Target (NYSE:TGT) has been criticized by investors for raising wages. The theory is simple. Higher wages put pressure on earnings. Weaker earnings reduce cash for shareholders. Of course, Target has a great history of returning cash to shareholders. It did it with 49 consecutive years of dividend increases. Now it is also using an aggressive buyback program.
Since Target took some political stances, investors may be inclined to think this was a political decision. Raising wages had very little to do with politics, but it had everything to do with intelligent business practices. Wages are driven by supply and demand. Demand for labor has been weak for years. Since the Great Recession labor demand has been weak. In 2015, we finally saw labor demand move higher as shown in the following chart:
Source: Calculated Risk Blog
In 2015, the volume of job openings finally surpassed the hiring rate per month. In 2014, the two had temporarily converged. It wasn't until 2015 that job openings moved above the hiring right by any material amount. It marked the end of the period where job openings were routinely lower than the number of new hires per month. The gap still wasn't huge, but it was present and it was following a clear trend.
Implications of Weak Openings
For years, the weak level of job openings suggested that every available job opening could be filled in the span of about three weeks. Due to variations in job requirements and hiring speed for different positions that won't be precisely correct. However, it does give us a general feeling for how long a company would need to post an opening to get enough applications that it felt comfortable filling it.
This is a metric used in both businesses and real estate in the concept of "days of inventory". A more direct comparison for days of inventory would be evaluating the total number of unemployed workers, but it works as a rough comparison. At the current rate of hiring and the number of openings reported, it would take over a month for all of those openings to be filled. This naturally creates pressure for higher wages.
It should be no surprise the ratio moving above one (openings to hires per month) coinciding roughly with the decision by several retailers to raise wages. Wal-Mart (NYSE:WMT) also raised wages. McDonald's (NYSE:MCD) raised wages. Even Costco (NASDAQ:COST) raised wages, and it started with a much higher base wage rate than any of the other three companies. Costco has routinely kept wages substantially above the normal level for retail jobs in those areas and enjoyed a competitive advantage in having employees that were more committed to their jobs and more capable of growing in their roles.
Last Company to Move Loses
Raising wages was a competitive plan. The intention was to avoid being stuck as the "Employer of Last Resort". The difference between the strongest employees and the weakest employees is substantial. This is a challenge for modern economics. In theory, there should be a meritocracy.
Does any investor actually believe we have a meritocracy? You might say yes initially, but take a deeper look.
If we have a meritocracy, then the last two candidates for a job must be the two most qualified candidates. If you believe that the two most qualified people to be President of the United States are Donald Trump and Hillary Clinton, I would love to hear what you're thinking in the comments.
Theoretically, if that was your belief, you would need to be thrilled that we are probably going to have one of those two people as president. You wouldn't even worry about who wins because you would be confident the winner must be the best candidate. If you only like one of the candidates, you don't believe in a meritocracy when it comes to the single most important job in the country. Care to explain how the most contest job in the country is not a meritocracy, and yet jobs that pay under $10/hour are perfectly competitive?
Please don't misquote me. Both candidates are disappointing. Meritocracy is the exception rather than the rule.
By raising wages quickly, Target had the opportunity to acquire employees from competitors. Companies leaving their wages at the federal minimum wage were more susceptible to turnover. The stronger employees would be more likely to leave them and join Target.
Some investors complain about the quality of employees at the local retail stores. When they visit Wal-Mart or Target, they find employees to be less than entirely helpful. Ironically that leads to a conclusion that the companies should not pay more for labor. When the product, in this case labor, fails to meet expectations it makes sense to look for a higher quality product. Expecting higher quality at lower wages does not make sense. Expecting immediate and rapid improvement does not make sense. The increase in wages gives the company's stronger hiring power relative to companies with a lower wage rate and it should reduce the employee turnover ratio. The high turnover ratio is one reason many low-wage industries struggle to retain any qualified talent.
Target has been criticized for increasing wages, but the fundamentals of hiring qualified employees required higher wages. The jobs are not inherently desirable and the last company to raise wages is the company with the weakest ability to pick its staff. The advantages of raising wages take multiple periods to show up. Any qualified employees acquired from competitors will still need months or quarters to get acquainted with Target's system. Lower training costs are a natural function of a lower turnover ratio. However, it takes time for that lower turnover ratio to be evident.
Target's earnings are already depressed by the impact of higher wages and lower traffic. Despite the lower levels reported in the lower earnings coming from those lower levels, Target trades at exceptionally low multiples. Is it reasonable to suggest that Target should trade at a lower multiple of earnings due to head wins that are already reflected in current period earnings? No. I do not believe so.
My rating on Target is a buy. I have a significant position in Target. I didn't buy Target on the grounds of it being an incredible company. I bought it because of attractive prices. The low multiple of earnings, EBITDA, and free cash flows means Target must fail dramatically to justify the low price. The EBITDA ratio is incredibly low. Even moderate performance by the underlying business would allow Target to outperform most of the economy. Between a strong dividend yield and an aggressive buyback program, the company is rapidly returning cash to shareholders.
Disclosure: I am/we are long TGT, WMT.
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.
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