Slim Margins Will Pump the Brakes on Target Corporation Stock Growth

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Target stock - Slim Margins Will Pump the Brakes on Target Corporation Stock Growth

Source: Mike Mozart via Flickr (Modified)

In late 2017, one of my favorite trades was long Target Corporation (NYSE:TGT) and short Walmart Inc (NYSE:WMT). Target stock was on the verge of a big move.

The thesis was pretty simple. Walmart stock had outperformed in 2017. Target stock had underperformed. But nothing had fundamentally changed about the decades-long competition between these two discount retailers.

Walmart was just kicking Target’s butt when it came to omni-channel commerce capabilities like digital shopping, same-day delivery, and pick-up-from-store.

Eventually, Target would figure those things out, too, and fight back. At that point in time, Walmart stock would underperform, and Target stock would outperform.

Fast-forward a few months, and that trade has played out very well. Target stock is up roughly 20% since early December, while Walmart stock is down more than 15%.

But I think now may be a good time to hit the pause button on that trade. Specifically, it looks like Target stock is maxed out here and now. The company just reported first quarter numbers, and while the revenue growth narrative is only improving as expected, the margin growth narrative is lagging.

As such, over-arching margin concerns mean that Target stock may be stuck in neutral for the foreseeable future.

Here’s a deeper look:

Target’s Quarter Underscores That Big Growth Comes at a Cost

From a revenue growth perspective, Target’s recent quarterly numbers were near perfect.

Comparable sales rose 3%, which was not only better than expected, but also substantially bigger than Walmart’s comp in the overlapping quarter (2.1%).

Moreover, Target’s traffic rose 3.7% in the quarter, the best mark in 10 years and also far better than Walmart’s traffic growth (0.8%). Meanwhile, digital sales grew by 28%, which is better than the year ago mark of 21% growth.

Clearly, Target is firing on all cylinders when it comes to top-line growth.

What is driving the top-line strength? For starters Target has 56 store remodels, three new brands, 250 stores that now have Drive-Up service and 700 more stores that now feature same-day delivery. Plus, now every store has Target Restock.

Target is finally building out its omni-channel commerce capabilities. It’s working, but it is also coming at a cost.

More digital sales means higher fulfillment costs, and that means lower gross margins. Moreover, in-store investments and wage hikes are causing the expense rate to swell, and that is putting further pressure on operating margins.

All together, operating margins compressed 90 basis points last quarter. Granted, that margin compression is occurring alongside some of the best top-line numbers Target has reported in several years. But margins are nonetheless compressing, and that is diluting profit growth.

Target Stock Isn’t Priced for Persistent Margin Headwinds

When it was at $50, Target stock was a good bet regardless of margin headwinds from a digital sales shift and higher wages.

But at $70, Target stock is fully priced. As such, persistent margin headwinds could keep this stock stuck in neutral for the foreseeable future.

Target is getting its act together on omni-channel commerce and figuring out how to best operate in today’s retail environment. But this is a big company, and growth is hard to come by. As a result, regardless of management’s big investments, revenue growth over the next several years will still only be about 2% per year, at best.

Wage pressures will eventually move into the rear-view mirror by 2019. But thereafter, higher fulfillment costs will still be around to counter any operating leverage from better unit performance. As such, operating margins are likely stuck in neutral at around 6% over the next several.

Low single-digit revenue growth on sideways margins leads me to believe that Target can net about $6.50 in earnings per share in five years. A market-average 16-times forward multiple on $6.50 implies a four-year forward price target of $104. Discounted back by 10% per year, that equates to a present value of right around $70.

Bottom Line on TGT Stock

Target stock will likely trade sideways into the foreseeable future due to persistent margin headwinds. But if the stock drops into the $60’s, this could rapidly turn into a buy the dip situation because the top-line growth narrative is about as good as it’s been in several years.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/05/target-stock-slim-margins/.

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