- We think Target has lost some of its luster.
- Expansion plans into Canada and the firm's credit card breach have changed the company's risk profile.
- Though Target boasts a decent Valuentum Buying Index score of 7, we prefer firms in the Best Ideas portfolio.
There's much to like about Target (NYSE:TGT). The company has a well-known brand and relatively loyal customer base. However, recent performance has left much to be desired, and the company's expansion plans into Canada and credit card breach speak to a heightened risk profile. We're not sure the market has come to recognize this "new" and more-risky Target. Let's take a look at Target's cash-flow-derived intrinsic value and run shares through the Valuentum style of investing.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Target posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. Though a 7 is a decent score on the Valuentum Buying Index, we prefer firms that register a 9 or 10 (a "we'd consider buying" rating). We include highly-rated firms in the Best Ideas portfolio.
Target's Investment Considerations
• 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 9.9% 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.). We view Target as one of the premier food retailers within the industry.
• 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.
• Target is struggling with poor public perception following a well-publicized and widespread credit/debit card data breach. Though the nightmare continues for the firm, we expect a full recovery by the retailer. The bigger issue at Target, in our view, is its venture into Canada, which we point to as a fundamental factor pressuring earnings.
• The company faces tough competition from long-time foe Walmart (NYSE:WMT) as well as rapidly-expanding online retailers, including Amazon (NASDAQ:AMZN). We don't think the competitive environment will ease anytime soon.
• Target's first-quarter results, released Wednesday, showed a business that is moving in the wrong direction. Same store sales in the US are declining, losses are mounting in Canada, and the firm cut its adjusted earnings per share outlook to $3.60 to $3.90, compared with prior guidance of $3.85 to $4.15.
• We're not big fans of Target's dividend growth potential. Though a board of directors can increase a dividend regardless of underlying fundamentals, Target's performance has been waning. The firm registers a score of 1 (parity) on the Valuentum Dividend Cushion.
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 with its weighted average cost of capital. 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 9.9%, 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 2.8% 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 Valuentum.com. At Target, cash flow from operations increased about 20% from levels registered two years ago, while capital expenditures fell about 21% over the same time period.
Our discounted cash flow model indicates that Target's shares are worth between $54-$82 each. Shares are trading at $56 at the time of this writing. Though this is at the low end of the fair value range, we believe a modest adjustment will be in order upon its next update as a result of the recently-lowered guidance. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The relatively large range speaks to Target's increased risk profile.
The estimated fair value of $68 per share represents a price-to-earnings (P/E) ratio of about 22.1 times last year's earnings and an implied EV/EBITDA multiple of about 9.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.5%. Our model reflects a 5-year projected average operating margin of 7.3%, which is above Target's trailing 3-year average. Our fair value estimate continues to give Target the benefit of the doubt that it will contain its credit card breach damages, turn around its US operations, and improve profitability in its Canada endeavor.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Target, we use a 8.5% weighted average cost of capital to discount future free cash flows. We think the long-term growth rate is reasonable for a firm of Target's size, and while an argument can be made that our discount rate is too low, we think it is still reasonable. In any case, there is a downward bias to both the fair value estimate and fair value range at the time of this publication.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Target to peers Wal-Mart and Costco (NASDAQ:COST). Target only look attractive from a relative value basis if it hits the high end (or beats) its newly-revised adjusted EPS target. This may be difficult given the trajectory of the firm's fundamentals.
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 $68 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 $54 per share (the green line), but quite expensive above $82 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 $68 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 $83 per share in Year 3 represents our existing fair value per share of $68 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
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.