Target's fantastic bull run looks to be finally coming to a close. With stretched valuations and recent signs of weakness from the consumer, this retail darling may no longer belong in portfolios. As a result, investors may be better served rotating to other companies with more attractive valuations during this period of market stress.
Target Corp. (NYSE:TGT) has been a stellar investment since the depths of the Pandemic. The leadership team has been nearly flawless in their adaptations to meet the changing consumer dynamic. As a result, investors have been well rewarded with the company's stock easily outperforming Amazon (AMZN) and Walmart (WMT). Unfortunately, it looks like this has come to an end and it is now time to move to other companies with less stretched valuations.
Target, Amazon, and Walmart Since February 28, 2020
Outperforming The Other Retail Giants
Target's run during the Pandemic has been nothing short of spectacular. Management's swift moves to change the way consumers shop led to big success early on and also invigorated customer loyalty. These changes came down to two main areas:
- Online shopping experience
- In-person shopping experience
Additionally, the blending of these two experiences ultimately led to the continued success for Target as the United States began rolling back quarantine restrictions.
The biggest change by far for Target was in their online experience for consumers. The company already had a successful website that was growing quickly with consumers before the Pandemic. This became a critical asset for the company at the start of the Pandemic as most of the company's stores were closed to consumers. During this time, Target's website saw unbelievable growth. While this was no different than the hundreds of other brick-and-mortar retailers that had an online presence, the way they handled delivery was key.
Since consumers could not simply stop by their local Target to pick up an item during the early months of the Pandemic, management had to adapt quickly. While the online team had kept pace with Amazon's Prime Service and maintained a fairly reliable two-day delivery timeline, this was no longer sufficient. The solution was to shift the way the company's nearly 2,000 stores to become distribution centers for online shoppers. Customers were now able to have many of their orders delivered to their home within hours, thanks to the company's ownership of Shipt. Alternatively, they could also pick up their orders in the parking lot of their local Target within a few hours of ordering.
This shift in online delivery made Target a better experience for consumers compared to Amazon as they could get most items within hours, instead of the one to two days that Prime was offering. Walmart was also fairly successful in making this transition for their customers as well. While Walmart's stock didn't perform as well, its challenges outside of the United States were more the driver of the company's relatively weak performance.
Target's leadership also continued to focus on the in-store experience, once their stores reopened. This included continuing to focus on the products that consumers want at reasonable prices. Management was quick to add to their already popular instore brand partnerships by adding Ulta Beauty (ULTA) pop-ups within their stores as well as popular online brands such as Harry's Razors. The constant focus on improving the company's large selection of products during this challenging time continued to attract customers to Target.
Additionally, Target's multi-modal process of shopping was helpful for the in-person experience as well. Customers could leverage the online system to "shop ahead" and pick up their items within the store. This enabled consumers to get their core shopping done ahead of time (groceries, office/school supplies, etc.) and then spend their valuable time on shipping for new clothes and household items. The result of this shift made shopping at Target much more efficient for consumers.
Forward-Thinking Management Is Key
Clearly, management's swift thinking during the Pandemic led to large success for the retailer. The foundation of these changes took place years before the Pandemic as it became clear that traditional retail needed to evolve to compete with online giant Amazon. This forward-thinking is the reason why Target excelled, rather than stumbled during the early stages of the Pandemic.
One main benefit from the Pandemic for Target has been an acceleration of the company's business model to compete more effectively with e-commerce. The race to faster delivery times for consumers has become one of the biggest factors in winning the war for consumers.
Shortening delivery to one day has been an exercise in optimizing delivery routes and logistics processing since it is possible to get anywhere within the continental United States within one day. This is something United Parcel Service (UPS) has excelled at thanks to their multi-year focus on automating and enhancing their delivery network. It should be no surprise that our three big retailers (Target, Amazon, and Walmart) all use UPS as part of their delivery network.
Target's management decided before the Pandemic that one-day delivery was not good enough to meet their customers' needs. As a result of this vision, Target purchased Shipt at the end of 2017. This acquisition provided the company with the capability to now deliver products to consumers within a few hours. This was important for two reasons:
- Met the Increasing Customers Demands - In a just-in-time world, customers wanted to minimize the time between completing their purchases and receiving their products. This new capability was the solution customers were looking for.
- Outdoing Amazon - Amazon had started the delivery war nearly a decade ago thanks to their Prime Service that offered two-day delivery. As the amount of products that were able to be delivered within two days and then within one day grew, brick-and-mortar stores were fighting to keep up with the impressive delivery timeline. The shift to delivery within hours enabled Target to "leap frog" Amazon. This is due to the infrastructure needed to service this model. By turning Target stores into "distribution centers", the company's same-day delivery service was within 10 miles of 75% of the United States population. While Amazon had built an impressive distribution network, it pales in proximity compared to Target's footprint.
It is important to note that Walmart is also following Target's delivery evolution. Although there is a fair amount of success within the United States, non-U.S. stores are a different story. In our view, a lot of Walmart's growth is also based on expansion overseas, rather than continued success with consumers in the United States.
Target has done very well thanks to the changes that management made and has even handily outperformed e-commerce giant Amazon. The challenge now is what to do with the stock. To answer this question, we look to two primary factors:
- Comparable Valuations
- Consumer Habits
On the valuation front, the numbers speak for themselves. One of our favorite metrics is Price to Earnings or "PE". This shows how many times earnings investors are willing to pay for a given stock. Since earnings per share are the ultimate driver of success for a company, this metric can be instrumental in comparing companies to each other and their past performance. For Target, this metric is flashing the "rich" signal as the company trades above its 5-year average and significantly (29.5%) above its peers (Sector Median in the chart below).
Another popular metric to use is a company's price to book value. Similar to PE, this gives investors an idea of how much the market values a company's assets. For this metric, the numbers are more dramatic. Target trades at a nearly 70% premium to its 5-year average and more than double the value of its peers.
While Target is clearly on a streak of fantastic performance, from a valuation perspective, it looks like the company's stock has gotten ahead of itself.
Target's Valuation Metrics
Source: Seeking Alpha.
The other key factor to follow for Target is the activity from its customers. Historically, the Back-to-School season has been a good precursor for the Holiday Season. Generally speaking, if the Back-to-School season is good, so is the end of the year. This is important as most of the profits made during the year for retailers tend to take place in the fourth quarter. While everything has shifted during the Pandemic, the Holiday Season has maintained its dominance over the rest of the calendar for retailers.
What is challenging in 2021 is that there has been little mention of the success of the Back-to-School season. Historically, we would have expected retailers to be touting robust sales by the end of September and generally be in a good mood as they approach their earnings season. This has not taken place this year. Instead, companies are generally only looking to provide an update to investors during their earnings presentations this month and next. In short, this does not bode well for retail-oriented companies.
Putting it together, with Target's already stretched valuations, any weakness on the business front could be a disaster for investors. Considering the warning signs that are coming from the Back-to-School season, now could be a good time to rotate from Target to other, more attractive companies in the markets.
Lacking a Meaningful Dividend
One last area to consider for Target is its dividend. The current yield of 1.3% is rather pedestrian, considering that the S&P 500's current yield is also 1.3%. To put this in perspective, over the past ten years the company's dividend has been above 2%. Considering at one point the dividend yield was over 4%, today's yield of 1.3% is rather paltry.
Target's Meager Dividend - Past 10 Years
Source: Seeking Alpha.
Target's low dividend yield is not for a lack of dividend growth. The company has been steadily growing its dividend over the past decade. The most recent dividend increase earlier this year was one of the largest increases in the company's history. Despite this aggressive growth, Target's stock yield is nearly the same as the broad equity market.
Strong Dividend Growth Couldn't Keep Up With Stock Gains
Source: Seeking Alpha.
As income-focused investors, Target's yield makes the company unattractive for us. For more broadly positioned investors, the company's dividend yield is also flashing a warning. Consider that management teams generally grow the dividend distribution to match sustainable future cash flows from the company (i.e. payout ratios below 100%). If the yield on the company's stock reaches levels significantly below their historical average, this can be another sign that the stock price has gotten too expensive.
To put it another way, we generally expect a stock to grow at the rate of its earnings growth. If the dividend distribution grows at the same rate, the stock's yield should be fairly steady. While there can be some volatility around the company's yield (since earnings change on a quarterly basis while dividend distributions generally only change annually), the trend should hold true. With Target's dividend yield so far below its historical average, this is yet another sign that investors have priced the stock for perfection.
While Target still represents plenty of opportunities for investors, it is always prudent to consider the potential risks associated with investing in the company.
- Shift In Consumer Habits - The biggest risk for all traditional brick-and-mortar stores is the disruption caused by e-commerce. In Target's case, this generally relates to Amazon encroaching on their wallet share. While Target has built a comparable online experience to Amazon and a delivery experience that is arguably superior, this threat is still a major concern. The convenience of Amazon's platform and ability to leverage one's shopping and internet habits to make better recommendations make Amazon a major disrupter. As Amazon is able to grow its wallet share from Target consumers, the stock may suffer.
- Consumers Going Upmarket - Another concern for Target is the potential for consumers to shift their buying habits towards higher-end products. Since Target is known for providing low-cost products, this shift can put a dent in sales. Fortunately, Target is focused on bringing in new products that meet ever-evolving consumer preferences. While this can mitigate some of this risk, Target can't compete if a customer decides to purchase groceries from Whole Foods (Amazon) instead of Target or purchase clothes at boutiques.
In conclusion, Target led the shift to online and more innovative retail strategies to meet evolving needs of consumers during the Pandemic. While investors have been rewarded for the company's changes, the company's stock price has gotten pretty expensive at this point. Adding in the recent lackluster performance in the Back-to-School period and Target looks less attractive to investors today. We would suggest that in this time of market volatility it would be prudent to rotate from Target to more attractive stocks that are not trading at stretched valuations.
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