Vertigo3d
In May of last year, I observed that shares of Target (NYSE:TGT) were hitting their targets, after strong operational achievements had been demonstrated upon, as higher online sales and margins were awarded higher valuation multiples. Notably that latter observation made me cautious, as the set-up was not too compelling from a risk-reward perspective in my book.
Some Perspective
After a misguided adventure in Canada quite a few years ago Target has been focusing on its core US operations, as that focus included a remodeling of stores, focus on food categories, smaller store formats, while shedding some unprofitable stores and product categories.
2019 was a fairly reasonable base case, a year in which sales rose nearly 4% to $78 billion as operating margins were up 13% to $4.7 billion that year, translating into operating margins around 6% of sales. Net earnings of $3.3 billion came in at $6.36 per share, translating into a market multiple of 17-18 times earnings at $110 in February 2020. Net debt of $8.9 billion worked down to a modest 1.3 times leverage ratio based on $7 billion in EBITDA. At the time, Target derived some 12% of sales from its online channels.
During the pandemic, the company saw strong comparable sales growth, driven by very strong online sales, as net earnings were held back amidst costs taken in relation to the pandemic related measures, as well as deleveraging as a result of lower margin online sales activities (as capacity rapidly needed to be scalded up). This drove a rally in the shares to a high of $216 per share in May when I picked up coverage.
At the time, the company had just reported in 2020 results in March, with sales up a fifth to $92 billion and change. Strong operating leverage was displayed upon in the second half of the year with full year operating earnings up 40% to $6.5 billion, as earnings rose 47% to $9.42 per share, far stronger than I could have imagined. This resulted in a massive deleveraging, with net debt down to $4 billion.
Trading at 22-23 times last year’s earnings, which were really strong earnings based on historical standards, I was a bit cautious as the market was awarding a higher valuation multiple on already stronger earnings. This means that if earnings would normalize to let’s say $7 per share, multiples would increase to 30 times.
Momentum Cools Off
While shares kept on rallying during the second half of last year, hitting a high of nearly $270 per share, we now see shares trade around a hundred dollars lower than that level. Right now, shares trade at $165 to be more precise, up from lows around $140 earlier this summer.
2021 has been a very strong year in terms of operating performance. Full year sales rose 13% to more than $104 billion, as fourth quarter sales growth slowed down to 9% and change. Full year operating margins rose 37% to $8.9 billion, for incredibly strong margins equal to 8.4% of sales. The company grew earnings per share by 44% amidst some share buybacks on top of this as well and lower interest expenses, with adjusted earnings up to $13.56 per share.
Net debt inched up dramatically to $7.8 billion, as the company pursued a massive buyback program, having spent $7.3 billion to acquire its expensive stock during the year. While the allocation of funds can be debated, leverage remains very modest with EBITDA coming in at $12 billion for the year. By the time of this earnings release, shares traded at $220, as multiples had compressed quite a bit already. The company did warn that the spectacular results in terms of growth of the years 2020 and 2021 would not be replicated in 2022. Sales were originally seen up in the low to mid-single digits, with operating margins seen around 8%, which if achieved would still translate into record and thus very strong results.
The first quarter results, as released in May, were a bombshell report. As if a mere 3.3% increase in comparable sales was not enough yet, operating margins of 5.3% were really soft amidst inventory clearance sales and higher freight costs. It was very painful to see an accelerated $2.8 billion buyback program being completed during the quarter as shares fell to $150 overnight, wiping out hundreds of millions, or close to a billion in shareholder value. This and higher inventories furthermore resulted in dismal cashflow generation. Following this soft quarter, the company cut the full year operating margins target to 6% of sales.
Shares fell to the $140 mark in June as the company warned for second quarter margins just around 2% of sales. Despite these soft results, the company actually hiked the quarterly dividend by 20% to $1.08 per share, increasing the payout ratio in a rather dramatic fashion with earnings seen down so dramatically.
In August, Target posted a mere 2.6% increase in comparable sales growth with operating margins seen as low as 1.2%. The lack of earnings, higher dividends, share buybacks and an increase in inventories made that net debt rose rapidly to $14.0 billion, in part because of a $4 billion increase in inventories on an annual basis.
EBITDA for the first half of the year has been cut more than in half to $3.0 billion, which annualised makes that leverage ratios increase to above 2 times, likely around 2 times if we factor in a seasonally stronger second half of the year. If the company delivers on 6% margins in the remainder of the year, earnings might come in around $7-$8 per share, translating into above-market earnings multiples as investors hope for better average earnings.
What Now?
The fortunes of Target have changed rapidly and investors have seen some pain as shares have been holding up quite well if you ask me. Believing an average run rate around $100 billion in sales, and average margins of 6%, I see after-tax earnings potential around $4.4 billion, that is after factoring in half a billion in interest and 20% tax rates.
This results in earnings of around $9-$10 per share, and if this is sustainable, shares trade at a market multiple, for which still some work needs to be done, as the company does not have the performance on its side in recent times. Such improved earnings power and some inventory reduction efforts makes that leverage might quickly fall towards the 1 times EBITDA mark again.
Given all these dynamics, I am still not yet attracted to Target here, even if shares are down $50 from May 2021, as the pullback has been more severe than I feared, as I see valuation only fair here.
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