Valuing Target

Friday we compared some big box retailers and argued that Target must serve up its wares with some secret sauce, for it has relatively strong margins. However interesting, if we are to assess Target as a business owner, our analysis should quickly move to its assets and earnings power.

First, the assets. At the close of their fiscal year—January 31, 2009, Target had 44.1 billion in total assets versus 10.5 billion in current liabilities and 19.9 billion in non-current liabilities; shareholder equity then stood at 13.7 billion. Yet, some have argued that Target’s balance sheet currently understates the value of two important assets—their remaining stake in their credit card business, and their real estate property. For example, William Ackman, founder and fund manager at Pershing Square Capital Management, has recently been agitating Target’s management to spin off some of its real estate into a REIT-like structure, with the assumption that the two parts valued separately would demand a higher price than the current aggregate. So what are these two important assets worth?

In 2008, Target sold half of its credit card business to JP Morgan for $3.6 billion; today the remaining half may not fetch the same price, but it is unlikely that it would be worth less than $2 billion. Pershing, in its public presentation on Target, values the remaining credit card receivables at $4.4 billion. A strict average would put a price of about $3.3 billion on the credit card business.

As for the real estate, estimates range widely. In Pershing’s public presentation of its REIT plan on Oct. 29, 2008, they highlight that the gross book value of Target’s owned real estate is $25.2 billion, and its replacement value near $39.1 billion. Were the REIT spun off, Pershing estimates that it would carry an equity value of $29 billion within twelve months (see the Nov 19, 2008 follow-up presentation). Again, a strict average of these three estimates would price the real estate at $31.1 billion.

Of course, there still remains the question of Target’s value as an operating retailer. Any valuation estimate would require some sales and earnings assumptions, but if we take their trailing 5 year average EBIT at $4.5 billion and give it a 6x multiple, we could conservatively value Target’s operating business at $27 billion. In sum, these three parts should carry a fair value of $61.4 billion to a private owner. As of Friday’s close (3/27/09), the market valued the entire company at $25.7 billion.

So, what’s the market missing? If Target is currently valued at less than 50% of its intrinsic value, shouldn’t bargain hunters be snapping up shares?

In my lights, the answer is cash flow. Looking at Morningstar’s numbers, one can see that Target’s free cash flow is quite low, given the wealth of assets that they must use to generate that cash. In fact, it has only broken a billion in FCF once, in 2006. For Target, almost all of its cash flow has been poured back into its business, with capital expenditures consuming at least 75% of its cash flow on an annual basis, for at least the last decade. And the crucial question for the shareholder must be, how long will this endure?

At some point, Target’s FCF does not find its most profitable home in future expansion. Hopefully that point is in the future, but it may be already past. Once Target has built enough stores, future stores will cannibalize the elders. And at that point, capital expenditures will need to come down, and the excess cash flow redirected into more productive endeavors. This is the crucial capital allocation test for retailers; can they transition their strategy prudently? Given Target’s current share price, a good number seem to doubt that they can.

Disclosure: No position

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Retailing and Moats

Few retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors. Seemingly the only thing to distinguish their goods is the price. Hence in retail, the widest and best moat is found around the business that consistently offers the lowest price. As Charlie Munger observes, “retail is a very tough business. [Warren and I] realized that we were wrong. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix. The dominant retailer in one twenty-year period is not necessarily the dominant retailer in the next.”*

Though only fools would dare position themselves contrary to Munger, it is striking, when one surveys the American retail space, how many retailers appear to thrive. Of course, Circuit City and Linen ‘n Things have recently taken the fall, but the majority still remain, even amid this dire economic environment. Yet, when I survey the survivors, it is hard to discern any economic moat, much less a wide one. The washing machines at Lowe’s, at Sears, and at Best Buy appear virtually indistinguishable; the same Dockers line the walls of Sears, Kohls, and JCPenney. Yet, more of our family’s dollars find their way to Target than any other, even though Wal-Mart often offers better prices. Are we doubly fools, or does Target offer something which its competitors do not?

Looking at the numbers, Target has 351,000 employees, which produce 64.95 billion in sales, at a gross margin of 28.6% and an operating margin of 6.78%. Sears is likely their most similar competitor—in inventory, assets, and sales—and it has 324,000 employees, producing 46.77 billion in sales, at a gross margin of 27.05% and an operating margin of 1.31%. Wal-Mart, with its gargantuan 405 billion in sales, brings a lower gross margin of 24.52% and an operating margin of 5.6%. (So that’s what we should mean when we say we will make it up on volume.)

With these numbers, Target’s excellent margins leap from the page—an observation which seemingly runs contrary to our opening thesis: that offering the lowest price produces the best competitive advantages in retailing. So the question is: how can Target sell the same stuff for higher prices than its competitors?

My hypothesis is that Target offers a unique shopping experience, one which many women in their 20s, 30s and 40s particularly love. I say women largely based on my own idiosyncratic anecdotal evidence. For one, my wife and her sisters craft their weekends and shopping needs around a weekly excursion to Target, and it is indeed an excursion, because most of the trip involves just walking around, picking over shoes, accessories, clothes, baby gear, towels, sheets, and household décor. For all of these items, I have never seen any of them make a purchase from Wal-Mart or Sears. And of course, once you’re in the door, the convenience brings household goods and groceries into your cart.

Perhaps more interesting and illustrative is a simple Google search for “I love Target” or “Why I love Target.” Compared to competitors, the fan base is quite remarkable. “Target Brand Boxed Riesling is packaged in such an irresistibly cute green box that I could not resist it.” “Tonight I popped in Target after teaching a Kindermusik class… I ran across these shoes [picture].” “This is why I love Target… I want to kiss the person who designed them and make out with the person that decided to only charge me $30! LOVE IT! [link]” Sure, such banter is fun, spontaneous, and whimsical, and not too much should be drawn from it. But it does strike me that Target has established a shopping experience, shared by many, that compels sales of superfluous goods at profitable prices.

Fans talk about wide, uncrowded aisles, the shoe designers, the lighting, the employees. The reasons are multiple, but the passion is earnest. When thinking about the prospects of Target’s moat, it is hard to interpret the competitive advantage expressed by this passion. But certainly something is there that other retailers are missing.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

* Schroeder, Alice.  The Snowball: Warren Buffett and the Business of Life (Random House, 2008): 332.