Target's Credit/Debit Data Breach Not Catastrophic

| About: Target Corporation (TGT)

In light of the recent credit/debit card data breach, first made public December 19, Target (NYSE:TGT) has come under some scrutiny. Target is doing what it can to keep customers happy, including guaranteeing zero liability for the cost of any fraudulent chargers arising from the breach and offering one year of free credit monitoring and identity theft protection to all guests that shopped at US stores.

Still, the good faith efforts by Target haven't been enough. The company provided an update to expected fourth-quarter 2013 financial results. In the US segment, Target now expects fourth-quarter adjusted earnings per share of $1.20-$1.30, compared with prior guidance of $1.50-$1.60 per share, a fairly drastic revision. The firm now expects a comparable sales decline of approximately 2.5%, compared with previous expectations of flat sales. The credit card breach is having an impact on customer confidence, as stronger-than-expected fourth-quarter sales prior to the announcement have been replaced with meaningful weaker sales, which are expected to decline at a 2%-6% pace for the remainder of the quarter.

Though we acknowledge that Target's credit card nightmare continues, the firm is doing all that it can to minimize financial damage to protect its brand image, which has undoubtedly been harmed. We do, however, expect a full recovery by the retailer and are viewing the security breach as a very unfortunate hiccup that has inconvenienced millions of its customers. We think customers will return.

At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.

If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Target posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Target to peers Costco (NASDAQ:COST), Walgreen (WAG), and Wal-Mart (NYSE:WMT). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

Investment Considerations

Investment Highlights

• Target scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 11.4% during the past three years.

• Target sells everyday essentials and fashionable, differentiated items at discounted prices. Approximately one-third of total sales are related to its owned (Archer Farms, Circo, etc.) and exclusive brands (Fieldcrest, Nick & Nora, etc.).

• Target's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

• Though its loyalty program has gained some traction, Target faces tough competition from Wal-Mart and online retailers, including Amazon.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Target's 3-year historical return on invested capital (without goodwill) is 11.4%, which is above the estimate of its cost of capital of 8.5%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Target's free cash flow margin has averaged about 3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Target, cash flow from operations increased about 1% from levels registered two years ago, while capital expenditures expanded about 54% over the same time period.

Valuation Analysis

The estimated fair value of $65 per share represents a price-to-earnings (P/E) ratio of about 14.4 times last year's earnings and an implied EV/EBITDA multiple of about 8.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.9%. Our model reflects a 5-year projected average operating margin of 7%, which is below Target's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.4% for the next 15 years and 3% in perpetuity. For Target, we use an 8.5% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $65 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Target. We think the firm is attractive below $52 per share (the green line), but quite expensive above $78 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Target's fair value at this point in time to be about $65 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Target's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $80 per share in Year 3 represents our existing fair value per share of $65 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.