A wise man once told me: “Never recommend a stock to anyone. You’re bound to loose. If it rises, they’re brilliant. If it tumbles, you’re an idiot.” In length, I emphasize that the following write-up is not a recommendation. It’s merely a collection of reflections that document my reasoning behind my investment decisions, hence allowing me to go back and learn from my mistakes and successes.
Abstract
- A previous post’s mechanic study concluded that Target Corp. might be the one bargain hiding in plain sight within the non-cyclical consumer goods sector, the so-called “expensive defensives”.
- This stock analysis seeks to determine whether it might be undervalued, as originally suggested, or not. Based on a ‘reverse discounted cash flow’ analysis, the market expects Target to grow at 1%. Though it sounds modest, I believe it might be too optimistic given various challenges and industry forces.
In the post Are there any bargains among the expensive defensives? I mechanically calculated intrinsic value estimates for 25 stocks with P/E multiples below 25 in the non-cyclical consumer goods sector, the so-called “expensive defensives”, to determine if any bargains were hiding in plain sight. I concluded that Target (TGT), the second-largest “all-things-to-all-people” retailer in the US, appeared to be the most promising pick. Now that I’ve scratched beneath the surface, I am no longer so bullish on Target.
Why Target appeared interesting
In afore post’s study, a mechanic valuation process grew Target’s latest free cash flow figure at 3% (into perpetuity) and discounted it back at 7.5% and 10%. These assumptions produced intrinsic value estimates of $143.5 and $84.9, respectively. Compared to the stock price of $70, I was intrigued. I then looked at the business’ historic free cash flow growth, and was pleasantly surprised to witness a double-digit compounded growth during the past 5 and 9 years. Applying more optimistic growth rates based on these historic figures obviously shot the intrinsic value estimates north. It turned out, however, that the starting points – the figures 5 and 9 years back – were the exact years Target’s FCF slumped, hence causing the compounded growth rates to be artificially high.
Why Target might not be interesting
Inspired by Stephen Penman’s book Accounting for Value, which suggests that one should use valuation models to challenge a stock’s price, I decided to uncover the growth assumptions that are baked into today’s price.
The most widely used valuation model goes under the banner discounted cash flow (DCF) analysis. The method is outlined in the post How much is LEGO worth?, but let me flesh it out quickly.
You may have heard Warren Buffet say: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” A DCF calculation aims to determine just that. The model seeks to estimate a company’s present value based on the future free cash flows of the business (into perpetuity). In essence, free cash flow (FCF) is the profits that are left after spending the money needed to maintain the operational assets (e.g. property, plant and equipment). Hence, the free cash flow is simply operating cash flow – capital expenditures. FCF is significant, as it represents 1) the cash you could pocket if you owned the entire business, and/or 2) the cash the company can allocate as it sees fit, e.g. reinvest in the business’ growth, pay dividends or share buyback programs. Once we’ve made our projections as to the growth rate of these free cash flows, we need to settle on an appropriate discount rate based on the investment’s risks. Finally, we subtract the business’ long-term liabilities and add its cash position.
In an attempt to assess the market’s expectations to Target, I fiddled with the numbers until the intrinsic value estimate equalled today’s stock price. Having settled on a 10% discount rate, a 1% growth rate into perpetuity was the magic number, cf. below calculations. In other words, at today’s price of $69, the market expects Target to grow at 1% from 2018 into perpetuity.
Though a 1% growth rate sounds modest for a market follower with $70 billion in sales, it just might be too optimistic. Various reasons could substantiate that claim, i.e. it’s plateaued sales combined with shrinking margins; Target’s EBIT-margins are below the industry-average (compared to Walmart, Costco, Walgreens and Dollar General); as well as the increasing threat of eCommerce competitors, namely Amazon with its newly acquired Whole Foods division.
These are, however, not my primary concerns. To stay competitive and build brand loyalty in a market marked by “emotionless shopping”, Target has decided to 1) cut prices, and 2) remodel their stores – both of which are bad news for Target’s future free cash flow, since the former initiative will probably squeeze operating cash flows and the latter will increase capital expenditures; in fact, Target expects to spend $7 billion on remodeling their stores by the year 2020. That corresponds into an average increase in capital expenditures of $2.3 billion per year.
If Target is facing a negative billion-dollar impact to its free cash flows in the years ahead, capital to grow its business has to come from other sources: debt. Speaking of growing the business, recent news speculate that Target and Kroger are in merger talks (though close sources say there’s “no truth” to these rumours). Let’s play with the thought though. Since Target only sits on $2.6 billion in cash, and Kroger’s market cap exceeds $20 billion, it would take some serious borrowing and stock-swapping to make these acquisition ambitions come true. Though it’s merely gossip, the numbers scare me.
Regardless of whether the Target-Kroger acquisition rumours are true, one thing worries me on behalf of Target shareholders. While Target invests billions on store remodeling, competitors are able to invest in growing their business via store openings, building eCommerce capabilities, acquisitions etc. In spite of i.e. Walmart’s colossal size (it’s approaching $500 billion in sales), it’s still growing its revenues faster than Target. Though Target’s management expects a remodeled store to increase its sales by 2-4%, it seems – in my view – like Target is treading water, especially when one compares it to the industry’s other players’ performance.
Conclusion
Maybe I am too pessimistic or haven’t accounted properly for Target’s remodeling endeavours. Though the above write-up is gloomy, I still can’t imagine Target not being around 20 years from now. Based on that flawed logic, should one invest in Target despite a – perhaps – few rough years ahead? Maybe. However, I am not pulling the trigger on Target at the current price despite my initial excitement. I hope I am able to find better picks in the “expensive defensives” sphere or elsewhere. Time will show whether that decision was correct or not.
“Why do you bore me with a stock analysis of an idea you don’t find compelling?”, you might ask. Well, I did promise you so in Are there any bargains among the expensive defensives?, so here you have it – my (now) bearish outlook on Target given its current price.
