The fabled discounter is aiming to thrive even if the economy sputters. That’s good news for shoppers — and shareholders
IN THE PAST TWO DECADES, Target, the Minneapolis-based discounter, carved out a unique niche as a purveyor of cheap chic. Its brand-name apparel and Michael Graves-designed housewares were stylish enough to earn it the Frenchified nickname “Tarzhay,” while its prices were low enough to lure serious bargain hunters.
This looks-are-deceiving formula worked like a charm until 2008, when the financial markets imploded, the economy tanked and America headed for Wal-Mart, which offered even lower prices, and the heck with style. As customers fled, Target’s sales and profits tumbled, and its shares, once 70, were marked down to 25.
Never underestimate a savvy merchant, however, especially one that can make potholders sing. Target (ticker: TGT) has crafted a comeback plan that looks to be winning new fans on Main Street and Wall, where its shares, like its wares, are now cheap and chic. They rallied very slightly last week, to around 52, helped by Thursday’s report that same-store sales, or sales at stores open at least a year, rose 2% in July, even as the broader economy showed signs of slowing. If the company’s merchandising and price promotions succeed in driving traffic and lifting profits, the stock could hit 70 in a year.
“Consumers do not appear to be returning to their bunker of late 2008 and early 2009,” Adrianne Shapira, a retailing analyst at Goldman Sachs, wrote in a recent report. Shapira rates the stock Neutral, with a price target of 55, but notes she is “warming up to the Target story,” given the company’s “unique top-line drivers that aren’t dependent on a macro recovery.”
These include initiatives such as PFresh, a rollout of fresh groceries in many of the chain’s 1,743 stores, and a 5%-discount program, which will be launched this fall. Target also boasts excellent cost controls, which could help boost earnings by more than 15% in the fiscal year ending January 2011, even if sales remain soft.
Analysts expect Target to earn $3.88 a share for fiscal ’11 and $4.40 for fiscal 2012. Shares trade for only 11.7 times 2012 estimates, in line with the valuation accorded Wal-Mart Stores but below that of Costco Wholesale.
BEARS CAUTION A sputtering recovery will hamper Target’s growth, and that PFresh is an expensive undertaking that won’t stimulate sufficient traffic and sales. They note that Target was badly burned by the recession that started in 2008: For many months, same-store sales trailed those of Wal-Mart, which is more reliant on low prices and nondiscretionary items such as groceries. Target earned $2.86 a share in the fiscal year ended January 2009, compared with $3.33 a year earlier, as revenue grew by a paltry 2.5%.
Last year the company began taking steps to re-energize top- and bottom-line growth, consistent with its “Expect More, Pay Less” marketing message. In July 2009 it started matching competitors’ advertised prices on identical items in local markets, and this past January it launched The Great Save, a seven-week program aimed at competing with warehouse clubs on staples such as bottled water.
Management, led by CEO Gregg Steinhafel, 55, also has been working directly with vendors to keep costs in check, and has increased Target’s reliance on higher-margin private-label goods, sold under names like up & up, Archer Farms and Market Pantry. Analysts estimate that private-label goods now account for more than 20% of all food products, up from 18% in 2007. Target declined to make Steinhafel or other executives available for interviews.
These initiatives and a typically intensive focus on costs seem to have worked, as earnings rebounded to $3.30 a share in the latest fiscal year, even though revenue rose less than 1%, to $65.4 billion.
This fiscal year started strongly: Target earned 90 cents a share in the April quarter, up from 69 cents the prior year, on a 5.5% jump in sales, to $15.2 billion. Same-store sales rose 2.8%, the best showing in 10 quarters, and operating cash flow approached $1.2 billion, compared with $1 billion in last year’s first quarter. Plus, the company paid off nearly $1.2 billion of long-term debt, leaving its debt-to-capital ratio at about 50%, reasonable for a capital-intensive business such as retailing.
Two other signs of good expense controls: Gross margin was 31.3% of sales, up from 30.8% a year earlier, suggesting Target didn’t take costly markdowns, and sales, general and administrative expenses totaled 20.6% of sales, down slightly from the prior year, and continuing a favorable trend.
Target sells at a slight premium to Wal-Mart, but a discount to Costco. Apparel, which made up 20% of revenue in the fiscal year ended January, has been strong this year, but home furnishings have been soft.
In the latest quarter, sales of housewares have slowed, but apparel has remained strong. Although same-store sales growth of 1.7% was below management’s prior guidance of 2% to 4%, monthly gains are trending up. Target will release July-quarter results on Aug. 18.
ONE RESPONSE TO TOUGH times has been a roughly 50% reduction in capital spending, to between $2 billion and $2.5 billion. Target opened about 100 new stores annually in the past few years, but plans to open a net total of only 10 new this year. The precipitous decline also reflects a dearth of viable real estate, as fewer shopping centers have been developed since the economy and financial markets tanked. The company said in a presentation to analysts earlier this year that it will add at least 20 new stores, net, next year.
Less money spent on store growth means more cash available to buy back shares and pay dividends. In late 2007, Target’s board authorized the repurchase of $10 billion of common stock, but suspended the program a year later to preserve liquidity. In January the company said it was resuming buybacks, and bought in $394 million of stock in its fiscal first quarter. Target has repurchased 111.1 million shares since late 2007, for a total cost of $5.7 billion.
The company has paid dividends for 171 consecutive quarters, or more than 42 years, and lifted its quarterly payout by 47% in June, to 25 cents a share from 17 cents, for a current yield of 1.9%.
About half this year’s capital expenses will fund the remodeling of 340 general-merchandise stores in markets such as Washington, Los Angeles and Chicago. In all, Target plans to remodel roughly 1,100 of its nearly 1,500 general-merchandise units, which are smaller than its 251 Super Target stores.
Central to the remodeling strategy is the introduction of PFresh, which adds meat, fresh produce and baked goods to an existing lineup of dry grocery, dairy and frozen-foods products. Nearly all PFresh products are prepackaged and bar-coded, facilitating checkout and inventory control. At an extensively renovated Target in Edgewater, N.J., which introduced PFresh in mid-July, the grocery section now features items such as ground beef, chicken and prepackaged cold cuts.
“Target can offer prices 10% to 15% below the grocery store,” says Stacey Brodbar, an analyst at asset manager W.P. Stewart, which owns shares. “It will be a home run if they can get customers to cross shop.”
Indeed, PFresh is designed to draw more shoppers into stores, in the expectation they will pick up higher-margin housewares and apparel after stocking up on consumables. Customers who purchase food at Target stores spend 8% more than those who don’t, and they visit the discounter four more times a year, according to Citigroup. “In order to drive traffic, you need to do consumables,” says Citigroup analyst Deborah Weinswig, who has a Buy rating on the stock and a 12-month price target of 75.
TARGET HAS A MINUSCULE share of the U.S. grocery market, and food will never be as central to the company as it is to Wal-Mart. But that doesn’t mean PFresh won’t generate tasty returns.
It costs roughly $3 million to remodel a store built in the past five to eight years, with about $1.8 million allocated to merchandising improvements, mainly PFresh. In the first year following renovation, Target expects to see an average increase of 6% in traffic and sales, Chief Financial Officer Douglas Scovanner, 54, told analysts earlier this year. By the third year it expects sales to rise 10%, and is forecasting 10% to 14% returns on invested capital.
“Even if it turns out to be 10%, that’s still a pretty encouraging metric for them,” says Barclays Capital analyst Robert Drbul, who rates Target Overweight, with a 12-month target of 65.
Target also is remodeling other sections of its stores, including electronics, beauty and shoes. At the Edgewater, N.J., outlet, some shelving units have been lowered to 54 inches from 84 inches to improve sight lines. In the electronics department, flat-screen televisions are displayed along a wall instead of on shelves. Interactive displays throughout the store give customers additional information about various products.
This fall, Target will start offering customers a 5% discount on nearly every purchase made via its REDcard program, which includes the Target Visa credit card and a Target charge card. The program tested well in Kansas City, even though the company relied only on in-store advertising and marketing, notes Colin McGranahan, an analyst at Bernstein Research. “Five percent is a number that gets people’s attention,” McGranahan says.
Target’s sales at stores open at least a year rose 2% in July, the company reported Thursday. Same-store sales tumbled in April, most likely due to an early Easter, but have been trending higher since.
Target Card charges accounted for only 5% of retail sales last year, and the discount is apt to spur more card use, which is lucrative for the company. Target hopes the discount program will lure new customers and induce existing shoppers to shift more of their spending to Target from other retailers. Management predicts the program will boost same-store sales by one percentage point in the fourth quarter, and one to two points next year, when it will be accretive to earnings. McGranahan reckons the discount program will increase annual sales by about $1 billion, split between new and existing card users, and add eight cents a share to earnings next year.
Competitors most likely will respond, but at Wal-Mart, at least, a higher percentage of customers use cash, not plastic.
TARGET’S CREDIT-CARD PORTFOLIOhas generated controversy in recent years. Hedge-fund manager William Ackman of Pershing Square Capital Management mounted an unsuccessful proxy fight in 2009 after pressing the company to sell the card business, which had mounting receivables at the time.
Target was late to get its hands around its worsening credit-card problems, but the portfolio is on the mend now. Although net charge-offs climbed in the latest quarter to 15% from 13.9% a year ago, delinquencies are trending downward, as is bad-debt expense. In the first quarter the provision for bad debt was $197 million, versus $296 million a year earlier.
The company has tightened its underwriting standards and lowered the size of its credit lines. Fewer receivables, and impending legislation that will lower late-fee revenue, mean less potential income, but a healthier portfolio also is less of a drag.
Some Target watchers fret about the company’s growth prospects, noting its U.S. footprint is mature. But Steinhafel told analysts in January that Target could boost its store count to as many as 3,000 outlets. Wal-Mart, which has a bigger presence in rural markets, has 4,100 stores and clubs. Target is considering smaller formats in cities that can’t accommodate mega stores, although it recently opened a 174,000-square-foot outpost in Manhattan’s East Harlem neighborhood.
As for international expansion, Target doesn’t see that happening for at least three to five years. Canada, Mexico and other parts of Latin America are considered ripe targets for expansion.
FOR ALL ITS FOCUS ON the “Pay Less” part of its marketing mantra, Target also is encouraging shoppers to “Expect More,” at least in terms of products and presentation. Some maintain the company has lost its merchandising edge, but company-wide promotions such as last spring’s Liberty of London for Target, which encompassed more than 300 products, suggest otherwise.
Other successful merchandising initiatives include the Giada De Laurentiis for Target cookware line, launched in January and endorsed by the Food Network star, and Converse One Star, a sportswear program that’s been built around the famously retro footwear. Target also is the exclusive bricks-and-mortar retailer for the Amazon.com Kindle, which could grow even more popular as prices continue to drop.
Lately Target has found itself the object of a boycott by consumers who are irate that the company donated $150,000 to a pro-business group backing a Minnesota gubernatorial candidate strongly opposed to gay marriage. As more corporations exercise their newfound right to make such political donations, however, the company could find itself just one of many denounced by the left or the right.
Unlike many retailers, Target is well prepared to combat an arguably more insidious threat: a second U.S. recession. Then again, being well ahead of the curve is just what consumers—and shareholders—have come to expect from Tarzhay.