Target - Room For More Than One Brick And Mortar Retailer

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About: Target Corporation (TGT), Includes: AMZN, WMT
by: Gary Gambino
Summary

Stocks of most general retailers including Target are priced cheaper than the market average as periodic headlines raise fears of Amazon dominance.

Target and Walmart have both made great progress in improving their online capabilities to keep up with Amazon.

Target has done better with recent major investment decisions and has a more shareholder friendly capital return policy.

Target is valued more attractively than Walmart and is still a buy despite the recent run-up.

Introduction

Retail has been undergoing a major transformation thanks to the behemoth known as Amazon. (AMZN) “Getting Amazoned” is every retailer’s fear, with examples cited in many retail sectors and even extending into financial services. On April 26, 2019, the mere announcement of free one-day (rather than two-day) delivery for Amazon Prime members knocked Target (TGT) and Walmart (WMT) by 5.6% and 1.9% respectively. On the other hand, many industry watchers recognize the value of physical stores and downplay the existence of the “retail apocalypse.” Target and Walmart have both managed to stay relevant with increased capital spending to improve both the in-store and online experience for customers.

Target vs. Walmart Source: 17 Easy Ways to Shop Smarter at Target

Target’s investment program has been more focused and better balanced between stores and online. Walmart took a riskier approach, adding debt to do a dilutive acquisition of Indian online retailer Flipkart which has already run into regulatory hurdles. Following this move, Walmart’s debt levels moved closer to Target’s with little to show for it in the near term while Target’s investments are already paying off based on 1Q 2019 results. Additionally for dividend investors, Target’s capital return policy is superior, beating Walmart in yield, payout ratio, and dividend growth. Despite these advantages, Target is valued more cheaply than Walmart by many valuation metrics. While this discount was even more glaring before Target’s great 1Q earnings report, Target still looks attractive and can be bought here, particularly when the market overreacts to the latest story out of Amazon. Those holding Walmart, particularly dividend growth investors, should consider swapping into Target.

Investing to Stay Competitive

Target began its current improvement program in 2017 with an agenda to remodel stores, improve the supply chain and order fulfilment process, and refresh its brand portfolio to recapture the “cheap chic” it was once known for. Store remodeling included not only refreshing the look of the stores, but creating small format stores in urban and college-focused areas and creating space for dedicated drive-up on online order pick-up. Supply chain improvements included the purchase of Shipt to gain same-day delivery capability. The company also introduced new brands and loyalty programs to drive sales.

Target Investor Presentation Source: Brian Cornell - 2019 Financial Community Presentation

These moves increased capital expenditure from a run rate of $1.5 billion per year up to $2.5-$3.5 billion in fiscal 2018 and 2019. The benefits have showed up in Target’s operating results, with same store sales and traffic improving 5% in 2018 compared to an average around 1% in the prior few years. Even with this extra spending, the company maintained its dividends and buybacks. With the capex tailing off in 2019, Target has further opportunities for capital return going forward, including reducing debt. The market appears to agree, with Target share price gaining over 20% since the earnings report, especially rewarding shareholders who bought in the days and weeks following the panic over Amazon Prime free one day delivery.

Target capex and net debt Data Source: Seeking Alpha Key Data Page (TGT)

Target Comp Sales History

Target Capital Deployment

Source for above 2 slides: Cathy Smith, CFO - 2019 Financial Community Presentation

Walmart has also been spending on store remodeling and online pick-up areas. They have also rolled out grocery delivery, even with an option for the Walmart employee to enter your house and fill the refrigerator for you. Compared to their run rate of around $12 billion per year capex this past decade, expenditures on these efforts have not moved the needle as much as Target. Instead, Walmart rolled the dice with a $15 billion investment in Indian online retailer Flipkart. The rationale was not only to grow business in India but to find best practices the company could apply in other parts of the world. The company predicted this acquisition would be dilutive to EPS by $0.60 this fiscal year, so it’s clearly a longer-term growth strategy.

Walmart capex and net debt

Data Source: Seeking Alpha Key Data Page (WMT)

Late last year, the Indian government threw a major roadblock in Walmart’s path with a law preventing foreign companies from selling their own products on Indian websites. Amazon is also impacted by this law. Since then, Walmart has not given any guidance on if or how the economics of the Flipkart deal will be impacted, choosing instead to play up the value in learning Flipkart’s best practices to apply elsewhere. Meanwhile in the US, Walmart is guiding to a 2.5% - 3% same store sales growth.

Walmart FY 2020 Guidance Source: Walmart 4Q19 Financial Presentation

Target’s investment plan appears to have been the more effective of the two so far. Perhaps Target learned from its ill-fated expansion into Canada in the last decade and has downplayed international expansion in favor of getting the fundamentals right at home. Walmart tried expanding into one of the few large markets in which it is not already dominant and appeared caught off guard by regulators.

Relative Valuation

Even with Target’s better execution and growth forecast, the market still values Walmart at higher multiples. Despite the over 20% run-up in TGT since the 1Q earnings release, Target remains the better buy at this point. Looking at price ratios, Target is cheaper on trailing 12-month and forward P/E, TTM price/sales and price/free cash flow. I always take long term growth forecasts and PEG ratios with a grain of salt, but TGT is cheaper on those bases as well.

Target vs. Walmart Comparison
Market Cap P/E P/E P/S P/FCF EPS FWD PEG
$ billion (TTM) (FWD) LT Growth
(3-5 yr CAGR)
TGT $ 45.0 15.0 14.8 0.60 18.5 6.35% 2.3
WMT $ 320.6 38.3 23.2 0.62 20.8 4.03% 5.8

Data Source: Seeking Alpha Key Data Pages

I would also recommend taking a look at the Profitability Ratios page for each stock. Target comes out better than Walmart on nearly all operational ratios, including Return on Total Assets, Return on Total Capital, and Return on Common Equity.

Target vs. Walmart Profitability Ratios (TTM)
ROA ROC ROCE
TGT 7.42% 10.71% 26.98%
WMT 3.57% 9.93%

11.66%

Data Source: Seeking Alpha Profitability Pages

Finally, on the dividend front, Target boast a better yield and 5-year dividend growth rate, along with a similar payout ratio.

Target vs. Walmart Dividend Comparison
Share Price Dividend Yield Payout Ratio Growth Rate
7/3/2019 1-yr FWD 1-yr FWD TTM 5 Year
TGT $ 87.90 $ 2.64 3.0% 47.22% 9.79%
WMT $ 112.32 $ 2.14 1.9% 46.23%

2.04%

Data Source: Seeking Alpha Dividend Pages

Conclusion

To put it simply, I cannot find a reason in any of the valuation metrics why Target is so much cheaper than Walmart. For this to be correct, Mr. Market must believe either Walmart will be the sole brick and mortar retail survivor over the long term, or that the Flipkart acquisition will work out and deliver value making Walmart a major emerging market online retailer. I personally think these are highly unlikely. Target seems to have found its "target" customer, so to speak, and has executed well on the improvements needed to keep them shopping there.

I came to this conclusion for my own portfolio back in mid-May prior to Target’s 1Q results and I sold WMT to buy TGT. Target is still attractive even after the post-earnings run-up in the share price. I can understand if an investor might want to wait for a pullback to start a new position at this point, but those holding Walmart or other retail stocks should take an updated look at the valuation metrics and decide if it makes sense to swap into Target now.

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.