2/25/2011
By Brian Sozzi, Research Analyst

Target (TGT) still has roots in the land of cheap chic retailing.  In fact, many would even say it did for cheap chic what Wal-Mart (WMT) did for EDLP (everyday low price).  These roots are in the infant stages of branching out, however, to encompass a greater selection of cheap chic goods from the designer apparel duds of yesteryear.  Target's one-stop shopping destination push is a logical evolution of the business, creating traffic driving departments inside the stores at a relatively low build cost.  Unfortunately, with such a change comes many puts and takes to consider from an investor standpoint.  Does one view the company on the basis of comparable store sales that are surpassing competing large box chains?  Or, does a devotion to the source of value creation, margins and in turn free cash flow, be maintained? In my humble opinion, attention should be assigned to Target's margins and in that vein, there are headwinds that will likely cap the stock's multiple near-term.  Storied investor Benjamin Graham would be proud of my analytical thought processes! 

As well as a rising penetration of food, consumables, 5% Rewards sales, and inflation Target's comp guidance for FY11 of +4% to +5% sure seems juicy.  The flat EBIT margin tempers the enthusiasm on the sales front, and with Canada being dilutive upfront ($0.10 per share impact in FY11) downward adjustments to consensus forecasts seem forthcoming.  I reduced my FY11 EPS estimate to $4.30 from $4.50 (we are part of consensus forecasts), also accounting for fewer share repurchases relative to our prior modeling.  For FY12, I am at $4.70 per share, which assumes 10% EPS growth.  Given the lack of multiple expansion I anticipate, no change to my Hold rating (downgraded pre-earnings call) was appropriate.  Price target $51.00.

Thinking Behind the Rating Downgrade
* The addition of 380 new P Fresh locations (341 added in FY10) will speed up the shift in gross margin during a period of inflation in many merchandise categories.
* Canada will be dilutive upfront (IT development costs, amortization of leases, interest and depreciation expense) and inhibitive of share repurchases to a certain extent.

What You the Investor Needs to Know

Overview: Some confusion existed on Target's (TGT) 4Q10 numbers.  Target's reported EPS clocked in at $1.45, though this included $0.07 per share of certain "discrete state tax items."  If push came to shove, I fancy that consensus excluded the tax benefit (hard to model for a tax benefit, after all), hence Target's EPS missed consensus estimates.  Assuming that is in fact the case, I was unsurprised as Target's three month comp trend and cautious management commentary teed the market up for a letdown.  Shares of Target have cratered to the tune of 17% since hitting a 52-week high on January 3, 2011 on concern that comp misses in two of three months of the holiday quarter would expose the evolution in the margin dynamics of the business.

The lowdown: To explain what is transpiring at Target, one need not look any further than the increase in the RedCard penetration to total Retail segment sales to 7.4% from 5.6%, a function of the November launch of the 5% rewards program.  Consumers have increased the number of units bought at Target per visit, part RedCard related part economic improvement related, but the product categories that are flying off the shelves are in food and consumables; the selling price per unit declined 2.7% compared to a 2.2% drop a year earlier.  More volume of discounted food and consumables by way of RedCard, and deflationary electronics on a stand-alone basis, equates to a pressured gross margin, which dipped 40 bps in 4Q10, and missed consensus for first time in over seven quarters. 

Analyst diary: Traffic logged the slowest rate of increase of the year in 4Q10; 21 store openings in FY11 (CityTarget arriving in FY12); management sees $100 billion in annual revenue and a doubling in EPS in six to seven years time; website relaunches sans Amazon (AMZN) partnership in fall 2011; standardizing of garment fabrics one way to mitigate apparel inflation, though prices increases planned; some form of transaction for the credit card business outlined for 2H11 or early 2012; $1.5 billion to $2.0 billion in share repos for FY11 (FY10 $2.5 billion).

Brian Sozzi
Wall Street Strategies

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