Facing Tough Competition And Growing Slowly, Target Gets A Hold Rating

Summary:

• Target’s Q2 results exceeded expectations, but its growth remains unimpressive, largely due to tough competition and inflation impacting core customers’ purchasing power.
• Despite Target’s challenges, its valuation is lower than many peers.
• Target’s price cuts and merchandising initiatives have helped lead to some positive results, including increased comparable sales in apparel and digital business.
• Risks include potential macroeconomic downturns and increased competition, but improvements in consumer confidence and inflation could boost Target’s growth.

While Target (NYSE:TGT) reported significantly better-than-expected second quarter results on Aug. 21, the retail chain’s growth is not very impressive. That’s not surprising, given the very tough competition that the firm faces and the fact that the purchasing power of its core customers are being undermined by inflation and high-interest rates.

On the other hand, the company’s performance in a few areas is improving by impressive amounts, and its valuation, which appears to be appropriate at this point, is much lower than that of many of its more successful peers. Additionally, consumers’ situation may improve going forward due to slowing inflation and interest rate reductions. Given all of these points, I view TGT as a hold at this point.

Better-Than-Expected Results But Unimpressive Growth

Target’s Q2 results, reported on Aug. 21, came in well above analysts’ average outlook. Specifically, its sales rose 2.7% versus the same period a year earlier to $25.45 billion. The latter figure was $240 million above analysts’ mean outlook. Meanwhile, its comparable sales increased just 2% year-over-year.

Target’s adjusted earnings per shares soared 42.5% year-over-year to $2.57, 39 cents above analysts’ average outlook. However, much if not most of those gains were likely driven by the large number of workforce reductions that the retailer has implemented in recent quarters. Also, noteworthy is that the company’s cash from operations rose by a much lower 5% YOY last quarter to $2.24 billion.

On the Q3 guidance front, Target expects its comp sales to climb just 0%-2% and predicts that its adjusted EPS will fall versus Q2 to a range of $2.10 to $2.40.

A number of Target’s peers are growing much more quickly than TGT. Last quarter, for example, TJX (TJX), Walmart (WMT), and Costco (COST) delivered YOY comp sales increases of 5.6%, 4.2%, and 6.9%, respectively. (Costco’s comp sales excluded changes in gasoline prices and foreign exchange fluctuations.)

Tough Competition and Pressured Consumers

In addition to TJX, Walmart, and Costco, Target also has to take on the dollar stores, Ross Stores (ROST), and, of course, Amazon (AMZN). That’s a fairly large list of large, popular, and, in most cases, rapidly growing competitors.

Simultaneously, Target’s core working-class and middle-class customer base is being squeezed by years of elevated inflation and interest rates. Providing evidence for the latter assertion, Citi CFO Mark Mason earlier this month reported that “payment rates (on the bank’s credit cards) are starting to come down a bit,” while consumers are starting to spend less on discretionary items and more on staples. What’s more, Mason added that “all of the spend growth is skewing from our largely affluent customers.”

While lower interest rates and decelerating inflation will help ease this situation, as shown by a 3% increase in The Conference Board’s index of consumer confidence last month, the bottom half of consumers is not in great shape and probably will not be for some time.

Some Improvements by Target

I believe that Target’s price cuts, which enabled the retailer to generate an increase in its comp sales for the first time in a year in Q2, and was likely the key factor behind its 3% YOY traffic increase, was the right move for the retailer.

Also, noteworthy is that the comparable sales of Target’s apparel business increased over 3% YOY in Q2. Although price reductions likely played a role in the increase, CEO Brian Cornell attributed the increase to “great design, newness, and value.” The CEO noted that the comparable sales of its All in Motion brand of apparel had soared around 13% YOY. Positive execution and price cuts likely both contributed to the significant comp sale increase.

Also, noteworthy is that, despite the price cuts, the company’s gross margin increased by 1.9 percentage points, reportedly due to its “merchandising initiatives.” Finally, the comparable sales of Target’s digital business rose by around 9% YOY. Cornell reported that the company had taken steps to improve its customers’ “digital experience.”

Lower Valuation Than the Sector and Faster Growing Peers

Target’s shares are changing hands at a forward price-to-earnings ratio of 16.2 times. That’s well below the sector average of 20.16 times. It’s also meaningfully below the valuations of the faster-growing peers that I mentioned earlier in the article. Specifically, the forward P/E ratios of Walmart, TJX, and Costco are 33, 28, and 54.7, respectively. Also, importantly, Target’s non-GAAP PEG ratio, a valuation metric that takes into account future, expected growth, is 1.49. That’s well below the sector’s average level of 2.3.

Risks to the Hold Call

In terms of macroeconomics, unemployment and underemployment may increase faster than expected, causing consumer spending to drop further. Inflation could also reignite, further eroding consumers’ spending power. Such scenarios would likely cause Target’s sales to tumble.

Target’s market share losses to its faster-growing peers could also accelerate, causing its growth to sharply decelerate. On the positive side, the increases in consumer confidence could accelerate and inflation could fall quickly, causing consumer spending to increase. Such a scenario would likely cause Target’s top-line growth to sharply accelerate.

Finally, the steps that the company is taking to improve its apparel offerings and its digital experience could cause its growth to accelerate more than I expect at this point.

The Bottom Line

Target is a hold for conservative investors who value exposure to the U.S. brick-and-mortar retail sector.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMZN 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.

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