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Target – Wait Till You Pull the Trigger on this One

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The Target Corporation (TGT) is one of the largest discount retailers in the US, operating 1,919 locations as of October 2013. The company’s operations had been limited to the US till March 2013, but it has since expanded into Canada with 122 stores. It also plans to add 200 more outlets to its new market over the next ten years.

Target divides its products into five major categories, of which Household Essentials contributes the largest share of its revenues. Food and Pet Supplies and Apparel and Accessories round off its three most important segments, followed by Home Furnishings & Décor and Hardlines.

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Review of Latest Earnings Report

Target, which is classified in the consumer staples industry, has underperformed the SPDR Consumer Staples ETF (XLP) in terms of price returns over the last twelve months by around 13 percentage points (ppts). The company has also underperformed its competitor, Wal-Mart Stores (WMT), by around 9 ppts over the same timeframe.

Target reported its third quarter fiscal year 2013 (3QFY13) results on November 21, 2013, which missed analysts’ estimates by a marginal 0.4% due to lower growth in same-store sales (SSS) than was expected. Target’s SSS grew 0.9% in the quarter, which was near the lower end of the company’s earlier guidance. According to the management, a 1.3% decline in the number of transactions and a 1.1% fall in the number of units sold per transaction were the two main reasons behind slower SSS growth.

In the announcement, the management also said it was revising its EPS guidance for the full fiscal year from $4.70-$4.90 to $4.59-$4.69. The company’s stock took a beating following the earnings announcement, and is still down 1.43%.

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Security Breach

The company’s stock took another hammering following the management’s confirmation of a massive data security breach at its US stores. The data theft, confirmed to have occurred from November 27, 2013 to December 15, 2013, will affect around 40 million US credit and debit card users.

Competition between discount retailers was already intense in the recently-passed holiday season, and the incident made it difficult for Target to attract traffic at stores, and undoubtedly led to lost sales.

The fallout from the security breach is also expected to hurt sales beyond the holiday season, and there is a strong likelihood that the company may lose the trust of some of its core customers. The management tried to make up for the security lapse by offering a 10% discount to its US customers on December 21 and December 22, 2013, but the effort largely failed to have the desired impact and hurt margins instead. Possible future payments to settle claims and disputes following the incident may also impact the company’s earnings.

A research firm that covers Target cut its earnings per share (EPS) estimates for the company by 25.5% on December 18, 2013, and then by a further 10.7% on December 24, 2013 following the news.

Gross Margins

Target operates with significantly higher gross margins – 30.1% – compared to its competitors Walmart, which has a gross margin of 25%, and Costco Wholesale Corporation (COST), which has a gross margin of 12.6%.

Target’s high-margin products and the private and exclusive brands it showcases in its stores support its higher margins. Target’s private labels and exclusive brands contribute around 33% of its total revenues, while Walmart’s contribute 18% and Costco’s contribute 20%. Target also generates nearly 55% of its revenues from the high-margin Apparel, Hardlines, and Home Furnishings product categories, while Walmart generates 23% and Costco generates 27% of its revenues from similar products.

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Low International Exposure

Target has very low exposure to international markets, and over 98% of its revenues are currently generated from within the US. This makes the company more sensitive to the US economy than both Walmart and Costco, which respectively generate over 29% and 28% of their revenues in international markets.

This is a significant handicap for Target, as international markets have provided greater growth opportunities compared to the US. Walmart and Costco have reported 8.4% and 13.7% annual growth in their revenues from foreign markets over the last five years, compared to comparable growth rates of 3.1% and 5.8% in the US. Considering Target’s reliance on the US market, its growth prospects therefore seem much weaker than its competitors’.

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In addition to Target’s high dependence on the US market, the retailer also depends more heavily than its competitors on sales of market-sensitive consumer durables. For this reason, Target stock has the highest beta – a measure of volatility that denotes the systematic risk in a security in comparison to the overall market – among competitors at 0.78, while Walmart’s is 0.41 and Costco’s is 0.65.

High Risk, Low Growth

Target has underperformed Costco when it comes to comparative same-store sales (SSS) growth rates, with its SSS growth lagging Costco’s by an average 3 ppts over the last 10 quarters. This is because Costco provides its customers better service and pays more attention to the layout of its stores to improve customers’ experience, which drives more traffic to its stores. Additionally, Costco also pays its workers double what Target pays, which explains why Target has faced problems motivating its workers to provide quality services to walk-in customers.

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Bidness Etc. estimates that Target stock’s required return* for it to be a viable investment, considering the risks involved in investing in the company, should be at least 13.2%, compared to 11.5% for Costco and 8.4% for Walmart. But Target has underperformed Walmart and Costco by around 9 and 10 percentage points over the last twelve months, which weakens the case for an investment in the stock.

*Calculated using the Capital Asset Pricing Model (CAPM), taking the S&P 500’s five-year annualized return as the expected market return, and the US 10-year Treasury note yield as the risk-free return.

Conclusion

But though Target’s growth prospects seem weak, Bidness Etc still warns against short-selling the stock. This is because most of the factors discussed in this report have been priced into its current valuation, which is at a discount to both the broader market and the company’s competitors.

Over the last five years, Target has traded almost in line with the S&P 500 and Walmart at an average price-to-earnings multiple of 13x. However, it is currently trading at a discount of 14.6% and 6.5% to the S&P 500 and Walmart, despite the 12.9% annual growth in earnings projected for the company over the next three years, compared to 9.7% for Walmart. Considering that factor, Bidness Etc recommends investors to hold on to their positions as the stock is valued too cheaply for it to be shorted profitably.

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