Target: Skeptical of Ackman's Valuation

Jan. 6.08 | About: Target Corporation (TGT)

On Wednesday, January 2nd, Bloomberg News reported that Bill Ackman told investors that Target Corp. (NYSE:TGT) could be worth $120 per share over the next few years. Ackman, through Pershing Square Capital Management LP, owns close to 10% of the Company and has lobbied TGT management to consider a variety of proposals such as selling off its credit card division and monetizing its real estate. Proceeds from these two actions would likely be used to fund a massive share repurchase, juicing EPS. Ackman's valuation target is not really surprising because it's basic financial engineering (which I highlighted in a previous post) and it's for that very reason Ackman's plans won't work.

I believe that financial engineering can work when a company's operations are headed in the right direction because while "financial engineering" sounds sophisticated, when it comes to corporate finance, it's really just about leveraging a company's capital structure. However, when there are operational issues, the market will see right through any proposed engineering and focus on the core business. Further, over the past few years "Value Creation 101" has gotten to be too vanilla where fund managers think share repurchases and monetizing every asset for short-term accretive EPS growth is a real solution. Ackman's proposals may make sense on paper but I believe his valuation target is dependent on far too many variables and ignores too many potential obstacles.

Ackman believes TGT should sell off its Credit Operations division which has been a substantial profit contributor to the Company. Management has also remained steadfast in its belief that the division is highly integrated into the core retail operations. Ackman thinks TGT is the best retailer in the business but in this case has generally dismissed management's view on one of its operating divisions. While management eventually hired Goldman Sachs (NYSE:GS) to explore a sale of the business, I suspect that credit conditions and signs that TGT's credit portfolio is experiencing some difficulty will make it unlikely that TGT would receive an attractive offer for the division.

Ackman also thinks TGT should monetize its real estate as he estimates the value to be roughly $40B. I am no real estate expert but given the general climate in the retail environment and TGT's declining performance, I am skeptical of a bank's ability to backstop TGT's real estate against $40B. However, investors "get" what Ackman is generally doing which is just to simply leverage EPS growth through debt or implied debt through leases/rent-expense.

The TGT Levered Income Statement in my previous post approximated what Ackman is trying to do and if you look to the 2010 EPS projection you'll see a $5.51 EPS projection. I also wrote towards the end of that post:

If Pershing Square pursues this avenue and TGT management decides to gear its capital structure, shares of TGT may warrant a higher EPS multiple to reflect the accelerated EPS growth rate and return metrics. The geared balance sheet results in EPS growth of 20+% in the coming years compared to the 13% EPS growth rate based on the current capital structure. As a result, the market may place a higher P/E multiple on shares of TGT. If the Company achieves a 20-25x P/E, the new capital structure could result in an annualized return of 25-30% over the next few years, based on current share prices.

So a 2010 EPS of $5.51 multiplied by a 20-25x EPS multiple gets you to a share price of $110-$138 per share, basically where Ackman is projecting shares will be in 2010. It looks great on paper and in theory but I don't see the market playing along. First, Ackman's valuation assumes there are no disruptions in operations from the sale of the Credit Operations segment. Management has implied that it's an integrated part of the Company so why disrupt TGT when it's going through a difficult period with its core operations? If management is correct in its assessment that the Credit Operations division is an important part of the Company, one would have to expect some time and potential costs (beyond just separation costs) associated with divesting the business segment that could drag core operations.

Secondly, Ackman's price target assumes TGT management can work as effectively in a levered environment compared as in the status quo. There have been great managers that have not transitioned well into companies with more leveraged capital structures and that risk should not be understated, especially when the change would be drastic compared to the Company's historical capital structure.

Finally, the most important variable is the assumption that a higher market valuation is achieved. TGT is an iconic American brand but on the surface it looks like it might be becoming the new Wal-Mart ("WMT") in terms of investor sentiment. TGT is putting up WMT-like same store sales which is not something investors are accustomed to and if this trend persists, TGT shares could drop further and/or languish for a very long time. TGT looks cheap here and against forward estimates but those are Street estimates which impound the historical performance of high same store sales in their forecasts.

In addition, being U.S.-centric compared to WMT's global operations may result in even less enthusiasm for TGT shares relative to other seemingly "cheap" megacap retailers. On a trailing basis and against historically optimistic Street estimates, TGT looks cheap but I think the market is illustrating that the Company is really fair to overvalued given the economic headwinds facing the Company and its clients, which are proving to be not quite as resilient as the Street had initially expected. Simply stated, TGT's share price is cheaper but valuation on a forward basis is not that compelling, irrespective of Ackman's plans.