By The Valuentum Team
Target's Investment Considerations
• Target (NYSE:TGT) 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 future growth prospects have come into question as of late.
• The company's decision to exit Canada (NYSEARCA:EWC) will reduce spending, bolstering free cash flow. However, we don't like the decision to cease operations in our neighbor to the north, as we think it indicates management's focus is far too short-sighted.
• 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. Its venture into Canada, however, was also an absolute blunder, and the board may have fallen asleep at the wheel. Investor confidence has been shaken.
• Target recently sold its pharmacy and clinic business to CVS Health (NYSE:CVS) for $1.9 billion. CVS Health will acquire Target's 1,660+ pharmacies and operate them through a store-within-a-store format, branded as CVS/pharmacy. Management is hoping the deal to drive traffic higher while narrowing its operating focus.
• The company faces tough competition from longtime foe Walmart (NYSE:WMT) as well as rapidly-expanding online retailers, including Amazon (NASDAQ:AMZN). We view Target as one of the premier retailers within the industry, however.
• Target boasts a rather nice dividend yield, and we generally like its dividend policy and shareholder-friendly policies. That said, its Dividend Cushion ratio, while not terrible, isn't great. We think this is something that income investors should at least be aware of, even if it may not signal immediate trouble to the pace of future expansion in the payout.
Economic Profit Analysis
In our opinion, 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 14.3%, which is above the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
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 5.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
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. At Target, cash flow from operations increased about 60% from levels registered two years ago, while capital expenditures fell about 45% over the same time period.
In its first nine months of fiscal 2015, Target reported cash provided by operations of ~$3.7 billion and capital expenditures of ~$1.1 billion, resulting in free cash flow of ~$2.6 billion, an increase of ~282% compared to 2014.
This is the most important 'target' of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate.
Our discounted cash flow model indicates that Target's shares are worth between $57.00 - $85.00 each. Shares are currently trading at ~$68, in the bottom half of our fair value range. This indicates that we feel there is slightly more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $71 per share represents a price-to-earnings (P/E) ratio of about 18.6 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.3%. Our model reflects a 5-year projected average operating margin of 7.4%, which is above Target's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.1% for the next 15 years and 3% in perpetuity. For Target, we use an 8.6% 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 $71 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.
In the graph above, we show this probable range of fair values for Target. We think the firm is attractive below $57 per share (the green line), but quite expensive above $85 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 $71 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $86 per share in Year 3 represents our existing fair value per share of $71 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.
Wrapping Things Up
Target has faced some tough decisions as of late, including ceasing its operations in Canada as well as dealing with a credit/debit card breach. The company is focused on narrowing its operating focus and driving traffic, but future growth prospects have come into question as of late. We view Target as one of the premium retailers in the industry, but competition from the giants including Wal-Mart and Amazon help keep us at bay. We're not sold on the firm's growth strategy to drive traffic and keep geographic expansion on the back burner - its valuation, while at the low end of the fair value range, isn't as compelling as other ideas in the market. All things considered, we are not looking to take a position in Target at the moment in the newsletter portfolios. The firm currently registers a 3 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.