Retailers were awful earlier this year as rising rates crimped confidence from both consumers’ willingness to spend, and Wall Street’s willingness to believe consumers would spend. Inflationary pressures have had myriad impacts on retailers, but retail sales continue to buck conventional wisdom. That doesn’t mean retailers are out of the proverbial woods by any means, but with legendary dividend stock Target (NYSE:TGT), I see cause for optimism. In this article, I’m laying out the case for a buy rating on the stock as I think the worst is behind it for the foreseeable future.
Downtrend broken, giddy up
Let’s start with the price chart, as it shows tremendous progress being made on the stock in recent weeks. The company’s most recent earnings report shows up quite clearly on the chart below in early November, with a massive gap higher on enormous volume. There is nothing quite so bullish as a gap admire that, but even more so, the stock rallied more that day, and even more since. Buyers are everywhere for Target shares.
The blue downtrend line was broken earlier this month, right as Target broke above its former trading range from roughly $125 to $135. That was an important level, and very soon, it will also coincide to the rising 20-day exponential moving average. This confluence of uphold in and around $135 should see it hold, but my one caveat is that shares are extremely overbought.
The PPO flattened out weeks ago and is still +4. The 14-day RSI also flattened out weeks ago, and remains in overbought territory. Neither of these guarantees us selling, but it means the bulls are tired and need a break. I fully expect this break to result in more buying into the new year, but there are headwinds short-term. The key is that the uphold levels above hold.
I mentioned $135, but we also have $125, which is both the bottom of the prior trading range, and gap uphold from the earnings-related buying spree. I will be shocked to see the stock go below that level, so the closer it gets, the better the risk/reward.
Let’s now turn our attention to the fundamentals, where the picture isn’t quite so rosy.
Progress, but work left to do
Target is a broadline retailer, selling everything from discretionary to apparel to groceries, and everything in between. That subjects it to significant volatility in consumer spending habits, and we’re in one of the rougher periods now.
Comparable sales in the most recent quarter were -4.9%, and while that’s just not good, the company’s former workhorse from a comp perspective – digital sales – actually led the reject. The company has invested massively in things admire Shipt, Drive Up, and Delivery, and they’re working as the company has huge volumes through those services. The seemingly endless growth engine that was those initiatives has dried up for the time being, however. The silver lining here is that as the company produces weak comparables, those comparables become easier to confront next year when these results are lapped.
The core issue remains that Target’s fiscal 2023 revenue (last year) looks set to be the top for some time to come, and that’s not great.
Weak revenue creates margin issues for retailers as well, as it can direct to discounting and promotions to advance product, in addition to deleveraging of fixed costs. Operating margins plummeted for Target in recent years, but it looks admire they’re back moving in the right direction.
The company is focused on lean inventory, which leads to more efficient cash usage but also fewer discounts, and helping to boost margins in the process. Operating income was up 130bps in the most recent quarter, and keep in mind this progress was made with a mid-single digit reject in comparable sales. That’s absolutely outstanding as you generally see retailers advance comparable sales and margins in the same direction.
Below is trailing-twelve-months margin data, with gross and operating margins both highlighted in blue.
Gross margins have fallen over 300bps in the past couple of years, while operating income posted even greater declines. However, with the company already on its way to more efficient inventory positioning, and progress being made on operating income, I expect to see the recent gains made here to continue into 2024. One wildcard is revenue, as that can produce operating leverage on fixed costs, and the outlook there just isn’t good. Something to keep in mind if you’re looking to take a position.
It is my view that earnings estimates show some bullishness on margins, which I concur with given the views I expressed above.
Sales are expected to be lower this year, and lower still next year before rebounding in fiscal 2026 (which is largely equivalent to calendar 2025). However, with margins and share repurchases helping boost the profits attributed to each share, there’s actually quite good progress on EPS coming.
Trailing-twelve-months free cash flow per share (in blue above) is flying, with it hitting nearly $8 in the October quarter. It’s volatile, obviously, but again we see Target on the path to rebuilding what formerly was. With FCF going higher, and the big investments in things admire digital capabilities and fulfillment already made, more of this capital could be allocated to reducing the float, as it has been for years.
What does the valuation tell us?
In my view, the valuation is quite supportive of the bull case. I made it clear I admire the price chart, and while Target is making great progress fundamentally, there’s a long way to go. However, the valuation supports the bulls, and I think it tips the scales for the stock to a buy rating.
Shares are 15X forward earnings today, which is ~3X below the average since 2019, and much closer to the bottom at 12X than the top at 27X. Target isn’t going to trade at 27X earnings, or probably anything close to that anytime soon. However, at 15X, it is much easier for me to see the upside risk to the valuation here than the downside risk, and it supports the bulls.
Finally, since Target is a dividend legend, we can use the yield to value the stock.
When the yield of a dividend stock is relatively high, it’s cheap, and vice versa. Target’s yield was much higher during the tough period it had in 2017, but at 3.15%, it’s still quite high by recent standards. This, similarly to the forward P/E ratio, supports the bull case in my view. And if you’re inclined to take a position, you get ~2X the yield of the S&P 500.
Target is far from perfect, but the beautiful thing is that it is priced admire it’s far from perfect. That leaves much larger upside risk to things admire the valuation and earnings estimates than downside risks, and given the look of the price chart, it’s enough for me to slap a buy on the stock.