Market Is Giving Target Too Much Credit for a Sensible Strategy

Target's decision to exit Canada should allow management to focus investments on the U.S. business, in which the company intends to concentrate on five strategic pillars: on-demand shopping, signature categories, localization, urban formats, and cost cuts. If successful, Target's omnichannel and REDcard strategy could drive per customer spending higher, and the firm could still justify operating with a large store base amid intense competition from the online channel. However, switching costs are virtually nonexistent in the retail channel, and we don't see conclusive evidence that Target commands a throughput-driven cost advantage over other big-box rivals or that it is able to charge sustainable price premiums in its categories. Even after factoring in differences in growth rates between Target and wide-moat Wal-Mart, Target still trades at a higher valuation than Wal-Mart, which we see as a more attractive option given our view that wide-moat firms deserve higher valuations than no-moat retailers, all else equal.

Target also recently announced that it will sell its more than 1,660 in-store pharmacy clinics to CVS Health CVS for approximately $1.9 billion ($1.2 billion after taxes). These pharmacies generate nearly $4.2 billion in annual sales, representing about 5% of total sales, but operating profit dollars should be relatively unaffected after the sale; the business operates near break-even. We do think the partnership with CVS will allow Target to improve the competitiveness of its pharmacy offering, as Target's pharmacy business operates at a significant scale disadvantage to rivals. Only around 5%-7% of Target's customers use the pharmacy, so we see a material opportunity for Target and CVS to leverage an increase in script counts. Improved traffic and profit margins should give a slight boost to Target's return on invested capital. Longer term, we see Target's small-format stores benefiting from the pharmacy partnership with CVS. Although Target operates only a handful of Target Express stores, it is looking to expand this format over the coming years. Wal-Mart already operates a larger network of small stores, which have successfully used pharmacy offerings to drive traffic. Target can also leverage CVS' real estate expertise to build out its small-store footprint, although cannibalization is a larger risk for CVS.

Some Competitive Assets, but No Moat Target boasts some competitive strengths, but we do not believe that it has a sustainable cost advantage or pricing power over its direct rivals; although Target has generated returns on capital above its cost of capital in the past, we do not assign the firm an economic moat. A record of generating ROICs above cost of capital is a potential indicator of a moat, but it doesn't guarantee that a firm can sustain results on a forward-going basis.

Target has some competitive advantages working in its favor, such as its well-known brand, convenient locations, and competitive scale. However, we don't believe that Target's throughput is higher than peers', and we aren't highly convinced that its margin difference (over some other defensive retailers) is underpinned by sustainable pricing power (within its categories) either. Instead, we believe that its margin differential is due to product mix differences. Moreover, Target has considerable operating leverage, and margins could erode quickly if its business comes under pressure from various channel players. As a result, our confidence that excess returns can be sustained over the very long term is not high enough to assign the firm a moat.

We believe that a firm with a narrow economic moat should be able to charge material price premiums for comparable products and/or have the ability to drive more traffic and sell more products than its competitors; the latter case involving higher throughput tends to drive an economies of scale based cost advantage, which we view as more durable for retailers than pricing power alone. We assign wide moats to the small number of firms that have the strongest (and potentially mutually reinforcing combinations of) brand intangible assets and cost advantages.

We use this framework when taking a closer look at the drivers of Target's margins and invested capital turnover. When we look at the ROICs and ROIC drivers for Target, Wal-Mart, Kroger KR, and Costco COST, Target's margins drive its returns on invested capital, whereas high invested capital turnover is the primary driver of these competitors' ROICs. Thus, we believe that examining the drivers behind Target's margins and invested capital turns provides some color around its ROIC.

Sales per Square Foot and Margins Help Us Assess Moat To dig deeper into each of these ROIC drivers, we look at sales per square foot and margins; margins are a direct driver of ROIC, while sales per square foot is highly correlated with invested capital turnover. Above-average sales per square foot suggests that a firm has above-average throughput (for its size), above-average prices, or some combination of both; above-average margins suggest either pricing power or a cost advantage, assuming product mix is the same. Looking at both metrics helps us to identify potential moat sources.

Very few grocers command very strong pricing power and throughput-based cost advantages simultaneously. Relative to one another, defensive retailers generally face a strategic trade-off between store productivity (sales per square foot) and margin. The productivity and margin trade-off isn't surprising, as large stores tend to use low markups to drive substantial volume, while small stores tend to have low turnover and higher per unit prices due to their convenience.

Target has lower sales per square foot but higher margins than most of its major big-box competitors. Based on these findings, we rule out the possibility that Target both sells more than these competitors (on a square-footage-adjusted basis) and charges higher prices; Target's average price points or volume (traffic and items per transaction) could be higher than these competitors', but (like most firms) not both.

To decipher what drives Target's sales per square foot--volume or price points--we decomposed the sales per square foot metric to identify its key drivers. Target has relatively high markups--about 42%--which compares with a 12% markup at Costco, a 32% markup at Wal-Mart (aggregate), a 22% markup at Kroger, and a 45% markup at Dollar General DG. The average price point for the items that consumers buy at Target appears to be higher, on average.

On the volume side, Target's inventory per stock-keeping unit per store is higher than most other firms', and its inventory turnover is lower than most other firms'. Costco holds much more in inventory and turns its volume about twice as fast as Target, while Wal-Mart holds much less in inventory but still turns its inventory about 25% faster. On the basis of these results, as well as other survey data, we do not believe that Target has a throughput-based cost advantage over its major rivals.

On the pricing side, we believe that Target's higher prices (per item in each transaction) are explained by the fact that its sales mix skews toward higher-margin general merchandise items, rather than by price premiums relative to direct competitors. Target generates only about 25% of its sales from grocery, sundries, and pet supplies, which compares with about 55%, 80%, and 42% at Wal-Mart, Kroger, and Costco, respectively. At the same time, Target generates about 19% of sales from apparel and 17% from home furnishings and decor, which compares with a combined 14% at Wal-Mart and 11% at Costco.

Overall, we think that Target's prices are competitive in many categories where products are comparable, and given that many of Target's SKUs can be found in a Wal-Mart, we don't believe that Target's price gaps, where they exist, are broad enough or large enough to explain our estimated price difference. Minimal customer switching costs make it unlikely that Target would be able to charge large markups for most of its items (particularly fresh produce, branded consumable items, and electronics) that competitors also sell.

Strategic Priorities Leverage Strengths and Should Drive Improving Results After spending several months evaluating the business, Target's new management team provided its long-term strategic priorities and financial targets. The company intends to focus on five key strategic pillars: on-demand shopping, signature categories, localization, urban formats, and cost cuts. Management believes that this strategy, if executed properly, can drive 3% annual revenue growth (driven by 1.0% annual store-based comparable-store sales growth and 40% annual digital sales growth), 29.5% gross margins, and 9.5%-10.0% EBITDA margins, all on $2.0 billion-$2.5 billion in annual run-rate capital expenditures.

We believe that these estimates are reasonable, as they assume minimal transaction growth but growing basket sizes and pricing roughly in line with inflation. We estimate that free cash flow margins could average around 4% on average; this level is in line with historical levels and should allow Target to sustain a 40% payout ratio (implying 5%-10% annual dividend growth through 2019) and to repurchase roughly $3 billion in shares annually after 2016.

On-Demand Shopping We think that establishing a competitive omnichannel presence will be vital to Target's growth prospects; if Target can successfully build out an omnichannel model while driving REDcard penetration 300 basis points higher to 25%, we think that its comparable-store sales growth could benefit by 50-100 basis points annually over the next five years. Switching costs have historically been very low in the retail channel, and the emergence of online/mobile commerce has lowered them further. A retailer that does not adapt to changing consumer channel preferences risks losing market share, but those that do could benefit from greater customer loyalty and sales. Symphony IRI estimates that more than 80% of consumers already shop in more than three channels, and we believe that consumers will increasingly shop multiple channels in the future.

Smartphones and tablets have made consumers ever more demanding with regards to convenience, and many consumers want the option to not only purchase whatever they want at the click of a button but to also take possession of the item wherever and whenever they want. These trends are particularly relevant to Target, as its product mix skews toward discretionary items that consumers are opting to buy online. Since Target overindexes in several of these categories, such as apparel and accessories (19% of Target's sales come from apparel) and furniture and home furnishings (17% of Target's sales), we think that it could come under more pressure from the online channel than some of its rivals.

At the same time, we think brick-and-mortar firms like Target have the opportunity to deploy real estate assets in a way that pure-play online retailers cannot; store locations still offer customers the opportunity to touch and feel products before purchasing and also to take possession immediately without paying and waiting for a delivery. It's also easier for a firm to create a local community-centric environment in a store.

An omnichannel model makes sense when the benefits of selling through multiple channel formats (namely customer loyalty, market share stability or gains, and higher overall sales) offset the added costs and the potential impact of cannibalization. Encouragingly, most omnichannel retailers have noted that consumers who shop in one or more channels tend to spend 2-3 times the amount that consumers who shop in only one channel do.

These general industry findings are applicable to Target. Consumers who shop with Target in multiple channels visit Target 3 times as often as store-only customers; these customers also generate 3 times the sales that store-only customers do. More important, this multichannel sales lift isn't solely due to incremental online sales; omnichannel customers spend about 3 times as much in stores as those who shop in stores only, suggesting that online sales don't necessarily cannibalize store sales. Thus, a firm like Target could justify operating stores in a digital era, provided that the mix between in-store and online sales remains in the appropriate range.

Moreover, consumers who shop with the same retailer in multiple channels tend to be more loyal. Consumers who purchase from the same retailer in two or three channels are much more likely to shop with that retailer for their next purchase. Thus, a retailer that retains its core customer base across channels has the opportunity to sustain sales growth over time.

We think that Target's REDcard, which offers customers 5% back on all purchases, free shipping for orders purchased at Target.com, and an extra 30 days of return, will be an important complement to Target's omnichannel growth strategy. The firm first began implementing the REDcard in Kansas City, which management believes is a strong test market for its stores because of its demographics as well as the high correlation between results in Kansas City and national results. For example, the company's penetration in Kansas City has steadily increased from about 5% to around 25%, with the national average following an almost identical trajectory to about 22% (reflecting the lag in REDcard rollout).

We don't see conclusive evidence that the REDcard proposition is superior to other retailers' loyalty cards or pricing strategies, but on the basis of how much more REDcard users spend relative to non-REDcard holders, we believe that Target's competitive defense also hinges upon its ability to drive REDcard penetration higher over time. REDcard members make a greater number of trips to Target's stores than non-REDcard members and also spend about 1.5 times more after signing up for a REDcard. Moreover, these customers tend to shop two or three more departments during the year, arguably helping Target to drive customers to its higher-margin discretionary items.

On the basis of these figures, we estimate that driving nationwide REDcard penetration to 25% from 22% could add a little less than 1% to annual same-store sales growth. Exhibit 13 shows the potential comp growth upside associated with different scenarios for ending levels of REDcard penetration over a five-year period. If REDcard penetration were to hit 30% over the next five years, we estimate that comp growth could benefit by about 2% annually; if nationwide penetration stays roughly flat, we see minimal incremental contributions to growth. We derive these estimates by assuming that about 2% of Target's shoppers sign up for a REDcard during the year, and that their spending increases to (average) levels of current REDcard holders.

Signature Categories Going forward, Target intends to focus on four signature categories: style, baby, kids, and wellness. Collectively, these categories generate about $20 billion in annual sales (or around 25%) for Target and are higher margin, so driving penetration of these items should bolster profitability over time. It's worth noting that food is not considered one of Target's signature categories, although the incremental emphasis on health and wellness will influence Target's food assortment. We think that food (about 20% of sales) will remain vital to Target's overall strategy, as it is a very important traffic driver; relative to other categories, food is better insulated from online competition. We just don't believe that Target intends to craft its competitive positioning around the food offering.

In general, we think that emphasizing these broad categories makes sense, as Target's home and apparel offerings are important differentiators, whereas the firm's food offering is not a large differentiator even though food has risen to about 22% of sales from 15% in 2008. Moreover, we do not believe that Target has a scale advantage over Wal-Mart, Kroger, or Costco in the food category. The challenge, in our view, will be for Target to keep a differentiated offering. The firm has already done this in the past through limited-time-only design partnerships, which we think are a key differentiator in apparel. The excitement around Target's Lilly Pulitzer launch is an example of the firm's ability to utilize this tactic to drive traffic. Target's differentiation strategies also tie in with its localization strategy; changing the product assortment to local brands can be a differentiator.

Localization The benefits of this strategic priority are fairly obvious, and localization initiatives should help Target to defend its competitive position. For example, sourcing locally allows retailers to keep produce and other food items fresh for longer, supporting the firm's health and wellness initiatives. Sourcing locally can also lower transportation costs for the retailer (Target is aiming to reduce food transit times from farms to stores by 30%) and even improve negotiating leverage if supply is fragmented.

But aside from its impact on costs, localization can also support Target's brand. Most firms already adjust their product assortment to meet regional or even store-specific demographic preferences, but we think Target still has an opportunity to drive these initiatives further, as we think that shaping the in-store experience (not just assortment) around local communities helps to drive loyalty. Concepts such as Trader Joe's have been effective with tailoring stores to the local community, a tactic that is harder to replicate online; online competitors can make offerings and recommendations more personal, but having a community-oriented shopping experience relies, to a large extent, on the physical congregation of customers. All this said, many brick-and-mortar firms have been working to source more products locally for some time, so this strategic emphasis is not a new idea, and it is unlikely to give Target a cost advantage because other retailers are already using this approach.

Urban Formats We are quite optimistic about the growth prospects of Target's urban stores. The firm only operates eight CityTarget stores across the United States (in Los Angeles, San Francisco, Portland, Seattle, Brooklyn, Boston, and Chicago), leaving a long runway for growth in densely populated urban areas. These stores could range between 60,000 and 100,000 square feet (the current average is about 100,000 square feet), about 25%-50% smaller than a traditional Target store (about 130,000 square feet), giving the company greater flexibility to find suitable locations. In addition, sales productivity levels are double those of traditional stores, and the product mix is more attractive (more discretionary items). As a result, gross margins are in the high 30s versus a corporate average around 30%.

Target is also looking to increase its small-format footprint, namely through the potential buildout of its 20,000-square-foot Express store. The company operates only one Target Express store in the Twin Cities, but it intends to open eight new Express stores this year. We expect 2015 to be another test year for the format, and we don't expect a nationwide rollout for at least a couple of years. We think Target could build out its small-format presence relatively quickly, however, as capital requirements are low; Target would only need to shell out $300 million-$400 million in capital if it were to add 50 stores in any given year. For perspective, the company spent around $1.6 billion to open 58 stores over the past three years.

Despite our optimism, urban stores would represent less than 5% of sales even if Target builds out to 50 stores (assuming urban store productivity is similar to those of currently operating urban stores), and even then, Target's small-format ambitions are not guaranteed to succeed. Other firms--namely Wal-Mart and the dollar stores--are aggressively adding small formats as well, and we expect competition to increase over time. Target's customer demographic is slightly different from those of the dollar stores (and even Wal-Mart), but its core product proposition is also different. Target's challenge is to emphasize its signature categories that make it different in smaller stores, which may not allow it to adequately display its full range of apparel and home and furnishing products.

Cost-Saving Initiatives Over the next two years, Target is hoping to save $2 billion (around 3% of costs, excluding depreciation and amortization) through various cost-cutting measures, with the intention to reinvest the savings in the company's overall value proposition. Around 25% of the savings should occur in cost of goods sold, 25% in corporate and supply chain, 25% in technology and nonmerchandise procurement, and 25% in process simplification. Management believes that Target's store productivity model is very strong, but that there is an opportunity to simplify functions at the corporate level. Recently, Target cut 1,700 corporate employees (it employs around 350,000) and announced that around 1,400 open job positions would not be filled.

Overall, we see these targets as achievable, and provided that sales trends are in line with our expectations, we think a 29.5% gross margin, 7% operating margin, and 9.5%-10.0% EBITDA margin are attainable.

No-Moat Target Is Priced Like a Wide-Moat Retailer We believe that Target's strategies will help the firm to remain a viable competitor, and we think the company's long-term targets are attainable; however, we also think the market is giving the company too much credit for its strategy, and we advise investors to look elsewhere in the space.

We believe Target's comparable-store sales growth expectation (1% growth in stores and 40% growth in digital sales) is reasonable. Traffic has been flat to down slightly, partially due to the data breach and partially due to competition, in our view. Average selling prices have also declined but recovered over the past few years; we believe the downward trend reflects deflationary pressures resulting from the financial crisis and a shifting mix to food, while the upward trend reflects the pass-through of broad-based cost inflation and improving customer spending trends. The biggest driver of comp growth has been greater units per transaction. We think these trends reflect a greater number of consumable purchases and REDcard usage.

Sustaining growth could be more difficult over time, as the competitive landscape is intensifying and consumers remain relatively cost-conscious. We expect transaction growth to increase 0.0%-0.5% over the long term, as we think that more trips from new REDcard members will be partially offset by fewer transactions from customers switching to online rivals and other convenient formats. We also think that transaction growth will slow, given that the food offering (which is a traffic driver) is now more established. Our traffic trend expectations are largely in line with historical trends, as Target's traffic declined 0.8% annually over the past three years and remained flat over the past five years.

We expect 1% annual units per transaction growth, as we believe that greater REDcard penetration will result in higher units per transaction, and we think greater incomes will drive more spending. This assumption is also in line with historical trends, as Target's units per transaction have been flat over the past three years and up 1.6% over the past five years. Finally, we think that average selling prices (per unit) will increase by about 1.5%-2.5% annually, essentially in line with inflation. Stripping out a 1% contribution from REDcard users, we estimate that 1.5% of comp growth will come from non-REDcard users.

Our estimates for 2.0%-2.5% annual comparable-store sales growth are roughly consistent with Target's expectation for store-based comparable-store sales to increase by about 1.0% annually, and for digital sales (about 1% of total sales) to increase by about 40% annually over the next five years. Based on these figures, we think total sales could increase by about 3% annually, in line with management's long-term forecasts.

Margins Should Improve Over Time, but Not to Extent the Market Prices In Target's gross and operating margins should improve as sales tick higher and consumers continue to trade up to higher-margin items. In addition, lower gas prices should benefit distribution costs, although competitors should benefit as well. However, we expect that increasing online sales penetration could be a drag on gross margins, as online segment gross margins (around 23%) are weighed down by shipping costs; 40% digital sales growth implies about 60 basis points of gross margin pressure over the next five years. Moreover, Target will most likely need to lower prices to remain competitive with rivals. As such, gross margins should average around 29.5%, below historical levels above 30%. That said, we think underlying cost improvements and selling, general, and administrative expense leverage should allow Target to drive operating margins back to around 7%, versus roughly 6% in 2014.

We expect that Target, with its margin expansion, should increase earnings at a faster clip than Wal-Mart over the next five years; if we were to value Target with longer-term assumptions similar to those that we use to value moaty retailers (represented in the second stage of our three-stage discounted cash flow model), we'd arrive at a higher fair value estimate that suggests shares would be fairly valued. However, with our limited confidence that Target has an economic moat, we do not give the firm as much long-term credit. Given this view, we estimate that comparable-store sales would need to increase by 3% annually over the next decade (versus our base case of 2.0%-2.5%) and that operating margins would need to expand to back to 8% over the next 10 years (about 100 basis points higher than we assume in our base case) in order to compensate for Target's lower long-term returns on invested capital.

Wide-moat, low-uncertainty Wal-Mart, by contrast, is priced for paltry results. Overall, we believe that Wal-Mart's sales will also increase by about 3% annually and that it can maintain an operating margin around 5.5% over the long term; in other words, we believe that Wal-Mart and Target could increase sales at a similar clip, but we see less opportunity for leverage (and margin expansion) at Wal-Mart than at Target. With pessimism priced in, Wal-Mart is more attractive.