TGT : An inflation hedge with a call option on growth

September 12, 2011

What a difference a couple of months makes in the ease of finding value stocks! Now that we’re awash with stocks trading at cheap valuations, what kind of stocks should one invest in? I humbly suggest Target, a stock that I think will hold its ground even in a double dip recession coupled with inflation, and will really take off if the economy stages a recovery.

The “Target will be driven out of business by Walmart” meme

Target is a familiar name to most US residents. The second-largest general merchandise retailer in the US (with 1750 stores exclusively in the US) had poor comparable stores sales during the recession, while its competitor Walmart posted better comparables. This led to phrases like “new normal”, and worries that Target customers were flocking en masse to Walmart. When comparable stores sales at TGT rose only 0.9% in January 2011, below the average for most other retailers, investors’ worst fears were apparently confirmed, and the stock staged a rapid 25% decline to the $45-50 range. This decline was probably accelerated by Bill Ackman puking out shares after a failed campaign to get Target to monetize its real estate holdings.

Competent retail analysts are aware that Target and Walmart are not, in fact, in direct competition. The two companies have different business models. Walmart strives for scale and operational efficiency, stocking less SKUs and maximizing inventory turns, appealing to its price sensitive and utilitarian shoppers who know what they want and want to get it at the lowest price. Target’s business model is akin to Costco’s, selling high quality merchandise in a pleasant shopping environment at low margins, while making more profit from shoppers who make discretionary impulsive purchases while browsing the store. Target’s consumers have retrenched during the recession and are doing less discretionary shopping, leading to lower comparables, but are still shopping for the essentials, an area where Target’s and Walmart’s prices are much closer. Shopping turns out to be a surprisingly sticky activity. Target is not losing customers; rather, its customers are changing their shopping habits in the face of the tough economy. Target management is aware of customers’ cash flow problems, and has rolled out the REDcard credit card initiative, which gave customers a 5% discount for shopping at Target, to huge success. Target also has a very low cost base, owning most of its stores outright and therefore not having to pay leases. These factors have led to Target staying in the black throughout the recession despite poorer profitability. I believe that Target’s customers have already retrenched all that they can, and that sales at Target have reached their nadir. Walmart’s growth coincided with a flood of low-cost imports from China, a phenomenon that likely has run its course, given rampant cost inflation in China, and going forward, Walmart’s customers are likely to find more pricey products and a higher incentive to try out Target stores. Going forward, investors will also see that the declining situation at Target has stabilized. More recent data bear this out, with Target’s August 2011 comparables up 4.1%. It is important to note that even if comparable sales do not take off and stay at this depressed level, Target is nevertheless profitable.

Target’s excellent growth prospects

Target has yet to saturate its core domestic market. Walmart has some 3000-4000 stores in the US, while Target has a relatively paltry 1750 stores. Management expects that an expansion to 2500-3000 stores is reasonable in the US market.


Target has also rolled out the P-Fresh concept, selling fresh groceries in stores. This is not expected to add to margins, because groceries are a low margin product, but does result in a 6-7% bump in overall sales in stores where the concept has been rolled out. Presumably, when the market recovers, this will translate to additional shoppers who will contribute to high margin discretionary purchases. While rolling out the P-Fresh concept will cost an estimated $1.8B, the returns are sufficiently high that this will add to growth, especially in a market recovery.


In addition, Target has announced plans to expand into the Canadian market, where it already has high brand awareness from spillover US advertising despite no retail presence. It has recently purchased 220 Zeller’s retail locations for $1.8B, with its first Canadian stores slated for 2013.

Target’s many assets

Property. Target owns 1500 of its 1750 stores. This was the prize coveted by Bill Ackman when he acquired a large block of Target shares during the peak of the real estate bubble, and subsequently tried to force management to spin off the real estate holdings into a separate company and to lease back those stores, thereby “unlocking” value. The popping of the real estate bubble put a crimp in that plan. Now, the value that Ackman’s prize is Target’s competitive advantage, dramatically lowering its operating costs compared to competitors, and helping Target remain profitable in a downturn.

A near impregnable market niche. The moat around Target’s niche is demonstrated by the fact that Walmart once launched a campaign to take market share from Target, but the appearance of high cost products in their stores only caused dismay among its customers and a dilution of Walmart’s brand. The project was later unceremoniously canceled, and replaced with a new campaign to try to raise margins with Walmart’s existing customers. Target’s scale allows it to underprice all other competitors aside from Walmart, and allows it to test out new concepts in select regions before rolling them out to all stores.

Goodwill. Target has enormous brand awareness and goodwill among both customers and suppliers. Suppliers desperately need a retailer of scale aside from Walmart, which has been relentlessly squeezing them on costs, and therefore are more likely to give Target preferable pricing. Among customers, Target’s brand awareness is very high. Target shoppers know that while they will not get the absolute lowest prices, they will have a better shopping experience with a larger selection and good value.

Capable management. Target’s management is known for competence in retailing and financial conservatism. They put a lot of effort into making browsing a pleasurable experience for the shopper, while balancing the need to simultaneously provide a good value proposition. The REDcard and P-Fresh concepts are evidence that management is not resting on its laurels, and are constantly trying to find ways to increase comparables. In addition, Target management is financially conservative, rejected Ackman’s financial engineering ploy as a way to boost earnings, and generally taking a measured conservative approach to growth. While Walmart expanded aggressively into many international markets simultaneously during the boom, and had to retreat from several of those markets eventually, Target had stayed an exclusively US retailer, expanding slowly and preferring to acquire stores in cash rather than through debt. Management has only recently started to get aggressive about growing store count, taking advantage of the low costs to expand into Canada. TGT therefore has a lower debt-to-equity ratio than WMT, with long-term debt adding up to less than half of equity.

Summary of investment thesis

As a general merchandise retailer, Target is likely to be able to pass on inflation costs to its customers, and therefore serves as an inflation hedge. While currently experiencing depressed profitability, Target’s customers are expected to loosen the purse strings if the economy improves. Furthermore, Target’s current growth initiatives are also expected to bear fruit in a recovery economy. At a share price of $50, TGT has a market cap of $36B, or about 12x trailing free cash flow of about $3B, TGT is a stock with minimal downside but poised to explode on the upside with any recovery. Note that TGT has managed to grow the bottom line by nearly 10% annually through the recession, and sports a dividend of 2%.

The only fly in the ointment is that the huge success of the REDcard initially has resulted in credit card earnings making up a significant portion of the total revenues, as well as credit card receivables making up a large portion of the balance sheet. There is some concern that as a company without extensive experience in the credit card business, TGT may have mispriced its receivables. However, Target is expected to sell its receivables to a financial company in the future, a step which should bring in cash for its current expansion, as well as clear up any misgivings about the valuation by bringing in an independent set of eyes. This will also turn TGT into a pure play retailer once again, which would make it easier to analyze for retail analysts.

Disclosure : I have a long position in TGT.

{ 1 comment… read it below or add one }

Patrick December 15, 2011 at 4:21 pm

Fantastic article!

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