Value Investing

Undervalued Target Corp – 16% Shareholder Yield

One of the cheapest stocks in our Large Cap 1000 – Stock Screener is Target Corporation (NYSE:TGT).

Target Corporation (Target) is a discount retailer that offers everyday essentials and merchandise to its customers. The company sells a range of general merchandise and food through its stores and digital channels. General merchandise stores offer an edited food assortment, including perishables, dry grocery, dairy and frozen items. Digital channels include a range of general merchandise, including various items found in its stores, along with a complementary assortment, such as additional sizes and colors sold only online.

Target is a company that retains a strong brand following the hacking debacle in 2013. Under the guidance of Brian Cornell, Target made the correct decision to divest its loss making business in Canada, and more recently its pharmacy and clinic business. The company is squarely focused on its U.S. operations with the successful roll out of its smaller footprint “flex-format” stores that are customised according to the demographic of their neighborhood. Target is also starting to see significant growth in its online digital offering highlighted by December digital sales growth of more that 40 percent. The company generates loads of free cashflow and is shareholder friendly with the most recent authorisation of a new $5 billion share repurchase program off the back of its current $10 billion program. This equates to a buy-back yield of 12% (ttm), a dividend yield of 4% (ttm), and a shareholder yield of 16% (ttm).

A quick look at the share price history of Target over the past six months shows that the share price is down 15% to $63.70, just 1% off its 52 week low of $62.94. That places Target in oversold territory.

(Source: Google Finance)

The reason for the drop is the downward trend in traffic and sales for all of the large retailers highlighted by recent disappointing holiday sales. Target’s shares recently declined 5.77% in one day, January 18 after reporting comparable sales during the combined November/December period decreased 1.3 percent. For those two months, total sales decreased 4.9%, but its important to remember that this decrease reflected the impact of the December 2015 sale of the company’s pharmacy and clinic businesses. As a result of this softer-than-expected sales performance, the company updated its fourth quarter and full-year 2016 guidance.

“While we significantly outpaced the industry’s digital performance, the costs associated with the accelerated mix shift between our stores and digital channels and a highly promotional competitive environment had a negative impact on our fourth quarter margins and earnings per share”, said Target CEO Brian Cornell.

Target is a company that’s in the process of re-inventing itself following the July 2014 appointment of CEO Brian Cornell. One of Cornell’s first decisions was to stop the bleeding from the $5 Billion failure of Target’s 2011 Canadian expansion in which the company acquired up to 220 Zellers department store locations from the Hudson’s Bay Company for $1.8 billion. The failure was due to a number of reasons including poor store locations, poor inventory management and problems with point-of-sale technology between the U.S and Canadian operations. It was decided that these problems were too big to fix in the necessary time-frame and the Canadian operation was shut down.

This followed the 2013 hacking incident when Target announced that hackers had gotten into their system gaining access to around 70 million customer records. This is how it was reported by Bloomberg:

“The biggest retail hack in U.S. history wasn’t particularly inventive, nor did it appear destined for success. In the days prior to Thanksgiving 2013, someone installed malware in Target’s security and payments system designed to steal every credit card used at the company’s 1,797 U.S. stores. At the critical moment—when the Christmas gifts had been scanned and bagged and the cashier asked for a swipe—the malware would step in, capture the shopper’s credit card number, and store it on a Target server commandeered by the hackers.

Six months earlier Target had began installing a $1.6 million malware detection tool made by the computer security firm FireEye, whose customers also include the CIA and the Pentagon. FireEye spotted the trouble early and alerted Target’s security team in Bangalore who in turn flagged the security team in Minneapolis. But somehow nothing happened.”

The result was lawsuits and arrests but more importantly the company lost the trust of its customers.

More recently, in 2015 Target decided to sell its 1,660 pharmacies and 80 clinics for $1.9 Billion. These are now being re-branded as CVS Pharmacy and MinuteClinic stores within Target locations. Target’s Chief Financial Officer at the time John Mulligan had confirmed the pharmacy business was posted “modestly negative” results, despite $4 billion in sales.

Its fair to say that it has been a tough couple of years for Target but the company now appears to be on track following the appointment of Cornell. While Target’s comparative store revenues may be down, due to the sale of its pharmacy and clinic business, the company is now in the process of rolling out its smaller “flex-format” stores that could be a major part of Target’s future growth.

The smaller Target stores are established in high traffic urban locations and product selection is customized according to the demographic of the neighborhood. In September 2016 the company announced it already had more than 20 of these stores in major American cities with a further 16 expected by the end of 2016. The small store footprint is typically less than 50,000 square feet compared to over 130,000 square feet for an average Target store. According to a research report released by Morningstar analyst Erin Lash, “Sales productivity levels are double those of traditional stores, and the product mix is more attractive.”

Target is also having success with its online digital offering, last week announcing that December digital sales had grown by more than 40 percent. At the heart of the strategy is Target’s social media command center, known as Guest Central, which ensures the company has a pulse on everything their guests are talking about. Guest Central sits on the executive floor of Target’s headquarters, where all team members are encouraged to stop by. The room itself is outfitted with a wall of TV monitors that are following the social conversation about Target and also looking at key categories. The social media team uses this information to track customer sentiment, trending topics and engage with guests. They leverage social listening to understand how a guest has reacted to previous campaigns, initiatives, partnerships or products. The team funnels qualitative and quantitative insights to the Guest Center of Excellence to steer planning.

“From a data perspective, Twitter is the most accessible source of guest conversations that we have. It’s a real time research engine and provides a direct line of access to the customer, outside of the store,” notes Grant Olsen, Manager, Social Media at Target.

Shareholder Yield

What constantly seems to get overlooked about Target is that while its revenues may be down it’s still finding ways to generate significant benefits to its shareholders.

In September 2016, Target’s Board of Directors authorized a new $5 billion share repurchase program. This new authorization will commence on completion of the current $10 billion program, in which the company repurchased 133.1 million shares of common stock through October 29, 2016 at an average price of $70.52, for a total investment of $9.4 billion. A quick look at the company’s cash flow statements for the trailing months (below) shows that Target spent $4.3 Billion in cash on share re-purchases. With a current market cap of $35.9 Billion that equates to a buyback yield of 12% (ttm).

Quarterly Statement of Cashflows ($ amounts in millions) Oct 16 Jul 16 Apr 16 Jan 16
Net Income 608 680 632 1,426
Cash Flow from Operations 1,393 1,241 247 2,005
Purchase Of Property, Plant, Equipment -500 -399 -285 -309
Cash Flow from Investing -469 -390 -279 1,577
Repurchase of Stock -796 -1,340 -898 -1,242
Cash Flow for Dividends -345 -330 -336 -345
Free Cash 893 842 -38 1,696

(Source, Company reports)

In the same period Target distributed $1.36 Billion in dividends to shareholders which equates to a dividend yield of 4% (ttm). When you combine the buy-back yield of 12% and the dividend yield of 4% that adds up to a total shareholder yield of 16% (ttm). The reason the company is able to engage in such an aggressive share re-purchase program and pay out dividends is its ability to generate loads of free cashflow. Another look at the cashflow statement above for the trailing twelve months shows Target generated $4.9 Billion in operating cashflow. With capex of $1.5 Billion that equates to $3.4 Billion in free cashflow and a FCF/Price yield of 9% (ttm), or 6% (ttm) if you subtract dividends.

Valuation

With Target’s current market cap of $35.9 Billion, a quick look at the company’s latest quarterly balance sheet, dated October 29, 2016, (below) shows the company had $1.23 Billion in cash and cash equivalents and total debt of $12.83 Billion.

Quarterly Income Statement
($ amounts in millions)
Quarter Ending: Oct 16
Cash and Cash Equivalents 1,231
Short-Term Debt / Current Portion of Long-Term Debt 729
Long-Term Debt 12,097

(Source, Company reports)

When we add the net debt (total debt minus cash) to the current market cap of $35.9 Billion that means Target has an enterprise value (EV) of $47.50 Billion. We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents

The company also reported operating income of $5.17 Billion (ttm). Therefore with an EV of $47.50 Billion and operating income of $5.17 Billion that means Target has an Acquirer’s Multiple of 9.18, which places it squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Income*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

Summary

Target is a company that retains a strong brand following the hacking debacle in 2013. Under the guidance of Brian Cornell, Target made the correct decision to divest its loss making business in Canada, and more recently its pharmacy and clinic business. The company is squarely focused on its U.S. operations with the successful roll out of its smaller footprint “flex-format” stores that are customised according to the demographic of their neighborhood. Target is also starting to see significant growth in its online digital offering highlighted by December digital sales growth of more that 40 percent. The company generates loads of free cashflow and is shareholder friendly with the most recent authorisation of a new $5 billion share repurchase program off the back of its current $10 billion program. This equates to a buy-back yield of 12% (ttm), a dividend yield of 4% (ttm), and a shareholder yield of 16% (ttm).

In terms of its valuation, Target is currently undervalued trading one percent off its 52 week low on a P/E of 11.74, a FCF/Price yield of 9% (ttm), a FCF/EV yield of 4% (ttm), and an Acquirer’s Multiple of 9.18.