Equity Recommendation

BUY - Target Corp.

Abdulla Elsadig
+44 (0)7751 836 628
a-elsadig@hotmail.com

Summary
I am issuing a buy recommendation for the stock of U.S. retailer
Target (TGT US), as my analysis of the company suggests that
the current price overemphasises the permanence of the
companys current headwinds and that the stock is undervalued
by 30-40%.
Targets financial performance over the first half of the year has
been poor primarily due to:

Outdated Grocery Merchandise Mix

Supply Chain Issues

Deflation in the Food Sector

Sale of Pharmacy Business to CVS

Weakness in Electronics Sector

AFAs Target Boycott

However, Targets management have already put initiatives into

place that should significantly mitigate most, if not all of these
factors and result in much improved operating performance over
the next several quarters. Other factors and developments also
look favourable for Target.
For these reasons, Targets forward 12 month EPS is more likely
to be ~$5.40 vs. consensus estimates of $5.11, while faster

Investment Snapshot
Price at Issue: $68.56
Price Target: $90-$95
Potential Return: 30-40%
Time Horizon: 12 Months
Catalysts: Q4, Q1 Earnings
Potential Hedges: SPY, XRT, GPS
Company Snapshot
Sector: Retail
Geographic Sales: 100% U.S.
Revenues (LTM): $71.6bn
EPS (LTM): $4.90
FCF (LTM): $3.13bn
ROIC (LTM) : 14.2%
Stock Snapshot
Market Cap: $39.5bn
EV/EBITDA: 6.9
P/E Ratio: 13.5
P/S Ratio: 0.6
52 Week High: $84.14
52 Week Low: $65.50

growth, higher earnings and story development should be

leveraged into a P/E ratio of 16-17 that will realise the price

Price Performance:

target of ~$90.
I also carry out a discounted cash flow analysis and comparables
analysis which show that Target is trading at a minimum of a
30% discount to its intrinsic value and sector peers. The next
several earnings releases should catalyse this price movement.
Investment risks include managements initiatives failing or
taking longer than expected to boost traffic, a drop in consumer
spending, continued food deflation and a market correction.
BUY | TGT US | Oct 2016

Abdulla Elsadig
Equity Recommendation

Company Background
Target is the second largest discount retailer in the U.S. behind Wal-Mart with ~$75bn in revenues and
around 1800 stores across the nation. While they sell a large variety of goods, their niche is delivering
quality cheap chic apparel and home goods rather than the absolute focus on price that competitor WalMart possesses.
The company grew sales at low double digit rates in the 2000-2008 period as Targets products and brand
became popular with consumers nationwide. Post-GFC, sales growth has slowed down to low single digits
as Target became a mature company and the increasing pressures of e-commerce. New CEO, Brian Cornell
was instated after the previous CEO resigned over a large data breach in 2014 which damaged the
companys reputation.
Being a relatively mature company, the stock price has been driven primarily by expectations for current
and next year EPS as well as the performance of the wider U.S. consumer. As can be seen in Figure 1 below,
2016 has seen 2 major downward revisions for year-end EPS.

Figure 1: Bloomberg Consensus EPS Estimates (BEst) & Price for Target (TGT US)

The stock has seen high volatility over the past year as financial results have surprised analyst expectations
and as guidance and outlook has been updated by management. The start of 2016 began well for Target,
with the stock rising 20% sharply due to a Q4 15 EPS beat and managements guidance for FY2016 EPS
of $5.30, higher than the previous consensus estimate of $5.17.
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Equity Recommendation

But triggered by disappointing results across the retail sector, poor sales and traffic as well as lowered
guidance for Q2 sent the stock tumbling, even despite the EPS beat.
The stock saw some recovery heading into Q2 results but another poor quarter of sales and traffic results
saw guidance marked down again. This time FY2016 EPS guidance was marked down from $5.30 to $5.00
and the stock subsequently gapped down 6%. Since then, the stock has drifted to the $67 level, probably
due to poor expectations for Q3 and Q4 results after 2 disappointing quarters.
However, after analyzing the factors that have led to Targets poor operating performance in the first half
of the year and the initiatives that management have been or will be implementing, the second halfs
performance should be markedly improved at a time when sentiment is negative.

Figure 2 Target's financial results over the last year and the markets reactions

What is significant, is that while overall sales and traffic numbers have been lackluster, Targets core
Signature categories have performed strongly, with comp sales consistently growing over >5% since the
start of 2015. These are the four categories (style, wellness, baby and kids) that have historically been
Targets differentiating factor and why customers have shopped at Target. Accordingly, they have been at
the core of managements recent strategy as when CEO Brian Cornell arrived, Target was losing customers
to off-price competitors such as TK-Maxx and Ross Stores. Profitability has also beaten expectations with
operating margins about 100 bps higher YoY in recent quarters. This has been due to very effective cost
control, corporate restructuring and the sale of their Canadian and Pharmacy divisions that have improved
the companys return on capital.
BUY | TGT US | Oct 2016

Abdulla Elsadig
Equity Recommendation

Investment Thesis
The current market price, analyst estimates and management guidance all point towards negative comp
sales over the coming quarters. However, an analysis of the disrupting factors and other initiatives has
revealed that operating performance and earnings should deliver considerable upside.
The first halfs poor traffic and sales results were mainly due to the negative impact of:

An outdated merchandise mix

Supply chain issues

Deflation in the food sector

Sale of pharmacy business

Electronics sector weakness

AFA boycott

Outdated Merchandise Mix

While the grocery segment of Target only makes up 20% of sales, its an important part of Targets strategy.
They rely on groceries to drive visit frequency and cross selling of their signature categories, as home
goods and apparel are discretionary goods a large proportion of the time.
However, management have disclosed that their food segment has been underperforming recently. This is
because prior to April 2016, Target had a very conventional grocery merchandise mix which failed to take
advantage of buying trends and therefore did not inspire shoppers to choose Target over competitors.
Targets demographic has a high proportion of young and female shoppers and has a large presence in
states where healthy living is popular. This leads me to believe that shoppers were unimpressed by the
substandard grocery assortment relative to specialty grocers. This is confirmed in CEO Brian Cornells
comment: We have seen some trip erosion with guests coming in for that fill-in trip, on a conference call
in May 2016.
Target has since identified this failure as a key sticking point to their success and implemented numerous
initiatives to improve their ailing grocery sector. One of which is a grocery reset which occurred in April of
this year as the original grocery prototype (which dates back to 2008) was outdated. As part of the reset,
Target has dramatically increased the number of organic, natural and gluten-free items. These have been
some of the fastest growing food sectors in the U.S. with organic foods growing at double digit rates
annually. They have also set up the LA25 scheme which combines these changes with a host of others to
optimise the segment in 25 L.A. stores and prepare for a nationwide rollout. Results from the LA25 have
been extremely encouraging as grocery comps are 2-3% higher.

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Equity Recommendation

Marketing is being updated to emphasize the changes that have been made. Targets own brands have
been expanded to include these wellness products and their $1bn Market Pantry brand has received a
complete rebranding. There are also now dedicated grocery teams to ensure presentation is up to
standard and products that are increasingly popular amongst millennials such as Greek yoghurt, granola,
craft beers, fresh meat and coffee are receiving greater prominence in displays and marketing.
To make space, packaged foods, an underperforming sector, has seen its shelf space decreased. In other
categories, SKUs are being trimmed across the board as management believe that excessive choice is
leading to confusion and hampering the consumers decision making. This should not only help the shopping
experience but help Target sell more of the most popular products and keep them stocked consistently.
CEO Brian Cornells experience from his time as head of grocer Safeway and the appointment of Anne
Dament (a former Safeway executive who has brought on a number of other Safeway employees) as
Targets grocery head shows that management understand the importance of the sector and that they have
plenty of ability to execute these plans. These changes should attract more consumers and boost visit
frequency considerably. The extra traffic will then be leveraged into even higher sales for their Signature
lines.
Supply Chain Issues
Another food-related issue is that Targets is losing too much perishable food to spoilage. According to
people familiar with the matter, Targets loss of inventory in the perishables category has been significantly
higher than the industry average. This is due to the fact that Targets supply chain wasnt built for delivery
of perishables as Target noted that This challenge is understandable because we've been asking our supply
chain to move well beyond its original design. The CEO noted that Short term, it certainly has an impact
on our performance in grocery and food.
Currently perishables are shipped through infrastructure owned by C&S Wholesale Grocers and a
spokeswoman mentioned to the Wall Street Journal that they are considering moving more business to
C&S which should decrease shipping times. They are quoted as We are still in the early stages of our food
repositioning effort, which includes evaluating how we get fresher foods to our guests faster and finding
ways to better leverage our distribution centers and partners.
Target noted in the Q2 earnings call that an unacceptable number of vendor shipments received by our
DCs, either too early or too late. Newly appointed COO John Mulligan has been driving a number of
initiatives to improve inventory management by working with vendors and optimising inbound processing
at distribution centres. This has resulted in out of stocks being reduced by 50% between Q2 16 and Q4
15 and the percentage of shipments that arrive exactly on time has more than doubled over the last year.

BUY | TGT US | Oct 2016

Abdulla Elsadig
Equity Recommendation

Food Deflation
On top of poor grocery traffic and volumes, Targets food sales have been hit by particularly strong deflation
in the sector. The U.S. Food at Home Price Index, has seen prices decrease since the start of the year with
a 2.2% deflation reading for September (YoY). Supply is partly to blame, especially with dairy, eggs and
poultry where supply is known to be extremely high around the country. Demand from China has also been
resetting prices of many commodities and the strong dollar is causing international consumers to purchase
fewer U.S. produced goods.
As many of these factors are transitory
in nature, it is unlikely that prices will
continue decreasing past the short
term.

The

U.S.

Department

of

Agriculture supports this view as they

are forecasting average 2016 price
growth of -0.75 to 0.25 in the index
from a current standing of -1.1%
(which implies a strong end of year is
expected). 2017 is also forecasted to
have 1-2% price growth by the USDA
suggesting that this price growth will

Figure 3: Price Deflation in food at home

mean revert to its long term average of ~2.5% over the next few quarters. Furthermore, the price decline
in meats may have a positive impact on overall sales as Kroger CFO noted at the Jefferies Consumer
Conference in June 2016 that meat had been inflationary for so long, retail prices have gotten to a point
where people stop buying as much and price points are now more attractive and people are buying more".
Sale of Pharmacy Business
CVS purchased Targets pharmacy departments in 2015 for $1.9bn and began operating 1672 pharmacies
across the country in February 2016. This should increase Targets return on capital as while it drove
sales, it put pressure on Targets margins in recent years due to the Affordable Care Act increasing cost
pressures and decreasing profitability across the pharmacy business sector.
In the short term however, management have conceded that the rebranding is causing a material disruption
to traffic as consumers take time to become aware of the switch and get used to the new procedures. As
they do, consumers will surely appreciate the improved service that CVS provides. In the medium term, the
CVS transaction is expected to increase traffic due to the much larger scale that CVS brings. Target is also
partnering with CVS to produce stronger media and marketing to introduce clarity with the consumer and
work through this transitional period. They are also offering in store incentives like free $5 gift cards with
flu shots. The $1bn of net cash provided by the sale will likely be returned to shareholders given Targets
expansive share buyback program.
BUY | TGT US | Oct 2016

Abdulla Elsadig
Equity Recommendation

AFA Boycott
Targets new bathroom policy in April 2016 which allowed customers to use the restroom or fitting room
facility that corresponds with their gender identity alienated some customers and prompted the American
Family Association (AFA) to begin a Target boycott which gained more than 1.4m signatories. This likely
resulted in a not-insignificant dip in traffic and contributed to recent sales dips. Target has since solved this
problem by pledging spending $20m to install third bathrooms at all its stores by early 2017. This should
see boycotters return to stores, as Target has bounced back from PR problems before (data breach).
Electronics Sector Weakness
Target reported a double digit percentage comp sale decline in electronics in Q2 with a third of this coming
from Apple products. This is likely a broad decline across product lines as mobile, tablet, desktop and laptop
sales growth are all known to be in decline in the U.S. However, as can be seen from the chart below (which
uses electronics and appliance store sales as a proxy for electronics sales), at least part of this was caused
from an unusually high spike in electronics sales the previous year, rather than a fall away from the long
term trend. While Q3 comps will remain tough, comps in Q4 will be much easier to beat as sales in Q415
were around the 5 year average.
There are some strong areas
within the sector that may
partially cover the weakness
seen in the areas listed above.
Wearable technology has seen
strong
products

growth
will

and
likely

Apple
see

recovery with the iPhone 7, as

analysts have forecasted 2.5%
and 8.8% revenue growth for
the company over the next two
quarters (much improved over
the

(12%)

average

sales

Figure 4: Seasonally adjusted retail sales of Electronics Stores showing Q2-Q4 2015

decline over the last 3 quarters).

Management are also working with vendors to improve the offering in this segment and market to
consumers in an impactful way. Their large reset in TV (to 4K) should also help over the Christmas period.

BUY | TGT US | Oct 2016

Abdulla Elsadig
Equity Recommendation

Other Investment Factors

Signature Categories
At the core of Targets business and profitability is their Signature categories (Style, Baby, Kids and
Wellness). These are the segments that the company decided was most important for long term profitability
and success when Brian Cornell was instated as CEO in 2014. Historically, these areas are what has driven
Targets sales and what their brand is famous for. The decision to focus on these areas was sound as at the
time, Target was struggling with very low comp sales due to a double whammy of strong e-commerce
competition and crucially, a loss of differentiation among competitors.
Targets previous strategy was to compete on an absolute price basis to attract shoppers. But Target
cannot effectively compete on price given the business model of the off-price retailers and their ability to
minimise operational costs. They have since worked with a wide range of new vendors and entered into
several brand partnerships in apparel and home goods to ensure that they have quality offerings.
Popular brands Target has partnered with include Lilly Pulitzer, Hanesbrands, Marimekko, Victoria Beckham
& Sonia Kashuk. They have also
launched a number of own brands to
appeal more to their demographic.
These

efforts

have

been

very

successful thus far with the Signature

categories seeing comp sales of over
6% in FY2016. As seen in Figure 5,
total comp sales have had a strong
correlation with traffic (Target uses
no. of transactions as a proxy for
this). Given the strong success of the
Signature categories, Targets main
problem relates to the number of

Figure 5: Target relies on traffic over price & volume increases to drive growth

customers that visit stores.

Traffic & Digital
As detailed above, most of the factors causing the decline in traffic over the last few quarters will subside
over the next several quarters. But of course, the macro environment also has an important contribution.
As can be seen in Figure 6, U.S. retail traffic is in a long term down trend. This is mainly due to digital as
consumers make more and more purchases online. 2016 has seen an average of 5.4% decline.

BUY | TGT US | Oct 2016

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Equity Recommendation

While companies like Amazon have

taken significant market share from
Brick & Mortar retailers, Target is
fighting back with initiatives such as
free shipping between Oct 25 and
January, a store pickup service and a
fully integrated Target mobile app.
Over the last 6 quarters, Target has
seen average digital sales of 26.8%
versus 15.2% for the whole U.S. retail
ecommerce sector. While there are
small values involved (Targets digital
sales are still only ~$2bn), the high

Figure 6: U.S. Retail Traffic has been declining over the long term.
The figures on that chart show the average YoY change for each calendar year.

growth is encouraging, and the launch

of a brand new Target.com in Q2 will provide customers with an improved and seamless experience across
platforms. The store pickup service has been successful thus far through adding convenience with 50%
YoY growth, but by further reducing foot traffic, it puts more pressure on grocery to get shoppers into
stores (given that shoppers are more reluctant to shop for fresh foods online.
Target is also leveraging its extensive store network by shipping directly from some stores to lower
shipping times, and is expanding its capacity to do so by 500 stores over 2016. Store delivery and pickup
services will increase labour costs, but the roll out of self-service checkouts over the remaining 40% of
stores that dont have it should more
than offset this (~33% of transactions
go through self-service checkouts with
stores that have them).
The negative sentiment surrounding
Brick & Mortar retailers provides a good
buying opportunity in my opportunity,
given the low market multiples and that
their industry will always have a solid
standing. While Amazon certainly has
technological

and

first

mover

advantages, competitive dynamics and

Figure 7: Global Online Retail Index divided by Global Retail Index.

The former has outperformed the latter by 140% over the last 6 years.

brand power will ensure that Target defends its market share over the long term. Given Targets higher
potential for growth discussed above, and its return on invested capital of over 14%, the current forward
P/E of 13.5 seems considerably lower than it should be. Thus, paired with the attractive dividend yield of
3.6% (vs 2.1% for the S&P 500), the current price also presents a great entry point for long term investors.

BUY | TGT US | Oct 2016

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Equity Recommendation

Catalysts

The main catalysts for this trade to be earnings

releases, especially the Q4 16 and Q1 17 releases.
The Q3 earnings release is unlikely to show the full
effect of all the initiatives management has put into
place but given the low analyst expectations, its
even more unlikely that they will fail to meet
forecasts.
As the stock price has been very sensitive to sales
results and changes in sales guidance (which is
dependent on the former) as well as EPS, it is
imperative that Target delivers good revenue
numbers to drive multiple expansion.

Figure 8: Historical EPS and consensus estimate

(Bloomberg) and my forecasted EPS.

Target has also returned around $8.8billion to

shareholders through share buybacks and have
reduced their share count by 10% since Q2 2015.
Management anticipate that they will continue to
have cash available for buybacks going forward and
are requesting additional repurchase capacity from
the board. This will be a tailwind for future EPS
irrespective of operating performance. The buying
pressure from share repurchases will also help set a
floor under the stock price.
Favourable comparables for both Q3 and Q4 16

Figure 9: TGT Shares Outstanding have dropped by around

12% over the last 5 quarters.

should mitigate downside risk. In Q3 of last year, unseasonably warm weather pressured apparel sales and
a double digit fall in electronics sales due to the steep decline in tablets will help to positively frame the
current weakness in the sector. Digital sales were also only 20% in Q3 15, significantly lower than their 6
quarter average of 26.8%.
In terms of margins, both Q3 and Q4 will benefit from the margin improvement from the pharmacy
business sale. Q117 will be compared to this years poor traffic results and the initiatives and factors
detailed below should result in improved performance by that time.

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Target has recently been opening much smaller flexible format stores for urban locations. This is key as the
market for big box stores has become extremely saturated in the U.S. and urban stores have higher
productivity (I assume 30% higher sales per sq. ft. in my model). So far, Target has reported much higher
productivity for these stores and is planning to open a total of 14 in 2016, at least 19 in 2017 and have
said we're accelerating our pipeline of locations we can open in future years and we expect flex format
stores to be a key driver of future growth.
If sales and earnings results improve as I expect them to, I believe investors will pay more attention to this
theme and begin pricing in this growth which will drive additional P/E expansion.

Valuation
I have carried out a discounted cash flow valuation using the McKinsey method to approximate the intrinsic
value of Targets equity under a range of scenarios. The results show an intrinsic value range of $84.55 to
$92.43 per share.
The base case assumptions underlying the cash flows and returns on capital are:

Comp sales FY1 (2016) will be 0.8% (implying improved performance over the second half of the
year). This will then grow to 2% over 3 years and remain at this level.

New store sales will grow to 0.7% over the next 5 years assuming that the rate of opening and
closures of traditional big box Target stores over the last 3 years will remain the same. However, I
expect the rate of flexible format store openings to increase to 40 by 2020 and decline from there.

Gross and operating margins will gradually rise to 30.5% and 7.3% respectively.

The marginal tax rate will average 37% over time.

CapEx (net of divestitures) will mostly grow in line with revenues from ~$1.6bn to ~$2.5bn,
representing investments into infrastructure, new stores, refurbishments and technology.

The weighted average cost of capital (WACC) was calculated through solving for the discount rate that
makes the present value of the S&P 500s estimated cash flows equal to the current index level (2100 at
time of writing). All of my WACC calculations can be found in the presentation. The base case assumptions
underlying the WACC calculations and terminal value are:

S&P 500 earnings will grow at a CAGR of 6% (the average 5-year CAGR between 2002 and 2016).

The payout yield will average 5% over the next 5 years (current dividend + buyback yield).

An adjusted Beta of 0.87 (7-year post GFC average is used).

Return on new invested capital is set equal to WACC.

My calculations yield a WACC of 6.24% but I use a 7% WACC in my base case scenario to allow for some
error in the input figures.

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Valuation Snapshot

Figure 10: Target base case valuation. All figures in millions except per share values. Non-operating and non-recurring
incomes, expenses and assets have been excluded. Current year revenue growth excludes impact of Pharmacy sale.

Sensitivity Analysis
As my revenue growth rates are reasonably
conservative (averaging 2% over explicit
forecast period), I believe the main potential
sources of error lie in the assumed operating
margins and cost of capital. My sensitivity
analysis shows how the intrinsic value
changes as both inputs are altered.
Additionally, I forecast the return on capital
to average ~13.5% in the forecast period
but to gradually decline over time as return
on new capital is set equal to WACC.

BUY | TGT US | Oct 2016

Figure 11: Historical and Projected ROIC's. The large increase in

FY2016 due to the sale of Pharmacy and Canadian assets.

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My sensitivity analysis shows that even with a significantly higher cost of capital and much lower operating
margins, the potential downside risk is very limited. A WACC of 8% and average operating margin of 6.8%
gives an intrinsic value roughly equal to the current price but given that the operating margin has only been
lower than this once over the last 10 years, and that an 8% WACC is likely to be too high for a mature
company with an A credit rating and stable balance sheet, I believe this scenario is very unlikely.

Figure 12: Revenue Growth / Operating margin sensitivity analysis. The revenue growth numbers include the
2016 6% decrease from the pharmacy sale as stated by management in the Q1 16 earnings call.

Figure 13: WACC / Operating margin sensitivity analysis. The yellow box indicates my most probable range of outcomes.
Bold numbers indicate my base case scenario for WACC and average operating margin over the explicit forecast period.

In the revenue growth sensitivity analysis, at

a 6.24% WACC, even negative revenue
growth (value destruction) with low margins
still generates an intrinsic value premium.
Based on my analysis, the base case
scenario offers the most likely long term
growth rate and margin, but the valuation
suggests that the current price offers
enough margin of safety that only a
precipitous drop in operating performance
would lead to any loss of capital.
Figure 14: I've forecasted Target's productivity to rise due to cost savings via
technology and a higher mix of urban stores

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Comparables Analysis
Here, I carry out a comparables analysis to see how the market is pricing Target relative to its peers. I have
selected the comparables by screening for companies that are:

Large cap with large free float

Source a majority of their revenue from U.S.

Sell home goods and/or apparel, grocery and electronics

Figure 15: Comparables Analysis of Target. EBITDA margins not corrected for non-operating and nonrecurring incomes/expenses.

The valuation multiples of the peer group that Target is being priced lower than its peers based off lower
revenue growth. Therefore, if Target improves its growth to the average rate of its peers, then at least a
30% increase in stock price is likely based on current market pricing, especially given Targets superior
margins and return on capital.

Investment Risks
The main risks to the investment thesis that are presently foreseeable are:

Managements initiatives failing or taking longer to gain traction.

A decline in consumer spending

A large market correction

Failure of Management Initiatives

This risk can be controlled by monitoring progress through 3rd party industry research, customer reviews
and carrying out supplier channel checks to see how much inventory is being moved. If any of the following
show that the initiatives are failing to gain traction after 6-9 months, the investment can be exited prior to
a negative earnings release and subsequent price drop.

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Declining Consumer Spending

Since the GFC, consumer incomes and spending have been steadily rising as unemployment has steadily
decreased and now sits near its maximum natural limit. Barring any economic shocks, this trend should
continue uninterrupted. If the U.S. consumer does show signs of weakness, I suggest shorting specialty
apparel retailers such as GAP (GPS US) or Nordstrom (JWN US) as a hedge as they are less defensive
companies than Target who are diversified with a range of goods and brands.
Market Correction
The current level of the S&P 500 sits at 2100 and has returned just over 11% annualized since 2009 but
was flat in 2015 and is only up 6% so far in 2016. The BEst P/E ratio (12 month blended forward) sits at
16.7, a 14-year high. However, the market has endured several high-risk events without extended volatility
(Yuan devaluation, Fed rate hike and Brexit). EPS growth for the first time in 6 quarters and the recovery of
commodities and emerging markets may suggest that risk has decreased, but if this does become a point
of contention, I recommend shorts in the S&P 500 ETF (SPY US) and the retail ETF (XRT US) as hedges.
Additionally, even though TGT has an adjusted Beta of 0.8%, the low correlation of 0.48 (2 years, weekly
data) to the index, suggests the stock will be relatively resilient to any market corrections.

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