First quarter results provided a hint that Target (NYSE:TGT) may not be doing as poorly as the wider market may think. At least three insiders believe so as they put on a combined $1 million bet at current prices in March. The company valuation looks cheap while the stock appears to have stabilized. Any reported improvement by the company will mean recent lows were the bottom.
The stock took a dive in February as the company reported Q4. Same-stores sales dropped (-1.5%) for a third consecutive time, margins dropped (gross and operating were -1% and -0.7% lower) and guidance for the year disappointed. For 2017, Target expects a low single-digit decline in same-store sales (SSS), and EPS in the range of $3.80 to $4.20.
That's an 8% drop from $4.58 (adjusted) last year. The company had also guided for Q1. They expected a low-to-mid single-digit decline in SSS and EPS between 80c and 100c. When they actually reported Q1, they surprised with a 30c beat.
As the table shows below, we see that in Q1 margins were lower year on year. Gross margin was -0.4% lower while operating margins and EBITDA were -0.8% and -0.6% lower respectively. However, if we look at the year earlier, we see that margins are similar and actually Q1 was better than the quarter 2 years ago with EBITDA margin at 10.9% versus 10.5%. So things do not look so bad from this angle.
Analyst expectations are on the far right column (2Q). As you see they expect margin decline to accelerate as they see 6.4% operating margin in the quarter versus 7.7% last year. As a result they estimate EPS at $1.06 this quarter. Personally, I am looking for $1.15 as my base case.
How do I get to $1.15?
The company has guided for a low single-digit decline in SSS and EPS of 95c to 115c. I used a 1% decline in sales and a 6.86% operating margin. I assumed that the margin will decline in line with Q1 (which was -0.8% lower). Include interest and 34.5% and assume a similar decline in shares. Rough approximation? Yes. Logical result? Yes.
Now let's say the analysts get it right and the company comes out with $1.06 then it's a non-event. Of course, in both cases, price action will ultimately depend on the next quarter's guidance. So even if they beat, weak guidance that is below expectations or that would imply 2017 EPS below either expectations or management will likely push the stock lower.
The $1 million bet
The photo below was taken from Insider Monkey (link to TGT) which shows that three insiders purchased shares between $54.86 and $58.96. Combined these open market purchases total $1,075,750 with $230k, $295k and $549k invested by the three. For Knauss and Smith, these are significant increases. Insider buying is usually a good sign for a stock.
Valuation - So, is it cheap?
Insiders must think it's cheap and so do I. Firstly, it ranks among the cheapest 5% of stocks among 3,000 stocks I have in my own proprietary value model. And that is actually how I stumbled upon TGT. (I use models to screen for potential opportunities).
Secondly, the stock trades cheaper or around various discount dividend model (DDM) valuations depending on the assumptions you make. Let's take the simplest DDM where Price = Dividend * (1+growth) / (Cost of equity - growth). If you assume that growth is equal to 3.3% (the most recent increase) and the cost of equity is 8% then the value of TGT is $51.
Obviously, any growth in earnings, dividends or payout ratio improves the valuation. A multistage valuation is probably more appropriate. In a scenario where dividend increases by 3.3% for the next 4 years, by 7.5% for the following 10 years, 5% for the following 5 years and 3% perpetuity results in a value of $70.
Thirdly, using the historical multiples from the last 5 years, the stock is trading at over 1 standard deviation away from its average. Trading at its average multiple would put the stock at $70-80.
Fourthly, a DCF model assuming that margins are -1% lower forever, low sales growth over the next 5 years (-1%, -2%, 1%, 1.5%, 2%), along with higher CAPEX assumptions in the next 2 years results in valuation of $65-68. However this model assumes free cash flow (FCF) drops to $2.6bn in this year and next, while the highest FCF reached over the next 5 years $3.2bn.
This is significantly lower than the last twelve-month FCF of $4.7bn and the last two fiscal years FCF of $3.9bn and $4.5bn. A -0.5% drop in operating margins raise the valuation to $71-74.
Fifth, Wal-Mart (NYSE:WMT) is a competitor and trades at a higher valuation than Target. Below is a table that shows operating margin, return on equity, return on invested capital and FCF to capital for the last six years (most recent on the right).
Target appears to have better margins and returns, or at least is not worse than Wal-Mart. If Target were to trade at Wal-Mart's multiples then it would be valued at $73.
So based on the above, Target appears to be trading at around a 20-30% discount to value of $70-75. On the downside, TGT gets re-rated to a similar valuation as department stores which trade at around 5x EV/EBITDA. In that case, the store drops to $40; however, that is unlikely to happen unless fundamentals get worse than current expectations.
Technicals - Is the stock still falling?
Below is a monthly chart from TradeStation that shows the stock's history over the last 20 years. Yesterday's close takes the stock as far back as January 2014, while it first reached that price in July 2005.
The daily chart from TradeStation shows the 20, 50 and 200-day moving averages, as well as the trading band from March. As you see, the stock has been trading approximately between $53 and $58.50. It may have stabilized. Price is currently above the 20 and 50 moving averages while yesterday's dividend increase will likely support the stock until the next earnings release.
Keep an eye on the 200-day where the stock may find new buyers if crossed or may act as resistance if the move is not supported by improvement in the fundamentals.
The most important takeaway is possibly that the stock is no longer a falling knife and appears to be stabilizing. Short-term traders can play the range while worried long-term investors could use the 52-week low or range as an area to reduce if fundamentals get worse.
It is likely that management has under-promised with guidance as Q1 showed. If it is so, then a surprise next quarter will push the stock higher. If it's a non-event then I have some comfort that insiders are long at a similar price to me, the stock is cheap, the company continues returning capital to shareholders ($15 billion in dividends and buybacks over the last 5 years) and price is somewhat steady.
Disclosure: I am/we are long TGT.
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.