Is the target a buy after its reported decline in earnings? No it’s not (NYSE:TGT)

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The retail earnings reports last week were breathtaking. walmart (WMT) suffered its biggest crash since Black Friday 1987 following a shockingly poor earnings report. Not to be outdone, Target (NYSE: TGT) followed last Wednesday with its worst day in 35 years. The venerable mass-market retailer lost more than a quarter of its value in a single trading session.

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Data by YCharts

After a decade of poor shareholder performance, Target stock suddenly soared in 2020. There was the idea that Target had positively “bend” thanks to post-pandemic shopping habits. However, this idea is now being seriously questioned. Like so many other stocks that have rebounded strongly due to shifting economic models during the pandemic, it also looks like Target could be making a round trip back to 2019 price levels.

Target’s downfall didn’t come in isolation. On the contrary, it added to the whiff of big profits from Amazon (AMZN) last month with the miss from Walmart. Amazon’s problems, you may recall, were almost all related to the collapse of its retail business; The results of Amazon’s cloud services have lived up to expectations. Amazon retail, however, plunged into unprofitability in North America, adding to its loss-making status in international markets. Following this quarter, Amazon announced plans to begin subletting its warehouse space as it rapidly attempts to reduce excess retail logistics capacity.

When you have three flagship retailers in the US all posting unfortunate results at the same time, it’s clearly no coincidence.

You could say it’s just management spoiling something if one or even two retailers have missed the numbers, but when many large retailers are all reporting the same trends, there’s a macroeconomic problem at hand.

Retail: what is the problem?

The easy answer is supply chains and cost inflation and all that. You know, the same story we’ve been hearing for a year. Many of the immediate reactions I’ve seen to retail earnings reports follow this fairly simple line of analysis. Companies are paying workers more for work, paying more for gas and other transportation costs, and have seen their supply chains disrupted by numerous disruptions. The latest lockdowns in China provide another reason to lean on the supply chain issue as still being the deciding factor here.

However – and let me be clear about this – I consider this thinking to be outdated. Supply chains are starting to thin out in many areas. Rather, the problem is not so much getting inventory to put on the shelf, but rather getting consumers to buy that product once it hits the shelves. Consumers slowed down their spending. Specifically, they’ve stopped spending at peak 2021 levels, and that’s especially true for items that have high profit margins.

With the prices of food, gasoline and other necessities soaring, retail sales remain strong as people shop for their everyday goods. But with gas prices over $5 a gallon in many places and grocery bills skyrocketing, there’s less money left over at the end of the month for discretionary purchases. In areas such as furniture, clothing and sporting goods, demand has fallen rapidly as people withdraw from less necessary items.

This showed up in earnings reports from companies like Walmart and Target. Target CEO Brian Cornell explained what happened during last week’s conference call:

In our other three core merchandise categories: apparel, home and durable, we saw a rapid slowdown in year-over-year sales trends starting in March, when we started to annualize the impact of last year’s stimulus payments. Although we anticipated a post-stimulus slowdown in these categories and expected consumers to continue to refocus their spending on goods and services, we did not anticipate the magnitude of this change. As I mentioned earlier, this has led to us having too much inventory, especially in large categories including kitchen appliances, TVs, and outdoor furniture.

This fits with which high-end furniture player HR (RH) said in March. Its outspoken CEO, Gary Friedman, said that following the invasion of Ukraine and rapidly rising gas prices:

“Our demand has been hit 10 to 12 points. We’re not actually leading the demand. I just wanted to let you know there’s been a change. I think it’s going to be like that for everyone.

[…] Other people could hit a brighter and happier drum than me. Do they have better numbers than us? I do not think so.”

Those warning signs that Friedman pointed out in March became very clear throughout the retail sector in May. So what’s the way forward for mass market retailers in general and Target in particular?

Is the target worth investing in for the long term?

I think Target doesn’t have a particularly great management team or business model compared to other retailers in its peer group. Target’s previous manipulations of things like Target Canada’s failed expansion and its data security debacle has always kept this company out of my reach.

That said, Target was able to take advantage of the pandemic buying boom for a while and jump from its usual lackluster valuation multiples (15 PE and around 7x EBITDA) into higher territory. Now, however, we see the twin forces of multiple compression and declining earnings for Target, which may keep the stock down longer than expected.

In any case, the stock isn’t that low in the grand scheme of things. Stocks are still up sharply from January 2020 levels. And that’s remarkable, because Target stock has done virtually nothing for the entirety of the 2010s; it is not a company that has historically generated shareholder value at a rapid pace.

Here is its earnings per share over the past decade:

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Data by YCharts

Were these 2021 benefits sustainable? I guess they are not. As you can see, Target has generally earned around $5 per share per year over the past decade. There were times when they earned less due to one-time events such as the costs associated with closing Target Canada’s failed expansion. Either way, this company earns about $5 per share in a normal year. Over the past year, however, it has earned $14/share. If this is Target’s new stable state, then of course a much higher stock price would be warranted. If Target simply over-earned dramatically thanks to an exceptionally favorable economic climate that has now disappeared, those earnings will drop a lot.

Why did Target’s profit plummet?

The question of the sustainability of benefits really sums up the whole picture. Target was able to earn $14/share in 2021 for several reasons. First, the inventory turned very quickly. When Target was able to get the product on the shelves, it sold out almost immediately. Moreover, there was no need to cut prices or give up market share margins since retailers in general did not have enough merchandise to meet demand.

Now, however, as Target pointed out above, they’ve ordered too many TVs, appliances, etc. relative to demand. You’re cleaning up old inventory with price cuts and more aggressive marketing. Instead of earning super-normal profit margins, Target will see its profitability return to more normal levels or perhaps even below average numbers.

The decline in revenue is not just related to merchandising. Labor costs are significantly higher as workers demand wage increases to keep up with inflation. Soaring fuel prices are causing logistics expenses to skyrocket. Overhead costs such as electricity to run stores increase in an inflationary environment. The list continues. Last year, Target was beginning to enjoy an exceptionally prosperous retail climate while having lower operating costs. Today, operating costs are skyrocketing while retailer margins are falling.

Analysts, however, seem to think a return to the abnormal prosperity levels of 2021 is ahead. Here is the current Target Futures payout deck:

TGT revenue estimates

TGT (Seeking Alpha) Profit Estimates

Consensus sees earnings drop 22% for FY23 to $10.60 per share, which seems pretty reasonable. However, analysts then see earnings jump 27% in 2024 and another 12% in 2025 based on revenue growth of just 4% and 3%, respectively.

These numbers, to be frank, don’t make sense to me. In an inflationary economy where Target is having trouble managing its supply chain, it just seems baffling that the company is getting double-digit profit per growth on nearly flat sales numbers.

On the contrary, I would expect earnings to decline again in 2024 after the decline in fiscal year 2023. Let me repeat that Target typically earned around $5-6 a share in any given year before the pandemic. And it’s not like Target has fundamentally transformed its business since then. With no major new developments, it seems odd to expect the company to earn more than $10 per share in the future when it never has historically.

Is the target action a buy, sell or hold?

If you calculate $7 profit execution rate and a P/E ratio of 17x, that would get a stock price of $119 as a target. This is still a substantial downside from here. Thus, I view stocks as a sell-off, even after their steep decline last week.

And, let me be clear, that $119 outlook is still quite generous in light of Target’s historical performance:

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Data by YCharts

Target stocks were selling at $40 in 2002, $40 again in 2009, and $80 in 2019. This is not a fast moving business. It does not have a strong presence in international markets and its e-commerce efforts have also lagged behind its rivals. It’s not like Target suddenly flipped a switch and became a massive growth machine in 2020. It had a year of record profits, but unless you see a path to 2021’s prosperity levels continue indefinitely, Target’s stock price makes little sense here.

If you want to own the business, at least consider waiting for an earnings report where they’re controlling inventory and starting to see margins improve. This would be a better entry point than buying after the first quarter down in what is likely to be a prolonged downturn for the retail sector.

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