Target – Missoni is a Home Run!

A number of news reports have been out regarding the new exclusive apparel and home line designed by Missoni for Target (TGT). The Italian designer is very well regarded in the fashion world and Target getting an exclusive launch of this magnitude speaks to the credibility of the merchandising team and the power of the Target brand. Target experienced a website crash while the product line launched due to high demand (perhaps the site was intentionally crashed?). This has created enormous buzz and an air of exclusivity. There have been reports of lines at the door before stores open across the country. When you invest in Target you get one of retail’s best merchandising and branding teams in the nation. The success of the Missoni line has the potential to move the needle for Target immediately during the most important time of the retail year, which is Q3 and Q4. Missoni will help because apparel and home are above average margin categories for Target. Missoni product selling so strongly will lead to a much lower mark-down rate as goods sell at full price which will help boost gross margins. The stock at $51 is close to decade lows in terms of forward earnings based valuations. Target has the potential to rally if they simply stick to doing what they do best – great merchandising and great retailing. Over a number of years there is much more upside for actual investors.

Target is the third largest discount retailer in the US. The company has been a long-term success story based upon cultivating superior shopping experiences for guests, and building equity. Target has consistently grown sales at a faster pace than the overall US retail market – and has been a consistent share gainer. In addition, Target has monetized a tight relationship with guests through expanded offerings which have included a fast-growing credit business and on-line presence.

Target is positioned to perform well in an environment where US GDP growth rates are low but stable. Target has demonstrated an ability to grow organically over many years and should continue to be a market share gainer. The company has undertaken new initiatives to drive sales and create their own good fortune rather than relying on the overall economy. P-Fresh is an initiative which adds more fresh produce and food to the stores and is expected to drive traffic and more frequent guest visits. The 5% rewards Red Card program which has been extensively tested, is expected to increase guest loyalty amongst the best customers while reinforcing trusted everyday low prices. A third driver for Target is a large-scale expansion into Canada. Target announced in January 2011 that 220 leaseholds from Zellers were being acquired of which 100-150 would be selected to remodel as Target stores. Canada is a market where Target already has significant unaided brand awareness where other big box retailers from the US have thrived (Wal-Mart, Costco, Sears).

Target has five material moving parts:

• P-Fresh re-branding of the stores
• Launch of the 5% Rewards Red Card program nationally
• Entering Canada through leasehold aquisitions
• Sale of the credit receivables business to a financial partner this year or next
• Taking control of their website from Amazon and doing their own fulfillment

The above complexities have made it difficult for Wall Street to analyze Target with precision. Uncertainty and the difficulty of predicting Target’s investment costs have created a depressed valuation for Target shares which looks set to recover. All of the initiatives listed above are the correct strategic approach for Target and this is a management team I have tremendous confidence in. Sales have been strengthening this year (comp sales are running +4%) and earnings are being depressed through expenses related to the start-up in Canada. The Canada expansion artificially depresses current earnings because there are expenses (both cash and noncash) which are running through the P&L in 2011 and 2012 before they have opened a single store. The earnings leverage in 2013 and 2014 is enormous. Judging by the recently successful Missoni launch and Target’s overall savvy with branding and advertising I expect there will be tremendous buzz in Canada when the stores actually open.

The company has a goal of $8 in earnings power 5-years into the future. These estimates look conservative as the stock price has been depressed and the company has been buying back shares through their share repurchase program at great prices. Using normalized valuation ratios for Target of 15x earnings (which the company is likely to be awarded if P-Fresh, 5% Rewards, and Canada are successful) the stock would be at $120 in 4 years from today.  This would amount to a 24% compound return (per year) over the next 4-years. If investors wish to be more conservative and award Target a 13.5x future earnings multiple the stock would appreciate to $108, which is still a 20.5% return per year for the stock.