Excess Inventory to Hold Target’s Near-Term Earnings in Check, but Our Long-Term View Is Intact

Our $171 per share valuation of no-moat Target (TGT) should dip by a low- to mid-single-digit percentage after it disclosed that ongoing inventory mismatches should pressure near-term results to a greater extent than initially expected. Citing markdowns, removal and storage of excess inventory, and high costs, management reduced its guidance. The firm’s leadership now foresees operating margins around 2% in the second quarter and a roughly 6% second-half mark, down from around 5.3% and an implied mid- to high-single-digit level, respectively. Our 5% second-quarter margin forecast should fall in line with management’s new goal, with little change to our second-half assumption (already just short of 6%).

We are encouraged that management cites healthy increases in traffic and sales, suggesting that the pressure comes from efforts to keep inventory levels clean in a fast-changing environment compounded by long lead times. With Target ordering merchandise early to offset the impact of production and port delays, consumers’ rapid shift toward food, beverage, and essential categories at the expense of more discretionary expenditures (including Target’s home and small appliance offerings) as inflation has taken a toll has left the chain exposed. Although Target is nimbler now than it has been (the result of supply chain and store-related investments over the last several years), it cannot turn on a dime, and we are not surprised by the challenges. As essential items generally carry lower margins than discretionary categories, the mix shift also works to Target’s disadvantage from a profitability standpoint. We see these factors as transitory, with little long-term impact.

Our reaction is similar to the shares’ trading price move after the news, and with the stock trading near our fair value estimate (after accounting for our planned cut), we suggest investors await a more attractive entry point that affords a greater margin of safety considering near-term uncertainty.