- Target’s ugly second quarter was driven by management’s decision to aggressively clear excess inventory
- Even down 40%, Target stock is pricing in something close to the pre-pandemic performance
- Given internal and external challenges, that seems potentially too optimistic
In fiscal 2019 (ending January), Target Corporation (NYSE:TGT) generated adjusted earnings per share (EPS) of $6.39. Gross margins were 28.9% of sales while operating profit was 6.0%.
In fiscal 2021, adjusted EPS came in at $13.56, more than double the figure two years earlier; adjusted operating profit was 8.4% of sales.
The key question for Target stock at the moment is which of those two years is more representative of what the business looks like going forward. It’s a difficult question—but, currently, also a common one.
In early 2021, investors believed the gains would be long-lasting. In mid-2022, they don’t. After all, for many so-called “pandemic winners” like Zoom Video Communications (NASDAQ:ZM) or Peloton Interactive (NASDAQ:PTON), the debate really has been over whether the underlying businesses changed during the pandemic or they simply received a short-term boost.
Target isn’t Zoom or Peloton, but it’s evident that U.S. retailers were pandemic winners to some extent. Thanks to stimulus payments, consumers had extra cash to spend. Because of lockdowns and personal protective measures, they had fewer places to spend that cash. And so the likes of Target and Walmart (NYSE:WMT), among many, many others, benefited enormously.
It’s been a different story in 2022. Both retail giants now face billions of dollars of excess inventory. With so much stuff purchased in 2020 and 2021, there’s little need, and in some cases little room, for more.
As second-quarter earnings last week showed, Target is working through that excess inventory. But at the current valuation, success on that front alone doesn’t make TGT stock a buy. Even down 40% from the highs—largely thanks to a plunge following the Q1 report in mid-May—investors still believe that Target is closer to the 2021 business than the 2019 one.
An Ugly First Half
There’s little argument that Target’s first half was ugly. Again, the stock plunged after the company slashed its full-year guidance while reporting first-quarter earnings. It cut the forecast again just three weeks later.
Second-quarter results badly missed Wall Street consensus and, in terms of profit margins, were below the company’s already-reduced outlook.
But the Q2 margin miss came from the company aggressively discounting merchandise to get it out the door. Chief executive officer Brian Cornell defended that decision on the second quarter conference call.
“Consider the alternative; we could have held on to excess inventory and attempted to deal with it slowly over multiple quarters or even years. While that might have reduced the near-term financial impact, it would have held back our business over time.”
To some extent, investors have accepted that explanation. TGT did drop 10% in four trading sessions following earnings—but it also rallied into the report. Despite posting an operating margin of just 1.2% in the second quarter, shares have gained nearly 3% over the past month.
Meanwhile, based on FY22 analyst consensus, Target stock trades at just shy of 20x this year’s earnings. That’s a multiple that suggests that the market treats this year as a reset year, with growth to resume in 2023.
What’s Priced Into Target Stock?
In other words, investors are looking forward to at least some extent. But it’s worth looking backward as well.
Again, in FY19, Target generated operating margins of 6%. That was a strong performance, rising 50 basis points year-over-year. A strong consumer no doubt helped.
Assume that Target hit that same level this year. Based on revenue guidance, run-rate interest expense, current share count, and a guided full-year tax rate of 21%, Target’s earnings per share would be about $10.50.
In other words, if the U.S. economy were going just fine, TGT would still be trading at more than 15x earnings. Admittedly, that’s a reasonable, even attractive multiple.
But it’s also a multiple that suggests everything will be fine again. It presumes that Target hasn’t had any self-inflicted wounds this year. It assumes that consumers will remain resilient amid persistently high inflation and that a recession is not around the corner.
Target stock would probably be too cheap against a brighter economic backdrop. But that’s precisely the point: everything isn’t fine, which may be the case for some time.
Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.