This week, I started my series on COVID-19 with an update on McDonald’s (MCD), and will continue the series with an article on Target (TGT). The retailer is one of the companies I covered quite often in the past – most recently in September 2019. But not only can a lot happen in almost seven months, COVID-19 has also remixed all the cards, and for many companies previous analysis needs to be updated, or is in some cases even worthless.
All these articles will follow the same structure and focus on four different aspects that seem to be very important right now:
- Impacts from COVID-19 – I am trying to analyze how COVID-19 as well as the measure and political decisions (lockdowns, social distancing, closures, etc.) will affect the business model.
- Impacts from a potential recession – As a global recession seems to be inevitable, I will also analyze how a recession will impact the business model.
- Solvency and Liquidity – In turbulent times, debt levels, solvency and liquidity are especially important, and we are therefore taking a closer look at the balance sheet.
- Intrinsic Value Calculation – Although I included a potential recession in the near future in almost all calculations and considered a declining free cash flow, COVID-19 might call for an update of the intrinsic value.
(Source: Author’s own work)
In case of Target – similar to my last article on McDonald’s – I will also look at a fifth aspect: the dividend safety.
Impacts of COVID-19
Although Target stock performed better during the stock market crash in March, it still lost about 22% since February 20, 2020 (the day the S&P 500 marked its all-time high). But compared to other similar companies – like Kroger (KR) or Walmart (WMT) – Target’s performance was obviously substandard.
Nevertheless, Target might be among the very few companies, that could profit from this crisis and increase its revenue, although it is unclear at this point if the higher revenue will also result in higher earnings per share and/or higher free cash flow.
In the last few weeks, due to the fear of a total lockdown and supply chains not working properly and resulting shortages, we saw strong tendencies of panic buying and hoarding in many different countries all over the world, including the United States. And it is not surprising that Target has experienced unusually strong traffic and sales in the last few weeks as customers stock up on many different items, especially food, medicines, cleaning products or pantry items. In a press release from March 25, 2020, the company reported:
Beginning with the fourth week of February and into the first part of March, the retailer saw an increase in traffic and comparable sales across its multi-category portfolio. For the month of February, total Company comparable sales increased 3.8 percent. Beginning in mid-March, the Company experienced an even stronger surge in traffic and sales, with category mix heavily concentrated in the Essentials and Food & Beverage categories. Around that time, strength also emerged within the portions of Hardlines that support in-home activities, including Home Office and Entertainment, while performance softened meaningfully in Apparel & Accessories. Month-to-date in March, overall comparable sales are more than 20 percent above last year, with comparable sales in Essentials and Food & Beverage up more than 50 percent.
These are strong hints that Target will be able to report high revenue growth for the first quarter. According to Seeking Alpha Earnings Revisions data, analysts are now expecting $19 billion in quarterly revenue, instead of $18.2 billion a month earlier. But we don’t know how long this trend will last, and there are first hints that sales might decline again and customers might realize at some point they have enough products for now and we might see a regression to the long-term average again. The strong sales we saw in the weeks of February and March might be balanced out by weaker sales in the next few weeks.
Data from the COVID-19 Community Mobility Reports, which Google is currently releasing, is showing that mobility at groceries and pharmacies is 22% lower right now after it had been higher in the first half of March (compared to the baseline). This does not necessarily mean that revenue will be lower, as it could very well be that customers will visit the stores less frequently but the basket for each visit will be much bigger.
(Source: United States Mobility Changes)
Aside from Google’s data, there are other hints that sales might decline again and stay not at such high levels. In the third week of March, all major retailers like Walmart, Costco (COST) and Target saw declines, with Target declining especially steeply (20% YoY). In that week, Target also saw the lowest number of visits in a long time, down 25.8% from the weekly average baseline (calculated from data between January 2019 and March 2020). We should therefore be very cautious and not assume exorbitant higher revenue for the company.
Additionally, there is a second problem Target is facing. In the above-mentioned press release, the company also writes for the first weeks of March:
During that same period, comparable sales in Apparel & Accessories are down more than 20 percent compared with last year. While Target has maintained its low everyday prices during this period, stronger-than-anticipated quarter-to-date sales have led to gross margin dollar growth ahead of prior expectations. However, continued sales declines in higher-margin discretionary categories could result in lower-than-expected gross margin dollar performance for the remainder of the quarter.
To put it simply, customers are obviously spending more on lower-margin items, and despite the overall increased revenue Target might report for the first quarter, the company’s margins and, therefore, also the earnings per share could be lower. As a result, it is also not providing any clear guidance for the first quarter. To quote the press release once again:
Given the highly fluid and uncertain outlook for consumer shopping patterns and government policy related to COVID-19, there is an unusually wide range of potential outcomes for Target’s first-quarter financial performance.
And Target is also delaying some of its strategic initiatives. It now expects to do only 130 store remodels in 2020 instead of the previous expectation of around 300 store remodels, and will now only open about 15-20 new small format stores instead of 36 previously announced.
For the first quarter, analysts are expecting 7.8% growth for revenue and even 10.5% growth for EPS on average, but estimates for earnings per share range wide from $0.76 to $1.92. And for the full year, earnings per share are also estimated to grow about 5%, with revenue growing about 4.4%. While I won’t bet on growth at the end of the year, I am pretty confident that Target won’t see huge declines due to COVID-19, as its business model should be kind of immune against the virus and the economic consequences.
Impact from Recession
At this point, we can be pretty sure that the United States will also enter a recession (or is already in a recession). Hence, we also have to look at the performance of Target during last recessions to get a feeling how the company might perform in the next few quarters.
When looking at the financial crisis, we see high consistency for revenue. Although revenue growth was very slow in 2009 (only 0.6% growth), the company could grow its revenue every single year during the financial crisis. Earnings per share, however, decreased about 15% in 2008 compared to the year before, and Target could not reach the level of 2007 again for three years (it took until 2011). But compared to many other companies, it was not hit very hard during the recession of 2008/2009. And when looking at the recession during the dotcom bubble in 2002, Target could not only increase its revenue every single year, but it could also increase earnings per share every single year.
The stable performance of Target is not really surprising, as most of the products it sells can be described as essential or recession-proof products. A big part of the company’s revenue is generated from sales that have to be made in a similar way during a recession as during an economic boom. Its revenue is distributed between five different product categories (I couldn’t find an updated version for the chart below, but the distribution is pretty similar in 2019), and several categories include products which are also bought during economic downturns.
(Source: 2018 Annual Report)
We don’t know how Target will perform in 2020 and 2021, but its business model can be described as more or less recession-proof and revenue should be very stable (while earnings per share might decline in 2020).
As already mentioned above, in times of high uncertainty and probably declining revenue, the balance sheet, debt levels and liquidity of a company suddenly become extremely important. In my opinion, looking at the financial health of the company should always be an important aspect in any analysis, but in the last few years, it has seemed more and more as if investors don’t care about extremely high debt levels and “zombie companies” still surviving due to extremely low interest rates.
On February 1, 2020, Target had $2,577 million in cash and cash equivalents on its balance sheet, which is a good starting point to provide liquidity for some time. Additionally, the company has $161 million in short-term debt and other short-term borrowings and $11,338 million in long-term debt and other long-term borrowings. This leads to a D/E ratio of 0.97, which is acceptable and no reason to worry. And in the next few years (until 2024), only $2,205 million in debt is due, which should be no problem for Target.
(Source: Target 10-K)
When looking at the company’s ability to generate cash – in this case exemplified by the operating income of about $4.7 billion annually – we should also not worry about the debt levels, as it would take only about two years to repay the debt with the operating income (after subtracting the cash on the balance sheet).
Moody’s has a A2 rating for Target, which is pretty good, and in a credit opinion published on March 31, 2020, Moody’s stated that the company’s liquidity and credit ratings will remain strong despite the coronavirus crisis.
In my last article on McDonald’s, I also looked at the dividend as a fifth important aspect, as McDonald’s is a Dividend Aristocrat, and many investors might own the stock for the dividend. With 51 years of consecutive dividend increases, Target has also joined the ranks of Dividend Aristocrats, and might be interesting to many investors for the same reason. Right now, Target is paying an annual dividend of $2.64, resulting in a dividend yield of 2.84%.
(Source: Target Investor Presentation)
With a payout ratio of 40%, not only can the dividend be considered as very safe, but Target was also able to decrease the payout ratio in the recent past, and this makes dividend increases in the high single digits more likely. Even if COVID-19 and a potential recession have a negative effect on earnings, dividend investors should not be worried about owning Target stock.
Intrinsic Value Calculation
And finally, I will provide an intrinsic value calculation for Target, taking into account the analysis and assumptions from above. When talking about the company’s performance during past recessions and taking into account potential negative effects from COVID-19, it seems unlikely that revenue will decline (maybe in the very low single digits). But it might very well happen that earnings per share will decline due to higher expenses and people buying lower-margin products. To be on the safe side, we will assume a 20% decline in EPS and free cash flow for the following year.
When looking at the free cash flow of 2019, the number seems rather high compared to 2018, but in 2017, the free cash flow was even higher and the capital expenditures in the last few years were rather high, making us confident that Target can report similar high free cash flow numbers. But for 2020, we take a free cash flow of $3,272 million as the basis for our calculation (reflecting a 20% decline).
For the following years, we just assume 5% annual growth till perpetuity. When looking at the last 20 years, the net income of Target increased 5.2% on average annually (and this number is not including the effect of share buybacks). And we should not ignore share buybacks: since 2011, net income increased only 12% in total, but earnings per share could grow with a CAGR of 5.29% during that time.
When using these numbers, we get an intrinsic value of $126.82, which seems quite high and makes Target undervalued at this point. However, I don’t think the assumptions are unrealistic, and of course, we should include a margin of safety. Considering the high levels of uncertainty we are seeing right now – not particularly for Target, but for the entire market – a margin of safety of 20% seems necessary and leads to an entry point of $101.46.
It is difficult to estimate the impact of COVID-19 and the upcoming recession on Target’s business. I remain pretty confident that the company’s revenue will be stable or even increase in 2020, but it is very difficult to estimate the earnings per share and free cash flow. Although I don’t want to rule out the possibility that the stock will drop lower, I see it as undervalued at this point. And investors also don’t have to worry about the safety of the dividend as well as the company’s solvency and liquidity. It seems highly unlikely that Target will run into trouble.
(Source: Author’s own work)
Stay safe, stay healthy and don’t panic!
If you enjoyed the article and like to learn more about wide moats, please check out my marketplace service: Moats & Long-Term Investing.
Subscribers get access to extensive background information on wide-moats, at least weekly exclusive research, a watchlist of wide moat companies and a chatroom where members can ask questions and exchange opinions about long-term investing and companies with a competitive advantage.
For investing in companies that can beat the market over the long term and create a portfolio with companies you can (almost) hold forever, please check out my marketplace service. You can also take advantage of a free trial offer.
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.