Target (NYSE:TGT) is a leading retailer led by a management team with deep industry knowledge. As a provider of investor relations services, I find the company's brand name to be a critical driver of value. To think, the "Target" name was adopted at the turn of the millennium (does anyone recall that it used to be called "Dayton Hudson"?) In any event, this year will make winners and losers in the industry - effective communication to shareholders is critical for success. Much of the reason why Target is so undervalued is because it has (1) a low weighted average cost of capital (WACC) and (2) a sustainable brand.
I have already detailed the company's fundamentals here. In this article, I will run you through my DCF model on Target and will then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST). I find that these retailers are safe and meaningfully trading below intrinsic value. Smaller competitors, such as Dixon's Retail (OTCPK:DSITY) and Home Retail Group (OTCQX:HMRTY) are structurally advantaged to significantly appreciate from greater consumer expenditures.
First, let's begin with an assumption about revenues. Target finished FY2011 with $69.9B in revenue, which represented a 3.7% gain off of the preceding year. Analysts model a 11.1% consensus growth rate over the next five years, and I share this sentiment.
Moving onto the cost-side, there are a few items we need to address: Operating expenses, taxes, and capital expenditures. I expect cost of goods sold (COGS) to eat 79.5% of revenue over the next few years compared to 20% for SG&A. These figures are roughly in-line with the historical 3-year average levels. I model the same way for capex, so I assume 3% of revenue. Taxes are forecast at 36%.
We then need to subtract out net increases in working capital. I model accounts receivables as 10% of revenue; inventories as 16% of COGS; accounts payable as 11% of OPEX; and accrued expenses as 20% of SG&A.
As I stated earlier, WACC will be a main driver of value creation for the firm. Target has an unlevered beta of 0.52 and a debt/equity ratio of 1.11. With the equity market risk premium at around 5.9%, cost of equity is around 6.14%. Accounting for the overall capital structure, WACC comes out to 6.56%. Taking a perpetual growth rate of 1.5% and discounting backwards by 6.56% yields a fair value figure of $75.10, implying 33% upside.
All of this falls under the context of strong operating momentum:
We are pleased with Target's full year financial results, which reflect the ability of our teams to manage our businesses in an up and down environment. Our fourth quarter adjusted earnings per share, which we report as a measure of the performance of our U.S. businesses, were $1.49 per share this year, up 8.3% from 2010. For the year in total, our adjusted earnings per share were $4.41, up 14.3% from a year ago.
For the fourth quarter, our comparable store sales increased 2.2%, more than a percentage point below our expectation as we entered the quarter. This shortfall was concentrated in the peak of the holiday season as promotional activity throughout Retail was exceptionally intense, and we chose to maintain an appropriate balance between driving sales and profitability. Post-holiday, the pace of our sales returned to the much stronger pre-holiday pace, and we've seen sales momentum build, particularly in discretionary categories.
From a multiples perspective, Target is attractive. It trades at a respective 13.2x and 11.7x past and forward earnings versus 25.5x and 20x for Costco and 13x and 11.2x for Wal-Mart. Assuming a multiple of 16x and a conservative 2013 EPS of $4.76, the rough intrinsic value of Target's stock is $76.16.
Consensus estimates for Wal-Mart's EPS forecast that it will grow by 8.2% to $4.86 in 2013 and then by 8.8% and 9.3% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $5.19, the rough intrinsic value of the stock is $83.04, implying 40.8% upside. The hidden benefit to investing in Wal-Mart is that the retailer is actually a heed against inflation. It has expanded its real estate holdings and has significant international penetration. Costco is riskier due to its premium. On the other hand, the company is strengthening its image as a discount retailer and has a core focus on high-growth Asia. Management aims for 1K additions to the club pipeline, and it has strong liquidity to finance growth.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.