750 stores (all in the US), TGT's scale allows it to underprice local competitors the way WMT does. At the same time, TGT possesses an enormously valuable intangible asset: customer goodwill. This stands in contrast to other discount retailers and especially to WMT, which is widely perceived as downscale and in some cases unethical. TGT has carved out a niche for itself within American culture and enjoys widespread, positive mindshare. Its brand, signified by the iconic bullseye logo (which has been unchanged since 1969), has 96% unaided recognition (higher than even Apple and the Nike swoosh) in the US. The company is also admired for its corporate ethics. A fact that is well known to customers is that TGT donates 5% of pretax income to the local communities in which it operates, a significant "investment" that undoubtedly reinforces TGT's franchise value.

Despite TGT's clearly differentiated strategy, a misperception exists that TGT and WMT are locked in a zero-sum game. That this is not the case is convincingly illustrated by WMT's recent failed attempts to appeal to a higher-income shopper than its traditional customer base. WMT has acknowledged that these efforts alienated its core shoppers, and the company is returning to the strategy of everyday low prices and broad assortment.

TGT and WMT have successfully cohabitated for many years because they appeal to different customers. They will continue to take share in the multi-trillion dollar US retail market, of which WMT has a low-double-digit share and TGT only about 2%.

Despite its longstanding and highly defensible market position, TGT still has significant growth opportunities. The company believes that it can expand its US store base from 1,750 to between 2,500 and 3,000. In January, the company announced that it would enter Canada in 2013, where there is room for several hundred additional stores. Although international expansion is never a layup, I view Canada as a good opportunity because it has a relatively similar culture, where American retail concepts already flourish, and there is no incumbent with TGT's strategy. 70% of Canadians recognize the TGT brand and 10% have shopped at TGT in the past year.

TGT is currently executing on two additional opportunities to drive market share and same-store-sales gains. The first is a store remodel program, the most significant element of which is the rollout of grocery to general merchandise stores (an initiative called "P-Fresh"). Of the company's 1,499 general merchandise stores, 462 have P-Fresh, with another 380 expected this fiscal year. TGT earns 10-14% after-tax returns on capital on its remodel investments (similar to its new store investments) and expects remodels to contribute 1.5% to SSS growth in fiscal 2011.

A second initiative is 5% REDcard Rewards, a TGT-issued credit card with which customers receive 5% off the vast majority of items at TGT. This initiative was initially tested in Kansas City in 2009 and produced meaningful sales lifts net of the discount. Subsequently, the program has been rolled out nationally and on the most recent conference call, management stated that "our national experience has been a near-perfect replica of our earlier Kansas City experience in all material respects." TGT expects this program to produce 2-3% SSS growth company-wide in fiscal 2011.

TGT trades at 12x forward earnings, which is comparable to free cash flow. If one assumes a constant multiple and mid-single-digit earnings growth, and also incorporates the 2% dividend yield and a share count that shrinks reliably by 2-4% per year-the result is a roughly 10% base return. For what it is worth, management's expectation for the next 6-7 years is a minimum of 6-7% annual revenue growth and 10-12% annual EPS growth.

However, I believe that TGT's business quality and growth prospects deserve a higher multiple than 12x. Although the company's low-teens incremental ROIC is hardly mouthwatering, it is well in excess of its cost of capital (which the company pegs at 9%) and the reinvestment opportunity is clear and sizeable. DCFs can be useful when applied to a steady business whose incremental economics are fairly predictable. I believe TGT is such a case, and that a DCF exercise produces an implied P/E multiple that is greater than 15x. For what it is worth, prior to the recent recession TGT traded at a high-teens multiple of forward EPS

As is common in the retail sector, the stock appears to discount the company's growth prospects more reasonably when recent performance has been pleasing. So, one potential catalyst for multiple expansion is simply a return to the historical SSS growth of about 4%. It is possible that investors will not need to wait very long for this to occur, because unlike many retailers, TGT is making investments (mentioned before) to drive SSS independently of any improvements in the macro environment. On the earnings call in February, TGT stated an expectation of 4-5% SSS growth for the current fiscal year, driven mainly by store remodels and 5% REDcard Rewards.

Another possible catalyst is a resumption of square footage growth (which would also contribute to SSS growth, because new stores typically experience super-normal sales growth in years 2 to 5). TGT's traditional pace of 8% annual square footage growth slowed to 4% and 1% in 2009 and 2010, respectively, as economic conditions dictated a more conservative reinvestment posture and attention turned to the remodel program. As mentioned before, TGT intends to resume expansion of the store base through its entry into Canada in 2013, and at some point domestic growth will resume as well.

A final possible catalyst is the sale of TGT's $6.1 billion credit card receivables portfolio. TGT announced its intention to pursue this sale in a January press release. In the 4Q10 conference call in February, management stated:

We are pursuing a transaction that would remove the receivables assets from our balance sheet, preserve the integration of our card offering with our retail strategy, and maintain our card operations, including all guest contact touchpoints. This process will most likely take several quarters to unfold, such that if closing were to occur we would expect to achieve it late in 2011 or early in 2012.

I suspect that many investors are uncomfortable with TGT's credit card business, which is volatile, experiencing negative operational trends, and outside the analytical comfort zone of some retail analysts. After fully separating the credit card segment, TGT would be a pure retailer and a more predictable business.

It is worth noting that the credit card business comprised only 10% of TGT's 2010 operating income, so the stock's current valuation is not very sensitive to assumptions about the performance or value of this business. Attributing zero value to the credit card business, TGT currently trades at 14.4x trailing retail net income. I believe a sale would be likely to yield proceeds (net of external funding) in excess of $2.5 billion, which would likely be used for share repurchase and debt paydown.

If TGT's multiple does expand to 15x in the next couple of years, the stock could produce very high annualized returns. Here is a sketch of how I get there:

Fiscal year                                           2010    2011    2012    2013

Net income ($ millions)                       2,818   2,931   3,048   3,170
Y/y growth                                                       4%       4%       4%

Buybacks ($ millions)                          1,500   1,500   1,500   1,500
Assumed share price                            $50      $58      $69      $81
Y/y growth                                                       18%     18%     18%
Shares retired (millions)                                   28        24        20       
Shares outstanding (millions)               714      687      663      643
Y/y growth                                                       -3.9%   -3.4%   -3.0%

EPS                                                      $3.94   $4.27   $4.60   $4.93
Y/y growth                                                       8.2%    7.7%    7.2%

Implied stock price @15x fwd EPS                 $69      $74      $79     
Annualized return                                            38%     22%     16%

Note that the annualized return figures exclude the 2% dividend yield.


Return to historical sss growth rate of 4%, possibly this year
Resumption of square footage growth
Sale of credit card receivables portfolio and subsquent buybacks
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