Enlightened Capital Blog

Target (TGT) Investment Write Up

After struggling from 2013-2017 through a data breach, unsuccessful expansion into Canada, and weak growth, Target restored itself by successfully executing on its e-commerce strategy. Target has leveraged its roughly 1900 stores as ecommerce distribution centers, remodeled stores, launched a loyalty program, and expanded merchandise selection. This transformation has led to improved ROIC’s and strong EPS growth from 2017-2019, with further improvements in 2020 driven by the COVID-19 pandemic. Strong e-commerce sales (+163% YTD), and much larger average basket sizes (+15% YTD) have led to record revenue and EPS for Target in 2020.

Going forward, I expect Target will continue to execute on its strategy and benefit from several tailwinds such as consolidating market share from weaker retailers who lack an omni-channel strategy, as well as continued fiscal and monetary stimulus supporting the U.S. economy. Furthermore, e-commerce as a percent of overall U.S. retail is expected to continue growing, and Target will benefit from that trend due to its strong e-commerce platform. As a result, Target should continue growing EPS and FCF at strong single-digit growth rates over the next 5+ years.

The biggest risk to my thesis is weaker than expected EPS growth, as consensus estimates currently expect 1% revenue growth and 4% annual EPS growth through FY24, well below my expectations. However, consensus estimates have consistently underestimated TGT’s financial performance over the past few years, and were subsequently revised upwards. Furthermore, Target has demonstrated strong financial performance prior to the pandemic, as well as during the pandemic. Absent a major shift in the e-commerce landscape, it is unlikely that TGT’s EPS growth rate will decline materially. Specifically, it is unlikely that consumer habits developed over 2020 and 2021, will be broken once COVID-19 vaccines are fully rolled out, and quarantines have ended. At that point, consumers will have become accustomed to shopping at Target, and the company will have further refined its logistics and operations to provide consumers with significant convenience in addition to attractive merchandise. I expect Target to generate 13-16% IRR’s over the next 5 years without any multiple expansion, driven by a 5% FCF yield and 8-11% FCF/share growth.

Key Stats

 

E-commerce transformation driving Revenue/EPS growth


From 2013-2017 TGT experienced minimal revenue and EPS growth, as the company faced setbacks including the 2013 data breach and a failed expansion into Canada.

revenue eps 2013 2017

 

Following this challenging period, Target invested heavily in technology to leverage its substantial retail footprint across the U.S and has leaned heavily into an omni-channel strategy. Specifically, Target’s has:


• Remodeled stores, leveraging them as e-commerce hubs, while expanding delivery and pick-up options to improve customer convenience.
Launched a loyalty rewards program to drive repeat customers and increase average transaction per customer.
• Expanded merchandise selection to provide exclusive access to numerous digital only brands as well as Target brands.

As discussed below, TGT’s successful strategy execution has driven strong revenue and EPS growth, and improved ROIC’s over the past few years. Target has also taken meaningful market share from weaker retailers who have struggled to adapt to e-commerce. Furthermore, I expect this strategy to continue to work for Target as the company continues to remodel stores, expand merchandise, and further increase its market share.

Remodeling stores to leverage as e-commerce hubs


At the center of Target’s strategy, is the use of Target’s 1,900 store footprint for e-commerce distribution. Products flow from TGT’s distribution centers to Target Stores or are shipped for next day or later delivery to customers. Target’s model provides substantial convenience for customers, who can pick up merchandise directly in stores, through curbside pickup, or through delivery options.

The company understands the importance of stores in an omni-channel retail environment. An omni-channel strategy improves unit economics by delivery costs as click and collect is the cheapest form of same day delivery. Shipping from the store is 40% cheaper than from a distribution center and click and collect is 90% cheaper than from a distribution center. This is driven by the fact that 75% of digital sales were fulfilled by stores in Q3, and 95% of total sales were fulfilled by stores in the quarter.

Additionally, TGT’s omni-channel customers spend four times as much as store only guests and 10 times as much as digital only guests. TGT' has experienced massive growth in these offerings, with same-day services (Pick Up, Drive Up, and Shipt) revenue up more than 200% y/y in Q3, with Drive Up alone, up more than 500% y/y. 

To build out its e-commerce capabilities, Target acquired Shipt for $550M in late 2017. Shipt provides same day delivery for Target and other retailers and grocers such as CVS, Office Depot, Costco, and Kroger. Target also spends roughly $300M/yr. in IT to bring the store and e-commerce experience together.

BAML picture

 

Additionally, Target will spend more than $7bn (60% of total capex), to remodel roughly 1000 stores from 2017-2020. Going forward, Target plans to remodel an additional 150-200 stores per year, and at that rate all 1900 stores will be remodeled within the next 5-6 years. Remodeling stores involves improving areas such as food & beverage, apparel, home décor and furniture, and adding space for pickup services like Order Pickup and Drive Up. Refreshed stores generate an average sales lift of 2-4% in the first year, and a 2% uplift in sales in year two. 

Target has also launched smaller format stores, taking market share from grocers, drug stores, and convenience stores, and Target plans to add 30 of these stores on an annual basis. The smaller format stores allow Target to expand into urban neighborhoods and college campuses, expanding from the company’s largely suburban footprint.

Loyalty rewards program driving increased transaction size


Another key driver of improved financial performance has been the launch of Target's loyalty program. In late 2019, Target launched a loyalty program, Target Circle, which encourages bigger baskets through targeted offers and digital coupons, and special rewards. Target beta tested the program for a year and a half prior to launching, and the program includes 1% savings on purchases, birthday rewards, and personalized offers and savings. The program is designed to attract and retain customers who don’t currently have a Target store card, which makes up 23% of customers.

Average transaction amount has increased roughly 15% this year, after being relatively flat over the past 5 years. Furthermore, mobile app usage has grown materially, with a strong acceleration in late 2019 following the launch of Target Circle. Impressively, TGT’s monthly active users are well ahead of WMT’s, even though WMT operates 150% more stores than TGT.

Mobile app usage


Exclusive branded merchandise

Furthermore, Target offers both owned brands and exclusive branded merchandise not available at other retailers and is an ideal partner for a number of brands who don’t want to sell through Amazon because they don’t want to give up data, but don’t have the scale to operate their own stores. Owned brands include Archer Farms (food), Cat & Jack (Kids and baby apparel), Good & Gather (food), Goodfellow & Co (men’s apparel), and Room Essentials (home furnishing), as examples. Examples of exclusive brands that distribute through Target include California Roots (wine), Defy & Inspire (nail polish), and Who What Wear (women’s apparel).

Successful execution driving financial results

As a result of TGT’s strong execution, revenue and EPS growth has been strong over the past few years and accelerated in 2020 due to COVID-19.

EPS turnaround

This has been driven by strong same store sales growth due to improved convenience for customers, remodeled stores, Target’s loyalty program, and expanded merchandise selection. As shown below, same store sales growth was negative throughout 2016 and early 2017, prior to remodeling stores. From 2017-2019, same store sales growth was driven by an increased number of transactions, but in 2020, same store sales growth has been driven by larger average transaction amount, discussed below.

SSS Growth

 

Furthermore, online sales have grown at a 44% CAGR from 2015-2020E with digital sales up 163% YTD! Digital sales now make up ~17% of total sales for TGT, up from 7% in 2018 and 3% in 2015.

 Digital Sales

Improving ROIC’s

Additionally, TGT’s ROIC has improved from 12.6% in 2017 to 15.6% in 2019, and 19.9% through 3Q20 driven by record sales growth, operating leverage, and strong FCF generation. At its 2020 Investor Day, management noted that low single digits same store sales growth results in mid-single digit operating income growth, high-single digit EPS growth, and improved after-tax ROIC. To illustrate TGT’s operating leverage, revenue increased 4% in 2018 while EPS grew 15%. Similarly, in 2019 revenue grew 4% while EPS increased 19%. As demonstrated, TGT only needs to drive low single digit revenue growth to lead to high single digit/low double digit EPS growth, due to operating leverage.

ROIC

Continued growth in digital sales should lead to operating margin expansion driven by productivity improvements and lower shipping costs, as well as slight D&A leverage, as capex comes down going forward. Capex is expected to decline from $3.5bn in 2020 to $3-3.5bn in 2021, and $3bn of less in later years due to a lower number of stores remodeled per year.

Target benefiting from multiple tailwinds

Taking market share from weaker retailers

From 2017-2019 TGT took $5bn of market share from weaker retailers such as: JCPenney, Sears, and Toys R Us, who have filed for bankruptcy and are closing stores. These failing retailers lacked an omni-channel strategy and have struggled to adapt in this environment. Market share gains include $2.5bn from apparel & beauty, $1.1bn in toys, $680mm in baby, $390mm in essentials, $160mm food and beverage, and $80mm in electronics.

Furthermore, TGT should continue to consolidate market share as it executes on its omni-channel strategy, by driving improved customer convenience, loyalty programs, improved merchandise selection, and small format stores. Per Gavin Baker's excellent presentation on Target, the top 15 challenged retailers generate $150bn in annual revenue, and have roughly 11,000 stores within 5 miles of Target. Examples of other weaker retailers TGT can take market share from include Macy’s, Kmart, GNC, Stein Mart, Pier 1 imports, and Payless, who have all closed stores in the past year.

Improved household finances

In aggregate, U.S. consumer balance sheets have improved over the past year despite the COVID-19 pandemic. Personal Income is well above pre-pandemic levels driven by Fiscal stimulus, and private wages and salaries are at all-time highs. Additionally, debt service payments as a share of income continue to decline due to debt repayment, low interest rates, and strong income growth. As an example, Americans reduced credit card balances by $100bn in 2020. Furthermore, the personal savings rate is well above pre-pandemic levels at 14%, up from an average of 7% pre-pandemic.

Furthermore, fiscal and monetary stimulus should remain accommodative with the Federal Reserve expecting to keep rates at 0% through 2023, and President Biden proposing an additional $1.9tn of fiscal stimulus. As a result, the Federal Reserve forecasts real U.S. GDP growth of 4.2% in 2021. All of these trends point to strong retail sales going forward.

Risks

Growth weaker than expected

The biggest risk to my thesis, is weaker than expected EPS growth, with consensus estimates below my expectations for the next few years. Specifically, consensus estimates expect TGT to grow revenue by 1%/yr. through 2024, and EPS by 4%/yr. through 2024, compared to my expectations for roughly 3% revenue growth and 9% EPS growth. Consensus estimates have consistently underestimated TGT's EPS growth over the past few years, and were subsequently revised higher. I believe the same dynamic will persist going forward, as TGT generates strong revenue and EPS growth. 

Consensus Estimates

Given TGT's impressive financial performance over the past few years, and the numerous tailwinds described above, I believe consensus estimates are overly conservative. TGT should be able to grow revenue well over 1% per year, by remodeling its remaining 900 stores, in addition to taking market share from failing retailers. Additionally, TGT's loyalty program should further  boost average transaction amounts.

Furthermore, TGT only has a 1.7% share of total U.S. e-commerce revenue, below other traditional retailers such as Best Buy, Home Depot, and Walmart, and should continue to gain market share driven by its omni-channel strategy which has propelled digital revenue growth at 44%/yr. since 2015. TGT's mobile active users continue to growth as shown above, and the company performed well through YE20, with holiday same store sales up 17% y/y and digital sales up 102% y/y!

Valuation

Target is attractively priced, trading at 18.5x FY21 EPS and 17x FY22 EPS, as well 19.4x FY21 FCF and 18x FY22 FCF. Given my expectation for strong EPS growth going forward, I believe TGT is priced to deliver 13-16% IRR’s over the next 5 years, even with no multiple expansion.

IRR sensitivity

Financials

TGT Financials

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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