First Signs Of A Successful Turnaround

Summary

• Target's EPS will come in better than expected.
• The company has managed to turn its comp sales around.
• Target's shares look inexpensive and investors get a nice dividend on top of that.

Thesis

Target (NYSE:TGT) is a very profitable and inexpensive retailer, which had to battle dropping same store sales. The company now shows signs of growth, which makes its shares attractive for those seeking capital appreciation as well as for those looking for income.

What has happened?

On Thursday Target's management announced that its second quarter earnings would exceed the guidance it had set previously ($0.95 to $1.15 per share). More importantly, management stated that its same store sales are performing better than expected as well, the company guides for an increase in its same store sales now (management had expected another decline previously). This means a pretty big improvement from what we have seen in the last few quarters:

Q1 2016: SSS were up 1.2%

Q2 2016: SSS were down 1.1%

Q3 2016: SSS were down 0.2%

Q4 2016: SSS were down 1.5%

Q1 2017: SSS were down 1.3%

We see that Target's same store sales problems started emerging one year ago, in Q2 2016, with the worst performance being recorded in last year's fourth quarter. Quarter to quarter Target's same store sales have already improved slightly, but with Target guiding for a positive same store sales number it looks like Target's comps will see a big bump in the next earnings announcement (which will be made in August).

This will not only support Target's share price in the short term, a major shift in Target's comps momentum also has a huge implication for Target's worth in the long run.

The Discounted Cash Flow method, which is used to determine a fair value for a company's shares, comes to significantly different results when we change the company's growth rate slightly:

Using the finbox.io DCF calculator I got the following results:

We see that a change in Target's long term growth rate from -1.0% to 1.0% means that Target's shares increase their value by more than 40%.

If Target is able to keep its comps growing going forward, the company's shares look attractive at the current price. In the DCF model I used (I calculated with a discount rate / required return of 7%), Target is currently undervalued by about 50% when the growth rate remains at 1% going forward. Even without any growth Target would be undervalued, due to the company's shares trading at a valuation that implies ongoing declines.

It is, of course, not guaranteed that Target will be able to keep its comps (and thus also revenues, cash flows, etc.) growing, but the fact that the company was able to generate enough sales momentum for a positive comps number in a bad retail environment is a big positive. Target's strategy of getting back to growth seems to be working: That strategy includes the introduction of new private brands, such as Cloud Island (which was released a couple of weeks ago). The company will introduce additional exclusive brands for Apparel as well as its Home products -- in total 12 new brands will be introduced over the next 18 months.

Management has also stated that they are happy with the results of the company's Target Restock program, which allows shoppers to order a shopping-cart sized box with next-day delivery. With Target Restock featuring over 10,000 different products, the program has a lot of potential to change the way people buy essentials and shop for groceries, and with next-day delivery being featured the program could hold up well against Amazon's (AMZN) offerings.

Takeaway

Target's long term outlook is improving, the company's shares are looking very inexpensive, and investors get a juicy 4.8% dividend yield on top of that. With Target's Q2 EPS forecasted to come in above $1.15, the payout ratio is still pretty conservative at roughly 50%. With interest rates still pretty low, Target thus looks compelling for income focused investors -- those will benefit from improving fundamentals at Target as well, through a higher dividend growth rate going forward (after Target's rise this year has been rather small at 3%).

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TGT over 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.