The news is obviously very bad news for Target, which has already faced stiff competition in its apparel categories, as the push into food and everyday essentials makes Amazon.com a direct competitor in nearly all of Target´s categories.
This move seriously impairs the future of Target as long as the business continues to make incremental investments into digital and channels its declining earnings into continued share buybacks and dividend payments. That's especially if the company needs to borrow to finance this trajectory; just look at the case of Fossil (NASDAQ:FOSL).
Mr. Cornell has to wake up and dramatically change the strategy, and investors should stop whining about dividends and repurchases if they wish to see any returns on their investment a few years down the road. I am not specifically calling out Target, as the business is doing reasonably well; rather, this deal has to be a wake-up call for executives of the company and its peers.
How Bad Is The News?
Amazon has grown its sales in the US from $55 billion in 2014 to $90 billion in 2016, and is almost certain to surpass the $100 billion mark this year, as it could double sales in three years.
Unfortunately the company does not break out sales into specific categories, but we know that some household essentials and apparel have become rapid growth categories on top of the core media/electronic sales as well as AWS.
Amazon.com first hit the electronics stores very hard, and department stores are now feeling the pain of its expansion and that of other online players. Businesses operating in auto supplies, selected food & household essentials and MRO supplies have already felt the emergence of Amazon.com. The deal with Whole Foods shows that Amazon.com is real about the grocery market.
As the company is now going all in on grocery products, how bad is this going to impact Target?
Target´s 2016 sales are classified into 5 categories, each making up roughly a fifth of sales. This includes household essentials, food & beverage, apparel & accessories, home furnishing & decor and hardlines. With the move to acquire Whole Foods, Amazon.com is essentially making a full invasion into the first two categories, each making up 22% of Target´s sales.
While Amazon is set to grow sales from $55 billion to perhaps $110 billion in the US between 2014 and 2017, Targets´s sales are set to drop from $73 billion to perhaps $68 billion this year. At the same time, the digital penetration has risen from merely 2.6% to 4.4% of sales.
Target has real challenges at hand and can only be happy that it has reversed its poorly planned expansion into Canada. This move saddled the company with big losses in recent years. Another positive is that the negative sentiment regarding the data breach is in the past. That being said, the operational issues are very real.
The good thing is that leverage remains reasonable: EBITDA came in at $7.3 billion in 2016, for a 1.5 times leverage ratio with $11.6 billion in net debt. The pension plan has liabilities of $3.8 billion, but fortunately the plan is fully funded.
Perfect Storm Arises
While investors had thought that Canada and the data breach were in the rear view mirror, earlier this year Target reset expectations as the 1H 2017 department store unwind was in full swing.
When the company posted the full year results for 2016 in February of this year, expectations were reset in a big way, prompting shares to fall from $65 to levels in the fifties. The shocker was the guidance for a low single digit decline in comparable sales, as adjusted earnings were seen at $4.00 per share this year, plus or minus twenty cents. This is down substantially from the $5.01 per share reported in 2016. That guidance cut roughly a billion from EBITDA, which means leverage ratios jumpin from 1.5 to 1.9 times EBITDA if the actual debt load is unchanged in 2017.
There were some bright spots in the first quarter, as the company maintained the guidance but acknowledged that adjusted earnings might surprise to the positive side. This optimism brought some relief to the share price, which recovered to the high fifties, but this optimism evaporated as Amazon.com announced the deal with Whole Foods.
Given that 40-50% of Target´s sales are set to face direct and more intense competition from Amazon.com, the $4 earnings number might be realistic for the time being, but not for 2019/2020. While digital sales are growing by +20%, it is just a $3-$4 billion business for Target. But their selection, price and delivery are no match for Amazon.com´s Echo ordering, no-cost same-day delivery and unmatched price capabilities, which are to become a reality in the coming years.
As a result, I can easily see Target running into major trouble. This is certainly the case given that adjusted earnings are running at just $2.2 billion this year, versus a +$11 billion net debt load (although backed by real estate). The issue is that, despite the emerging and very real troubles, Target still spent $650 million in dividend and share buybacks in Q1 of 2017. If we annualize these cash flows to investors, they even exceed the projected earnings for this year.
This means the current strategy is woefully inadequate to compete with Amazon.com, as cash flows are still geared towards investors rather than revamping its business (model).
While the natural reaction of many investors (including me) is to look constructively at large drops in the share price, there are a few factors at work that are convincing me not to buy this drop. Target has never faced a competitor like this before; it is miles behind this competitor in terms of quality offering versus service, assortment and price; and it is still in denial, funneling remaining profits to investors rather than trying to turn the ship.
Of course the stock is very cheap if you look at a 5% dividend yield, historical multiples and even current earnings multiples. At $50 per share, shares trade at just 12 times projected earnings of $4 per share, and if the company can restore historical earnings, shares look even cheaper.
The reality is that historical profits are history, as normal ¨reversion¨ of this cycle is not likely to repeat itself in this case. Does this mean I am shorting Target? Hell no; if Amazon.com does not execute well, Target would be a very dangerous stock to short given the cost of carry (dividend) of such a position and the move we have seen already. It simply means that I am not buying this drop yet, as the stock is not trading at firesale levels and no obvious value can be ¨unlocked¨ by, for instance, a real estate deal.
Do not think that Target is the only company being affected by this. And I certainly have no aversion to it specifically. Perhaps Kroger (KR), a former darling, is even more badly positioned to deal with this competitor given its higher leverage, expensive service levels and pure focus on groceries. Even very well run businesses like Wal-Mart (WMT), which has capital and price competitiveness, and Costco (COST), which has those same qualities, are suffering from the announcement. These businesses might be better equipped to deal with the new competitor given those features of the business.
I will await future developments with great interest, but to become a shareholder of Target I would like to see a big response, as it might come later than many realize. Believe it or not, if I were a shareholder I would welcome a halt of share buybacks and dividend payments, and would be pleased to see a comprehensive revamping of the business, including potential M&A. The current pace of incremental adjustments with little capital spending behind it are simply not going to reverse the trend.
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.