Target: Aiming Lower

Summary

• 2022 revealed that much of the massive growth that Target delivered over the prior 2 years came from a temporary shift in consumer behavior.
• Target is now aiming for 6 percent operating margin by around 2024, down from the 8 percent expected a year ago.
• 2023 looks to be a recovery year with minimal comp sales growth. The stock looks fairly valued on 2024 earnings if the retailer can hit the 6% operating margin goal.

Vertigo3d

More Help From The Market Than Previously Believed

A year ago, Target Corp. (NYSE:TGT) was coming off of two strong years of growth during the covid-influenced period of 2020-2021. The share price doubled during this time frame without having to rely on multiple expansion, as earnings per share also doubled during this period. Revenue growth was a key driver, with sales increasing $27.5 billion in 2 years (36%) after increasing only $5.9 billion in the 6 years prior to that.

Data by YCharts

Target adapted quickly to the change in shopper behavior during the pandemic, using its stores to fulfill online orders and expand drive-up and delivery options. Headed into 2022, management thought they could continue to deliver the 8% operating margin they achieved during the pandemic. They even expected to deliver this margin despite some headwinds such as increasing employee wages and benefits and a growing theft problem. Management noted at the start of 2023, inventory shrink had increased over $500 million in 2022. That's about 0.5% of sales and again, that's just the increase, not the total amount. Finally, in the first quarter of 2022, it became clear that consumers were switching back to pre-pandemic behavior, spending more on services and less on goods, and shifting their goods purchases more toward lower-margin staples. As a result, Target was stuck with excess inventory which it would have to mark down to clear out through the year. Along with the added operating costs masked by strong sales the prior two years, this cratered the operating margin to 3.5% by the end of 2022.

Data by YCharts

This first quarter result shocked the market and dropped TGT stock price to the $160 level, where it has basically flatlined since.

Data by YCharts

Lowering Future Expectations

Looking forward, 2023 is expected to be a recovery year. Same store sales are expected to be about flat. With inventories closer to right-sized, the company should see a small improvement in gross margin. Operating margin will also see a lift from lower freight and transportation costs, as supply chain issues and energy inflation have subsided. The overall impact is expected to be a $1 billion increase in operating profit for 2023. This represents an operating margin of 4.4%, which is still below historical averages. Longer term, Target now only expects to get back to 6% operating margin, or just in line with where it was prior to the pandemic.

I show the impact of these reduced expectations in the earnings model below. For 2023, the resulting EPS I calculate is $7.75, which is at the low end of the company's guidance of $7.75-$8.75 and requires a modest share buyback to reach that.

The picture improves considerably in 2024, assuming Target hits its rebased operating margin goal of 6%. The company should earn $11.41 per share that year. That also assumes a resumption of same store sales growth at 3% and a mix shift resulting in a further improvement in gross margin, though it remains below 2021 levels.

Author Spreadsheet

Looking further out, I expect Target to continue growing sales in line with nominal GDP, plus less than 1% more for new store openings or improvements to existing stores. This would result in long term sales growth around 5%. If margins remain constant at the 6% operating margin, the company can squeeze out another couple percent of EPS growth through share buybacks. Therefore, I expect 7%-8% EPS growth in the long term.

Valuation And Capital Management

2023 is still a recovery year, meaning I don't consider this year's earnings representative of the longer-term trend. At $163, Target is valued at 14.3 times 2024 earnings. We see on the chart below that the stock had an average P/E right around 15 prior to 2020 when the company had similar margins and growth rates as those expected in the future. As this is a trailing P/E, it implies a price target of 15 * $11.41 or $171.15 by the end of 2024. That is just a 5% return over the next 21.5 months, or about 2.8% annualized. Add in another 2.7% annualized for the dividend yield, and we get an expected return of 5.5%, below the market average.

Seeking Alpha

Target had $4 billion of operating cash flow in 2022, less than half of the 2021 result. Working capital consumed $2.4 billion of cash in 2022 compared to the $1.4 billion cash use in 2021. The company built inventories in 2021 and paid off payables in 2022. Capex in 2022 was $5.5 billion, meaning Target had negative free cash flow of -$1.5 billion last year. I expect this situation to improve in 2023 as Target now has its inventories in line. Assuming cash use for working capital goes back to the around zero average it had before 2020, operating cash flow should be about $6 billion next year. The midpoint of company capex guidance is $4.5 billion, meaning free cash flow will be $1.5 billion in 2023.

Target paid $3.96 in dividends in 2022. ($0.90 quarterly in the first half, $1.08 quarterly in the second half) This used $1.8 billion of cash. For 2023, I do not expect as large of a dividend increase. I will guess $1.15 quarterly for the next two dividends, which would be a 6.5% increase and a 2.8% forward dividend yield. The dividend will use about $2 billion of cash in 2023. Additionally, I expect a buyback of around $1.1 billion. If that happens, the company will need to issue another $1.6 billion of debt next year which is a 10% increase from the $16 billion of long-term debt outstanding at the end of 2022. From the earnings model above, interest coverage (operating income / interest expense) will be 9.4 times in 2023. Debt/EBITDA leverage at the end of 2023 will be 2.4 times. This level of debt is manageable for one year as Target gets back on track, but in 2024 I expect to see positive free cash flow after debt and buybacks. Based on the model above, leverage will also come back down to 1.9.

Conclusion

Target had a rough 2022 as the consumer spending that swung its way during the pandemic shifted back to historical patterns. In prior analysis, I made the mistake of attributing too much of Target's growth to their own operating capability rather than market conditions. I (along with management) also missed the operating cost growth as it was masked by stronger sales growth. Nevertheless, Target did grow sales and market share strongly in 2020-21 and is at least managing to hang on to it so far.

Looking forward, the company will deliver operating margins and growth similar to what they did before 2020, but with this higher sales base. 2023 will still be a recovery year but I expect Target to be back on track in 2024. Using that year as the basis for valuation, I expect positive but below-market returns for the next couple years. As a long-term owner, I will continue to hold Target due to tax impacts of selling and lack of clear winning alternatives in the sector. Those looking to start a new position should wait for a sale or shop elsewhere.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TGT either through stock ownership, options, or other derivatives. 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.