BUD - Is Target A Safe Dividend Stock In The Current Climate? Continue To Avoid

2023-06-04 21:13:57 ET

Summary

• Retailer Target Corporation is facing boycotts in reaction to its merchandise offerings associated with its Pride Month event. Management's response has sparked an uproar among LGBTQ supporters. A lose-lose proposition?
• In this update, I share my thoughts on the situation and discuss whether Target stock has become a risky investment.
• I discuss dividend safety given Target's current headwinds and potential resurgence of working capital challenges, taking into account TGT's balance sheet and debt maturity profile.
• I provide an updated valuation and explain why I continue to avoid TGT stock.

Introduction

Shares of iconic U.S. retailer Target Corporation ( TGT ) are currently in freefall. In addition to the familiar working capital management related problems and the inherently highly competitive nature of the retail sector, the stock is under pressure due to recently faced boycotts for offering product lines related to LGBTQ Pride. I have covered the company twice in the past - in May 2022 , I compared Target to Walmart Inc. ( WMT ) and concluded that the stock was too expensive given the current headwinds, difficult outlook, and competitive environment. In August 2022 , I took a look at Target's seasonality in terms of margins, inventory and cash management and shared my view on the company's near-term outlook at the time.

In this update, I discuss whether current events and other issues have made Target stock a risky investment, or potentially a compelling value opportunity. After all, TGT stock has lost nearly 20% since mid-May and is down nearly 50% from its (arguably exuberant) all-time high.

Why Has Target's Stock Price Dropped?

The main reason for the precipitous drop can be attributed to the broadly-covered marketing fiasco surrounding Target's offerings associated with its Pride month event. The company faced harsh criticism and removed certain offers from its stores in response , which also caused an uproar among LGBTQ supporters.

Calls for boycotts against the Minneapolis-based retailer's stores are very present on social media and should by no means be underestimated, as evidenced by this tweet , for example, which has been liked more than 67,000 times and retweeted more than 19,000 times. It is likely that recent events will have an impact on Target's sales, but I personally do not expect it to be permanent or overly significant - at least not to the extent that it justifies a drop in market capitalization of more than $14 billion. After all, the company has been offering products to celebrate Pride Month for more than a decade. Investors are - unfairly, in my opinion - lumping Target's situation in with Anheuser-Busch InBev SA/NV ( BUD ), whose Bud Light sales dropped dramatically in response to the well-documented controversy .

Instead, I think investors should focus on Target's other challenges, which continue to keep me uninterested in taking a long position, even though the stock marked a new 52-week low last week.

Before Considering Target Stock, It's Important To Look Beyond The Marketing Fiasco

In its earnings calls and press releases , Target refers to theft and organized retail crime as inventory shrink. While this is not a new phenomenon, it has become increasingly significant, and most retailers in the U.S. have faced steep increases in theft since about mid-2022.

While Target's gross margin improved slightly in the first quarter compared to the year-ago quarter (Figure 1), driven by lower freight and transportation costs and lower markdowns, theft was a headwind of about 100 basis points.

Inventory shrink is likely to impact the company's profitability by more than $500 million this year. In addition, selling, general and administrative expenses increased by about 90 basis points. However, a look at Figure 2 shows that Target still has its SG&A expenses well under control. Still, Target's operating margin in the first quarter was 10 basis points lower than in the first quarter of 2022 and was 452 basis points below the profitability in the first quarter of 2021, which was arguably fueled by a pandemic-related surge in demand.

Normalizing margins will likely take a while, but Target has made significant progress in improving its working capital accounts. For example, in the first quarter of fiscal 2023 (which ended April 29), the company recorded a positive change (reduction) in inventories of $883 million, compared with an increase of nearly $1.2 billion a year ago. From a balance sheet perspective, inventories are now back down to $12.6 billion, compared to $15.1 billion a year ago, or $13.9 billion at the end of April 2021. The reduction in accounts payable was the primary reason for the poor operating cash flow in the first quarter, but it is important to note that this liability account was over $2 billion lower than a year ago, or $3.5 billion lower than two years ago, at $11.9 billion. Taken together, a significant rebound in free cash flow can be expected in fiscal 2023.

While the company is clearly showing signs of improvement, I would still urge caution before running out and rushing to buy Target stock. Still-high inflation continues to squeeze consumers' disposable income, as evidenced, for example, by weak guidance from home improvement retailers The Home Depot, Inc. ( HD ) and Lowe's Companies, Inc. ( LOW ) (see my recent update ), as well as luxury department store chain Macy's ( M ). As I've pointed out in my previous articles, Target's procurement teams are keenly aware of current and near-term consumer expectations, which can be seen as an important part of the company's "secret sauce" for success in recent years. However, as consumers move more and more from wants to needs, there is less and less room for discretionary purchases, putting pressure on Target's proposition. The company's very large number of stock-keeping units (SKUs) does not help in this regard and could even lead to a resurgence of working capital challenges and consequently markdowns and pressure on earnings and free cash flow.

Finally, given the increasing pressure on consumers' wallets, credit card debt defaults should also be considered. Target generates some of its earnings through a credit card profit-sharing program with TD Bank Group (Target Credit Card and Target MasterCard), but at just 0.67% of total revenues in fiscal 2022 ($734 million, p. 43, fiscal 2022 10-K ), the contribution is not really significant. Credit card receivables - which are theoretically at risk - are also not significant. At the end of fiscal 2022, Target reported $600 million in related receivables, which is about 27% of cash and cash equivalents or 1.1% of total assets.

Is TGT Stock Undervalued After The Sell-Off?

As the FAST Graphs chart in Figure 3 shows, Target stock was highly overvalued two years ago. Since then, Mr. Market's expectations for the stock have weakened significantly. However, given the sharp drop in earnings and the relatively slow expected recovery, I have a hard time calling the stock a compelling value opportunity at this point. At the time of writing, Target stock trades at 14 times average 2020-2022 earnings or 16 times expected 2023 earnings.

Granted, if analysts are correct in their forecasts, the potential return of nearly 14% per year through the end of fiscal 2025 is very acceptable in theory, but it's important to remember that Target operates in a highly competitive environment. There are de facto no switching costs, and aside from a strong value proposition and forward-thinking inventory procurement, there's not much a retailer can do to retain customers. In an environment where needs are increasingly prioritized and wants are deferred, I think Target is in a disadvantageous position, compared to retailers with a much leaner SKU base like Costco Wholesale Corporation ( COST ), or retailers with considerably better scale like Walmart.

From a free cash flow ((FCF)) perspective, Target stock is not easy to value due to the severe working capital management issues and the pandemic-fueled - and definitely unsustainable - FCF growth. Using historical trends (Figure 4), taking into account the aforementioned effects, and assuming inflation remains at a slightly higher percentage than we have become accustomed to, a baseline FCF of about $4.5 billion per year seems a reasonable expectation or even slightly optimistic.

If this estimate is incorporated into a discounted cash flow calculation and a cost of equity of 9% is deemed adequate, Target would need to increase its free cash flow by more than 3% per year in perpetuity to justify its current valuation. Given Target's lack of meaningful economic moat, and given the challenging macroeconomic environment, I would argue that a 9% cost of equity is too low. If we account for volatility (i.e., calculating cost of equity via the Capital Asset Pricing Model, CAPM), Target would have to grow at a rate of 5% each year for the stock to be fairly valued at present. My regular readers know my skepticism about CAPM-derived cost of equity, but in this case, I think a value of 10.8% is quite justified, albeit partly for the wrong reasons.

Suffice it to say, I doubt Target can achieve such growth rates, especially in such a difficult environment and given the fierce competition in brick-and-mortar and online retail. I wouldn't go so far as to say the stock is grossly overvalued - and if I put myself in the shoes of a current investor, I wouldn't want to sell at this level - but I don't think there is a significant margin of safety to justify a long position at this level. Current investors will likely have to be patient, as I don't expect Target stock to go up again anytime soon given the widely-covered marketing fiasco.

Also, the high dividend yield of 3.25% by historical standards should not be interpreted as a sign of undervaluation, as Target raised its dividend quite aggressively by 32% and 20% in 2021 and 2022, respectively.

Is Target's Dividend At Risk Of Being Cut?

While the poor normalized free cash flow in fiscal 2022 suggests that Target's dividend is not sustainable, I think it's important to consider the company's balance sheet.

Target's long-term rating is A2 , but its outlook was recently changed from positive to stable. Moody's expects " an improvement in Target's operating performance and metrics in 2023 ," but noted " considerable macroeconomic uncertainty and consumer stress that could prove difficult to navigate ." That said, a long-term A2 rating is definitely strong, and it should also be remembered that Target's interest coverage ratio is about 10 times its 2020 to 2022 average free cash flow before interest.

The company's debt maturity profile is also far from concerning, however, a moderate increase in interest expenses can be expected due to the comparatively low weighted-average interest rate of the 2023-2028 maturities and the relatively high amount of debt coming due over the next five years (Figure 5).

Overall, I believe Target's dividend is safe from both a balance sheet perspective and a payout ratio perspective (less than 50% three-year average normalized FCF). If free cash flow does not recover as quickly and significantly as expected, the company has ample liquidity through its commercial paper program and credit facilities, in addition to available cash and cash equivalents ($1.3 billion at the end of the first quarter of fiscal 2023, up 10% year-over-year). There are currently untapped $1.0 billion 364-day and $3.0 billion revolving credit facilities available, and Target's commercial paper program had only $90 million outstanding at the end of Q1 2023 (p. 21, FQ1 2023 10-Q ).

The company clearly has enough balance sheet flexibility to avoid cutting its dividend. Moreover, it should not be forgotten that Target has a 51-year track record of consecutive increases, and management places a high priority on the dividend in its remarks, listing the dividend as one of its capital allocation priorities (p. 20, FQ1 2023 10-Q). However, given the aggressive dividend increases in recent years, I would expect a much more modest increase this year.

Conclusion And Outlook

Almost a year after my last article on Target stock, I think it is fair to say that the company's working capital management is showing clear signs of improvement, at the expense of significant inventory markdowns, of course. Profit margins remain under pressure, exacerbated by the significant increase in theft. This is another challenge facing management, and I think it will take a concerted effort to get a handle on the problem, as most, if not all, retailers are struggling with this issue.

In terms of customer traffic, Target saw a slight increase in the first quarter of 2023, marking the twelfth consecutive quarter of growth. While this is good news in principle, it should be recognized that Target's value proposition, due in large part to its forward-thinking procurement teams, is weaker than that of close (and much larger) rival Walmart and more distant competitor Costco Wholesale. In an environment where needs take precedence over wants, I think Walmart is better positioned because of its enormous scale, and Costco because of its extremely efficient operations and easy-to-manage inventories. As we know, Target also faces tough competition from online retailers, but has made good progress in this regard and can rightly be considered an omnichannel retailer with a good standing. Nevertheless, competition from Amazon.com, Inc. ( AMZN ) is fierce.

All in all, I think the boycotts in reaction to Target's offerings associated with its Pride Month event are less of a problem compared to the challenges mentioned above. After all, Target has been offering related products for more than a decade. While I believe the boycotts will weigh on the company's sales and possibly profitability, the impact will likely be temporary and relatively minor. I highly doubt that the Target brand has suffered permanent damage (unlike Anheuser-Busch's Bud Light brand). Nevertheless, current investors will likely have to be patient, as I don't expect Target stock to go up again anytime soon given the broad coverage of the marketing fiasco and generally negative sentiment.

In conclusion, I still think Target is a relatively safe stock to own, even considering the fierce competition in the retail industry and the arguably challenging environment. From a dividend safety perspective, I would not over-interpret the current weak free cash flow. Much improved working capital management will most certainly lead to acceptable free cash flow in fiscal 2023 that will cover the dividend. And in the unlikely event of a resurgence in working capital management related pressure, the company has ample liquidity and is operating on the basis of a solid balance sheet.

However, given Target's difficult position relative to competitors like Walmart, Amazon and Costco, and given its valuation, I continue to avoid the stock.

As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there is anything I should improve or expand on in future articles, drop me a line as well.

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