With Higher-than-Walmart FCF Margins, Target Stock Merits Richer Valuation

The market has it wrong on TGT stock, which should be at least 50% higher

Target Corp (NYSE:TGT) has been on a tear with its online and digital sales. And since it is more profitable on a free-cash-flow basis than Walmart, I believe Target stock should trade significantly higher than current levels.

image of the target (TGT) logo on the storefront
Source: jejim / Shutterstock.com

For example, in the 12 months to May 30, the Minneapolis-based retailer produced $4.96 billion in free cash flow (FCF). With its sales of $80.1 billion, that FCF margin was 6.18%. Walmart? The Arkansas big-box operation made $18.46 billion in FCF over its last 12 months. But with sales of $534.66 billion, its margin was just 3.45%.

That three percentage point difference should make all the difference in valuation.

Deserved Valuations

Target has a market capitalization of $67.30 billion at Wednesday’s $134.60 closing price. But since it made $4.955 billion in FCF in the last 12 months, its FCF yield is 7.36%.

This is much higher than Walmart’s FCF yield, meaning it has a lower valuation metric than WMT stock. For example, Walmart’s market value is $373.5 billion, but its FCF was $18.46 billion in the last 12 months. That gives Walmart an FCF yield of 4.94%.

But here is the thing. Walmart doesn’t deserve that better valuation since it has lower FCF margins than Target. As I showed above, Walmart’s FCF margins were 3.45% compared to Target’s 6.18%.

So the market has got the valuation for Target wrong compared to Walmart. For example, at Walmart’s lower 5% FCF yield, Target should be trading at a $99.1 billion market capitalization, not its present $67.3 billion. In other words, Target stock should be 50.4% higher at more than $200 per share rather than $134.60 where it is today.

Why is Target Stock So Undervalued?

I suspect that the market does not like Target’s comparable-store sales growth. In its last quarter, Target’s store sales grew just 0.9% on a like-for-like store basis. But if you add its 141% super-fast growth in its digital sales, total sales grew by 10.8% for the quarter.

As The Wall Street Journal pointed out earlier this week, Target’s performance made it an “emerging winner” despite the coronavirus pandemic.  But, as I noted, its growth is powered by online and digital sales, despite sluggish actual comp-store sales growth.

In fact, the WSJ highlighted that Target’s sales per square foot are much lower than Walmart’s. In effect, it needs more inventory in its stores. It makes $341 in sales per square foot vs. Walmart’s $510.

But don’t forget that Target has a much higher FCF margin than Walmart: 6.18% vs. 3.45%.

Still, here’s the thing. Walmart’s total comp sales (stores plus online) in Q1 grew 10.0%, a little slower than Target’s 10.8%. And its online growth was just 74% vs. Target’s 141%.  So, again, on a comparable basis, Target is worth more than Walmart.

So far this year Target stock has risen just 4.96%, vs. Walmart stock, which is up 9.56%. I suspect that this discrepancy will disappear, especially given Target’s higher profitability.

Waiting for Earnings

Next week, both Target and Walmart will report their fiscal Q2 earnings for the three months ending July 31. It will be interesting to see if Target’s FCF margins and comparable sales (both in-store and online) continue to outperform Walmart.

I suspect that if they do, the market will begin to revalue Target stock in terms of its performance. So stay tuned to their reports. Target will announce earnings on Aug. 19, and Walmart will release its earnings on Aug. 18.

While Target is worth at least 50% more than today’s price, or $199.97 per share, don’t expect this to occur right away. In fact, sometimes the best way to handle this is to average cost into your investments.

WSJ points out that Target is much cheaper than Walmart when looking at 2021 expected earnings. Target is at 19 times 2021 earnings and Walmart is priced at 26 times earnings. Others show a similar discrepancy.

In any case, it’s clear to me that in the past 12 months, Target has shown much better value characteristics than Walmart. Target has had higher FCF margins than Walmart and yet inexplicably it has a lower FCF yield valuation (i.e., a higher FCF yield).

Unless the Q2 earnings show dramatically different results than in the past, which is not likely, I suspect that this valuation anomaly is likely to correct.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. He runs the Total Yield Value Guide which you can review here.


Article printed from InvestorPlace Media, https://investorplace.com/2020/08/target-stock-is-worth-50-percent-more-given-its-higher-comparable-profits/.

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