Target Corporation (NYSE: Tgt) Is a Discount

Target Corporation (NYSE: TGT) is a discount store that operate almost entirely in the United States (it has plans to expand into Canada in the next couple of years). The company began life as Dayton's, but by the 1960s the Target name was had been launched and the company had begun to expand beyond its home market (Target.com, 2012). Today, Target operates two business divisions -- retail and credit card (Target 2010 Annual Report). The company's sales by product category are as follows:

Industry

Target competes broadly in the retail industry and more specifically in the discount retail industry. The retail industry, according to the U.S. Census Bureau was $4.13 trillion in size in 2009 (Farfan, 2011). That year, Target had sales of $65 billion (MSN Moneycentral, 2012). While this is just 1.5% of this highly-fragmented industry, Target is still one of the largest companies in retail, albeit well behind #1 Wal-Mart. The high degree of fragmentation in the industry belies the dominance of a handful of firms in the sector in which Target operates. Wal-Mart and K-Mart are direct competitors, Costco is a close competitor in another segment (discount stores) and so are category killers like Home Depot and Lowe's and online giants like Amazon.

The retail industry in the U.S. is driven in large part by consumer spending, and this in turn is affected by a number of macroeconomic variables. The unemployment rate is an important driver for two reasons. The first reason is that the more unemployed people there are, the less money those people will have to spend. This will naturally have a negative impact on retail sales if the unemployment rate goes up. The second reason is that the trend in unemployment has an effect on consumer confidence. If the unemployment rate is rising, people naturally begin to wonder if they will be next to lose their jobs, and will start reducing discretionary spending as a result. This can help to explain, for example, why Target's sales have been increasing in the past couple of years, even though the unemployment rate has been persistently high. Even with a high rate, if the rate is not getting worse, consumer confidence will improve and this will spur more people to start spending again.

While the overall level of economic activity is also important, a key driver for a company like Target is the need for household necessities and this is driven in part by new housing starts, all home sales, and how much people are moving. As real estate activity decreases, people are able to save more by delaying purchases, or they simply do not need to make large purchases.

Competitors

Target's competitors are in general strong, well-capitalized firms. Most of the companies against which Target competes share the same competitive advantages that Target has with respect to substantial market size, high levels of buying power, extensive market reach, and strong brand recognition. Most competitors also have strong balance sheets as well. In general, Target is a medium-strong competitor in this industry, although it should be noted that still makes Target one of the better-run companies in the United States. They are simply competing against the best of the best in firms like Wal-Mart, Costco, Home Depot and Amazon.

Financial Performance

Financially, Target has been relatively successful. In fiscal 2011 (basically calendar year 2010), Target earned net income of $2.92 billion on revenues of $67.39 billion. Both figures represent a high-water mark for the company over the past five years. Target has a reasonable balance sheet, if not a strong one. The company has $15.6 billion in long-term debt and $15.48 billion in equity, meaning that the company has a relatively high degree of leverage. In terms of cash flow, Target's cash flow from operating activities was $5.27 billion in 2010, down from $5.88 billion in 2009. The company also spent much more money than usual retiring stock, something that often occurs when a company feels that the stock is undervalued.

Part II Financial Analysis

Like most retailers, Target faced a challenge in the late 2000s with the economic crisis. High consumer uncertainty, job losses and higher savings rates resulted in suppressed consumer demand, and companies like Target suffered as a result. For Target, however, the company was able to continue to grow revenues during this period. Some consumers "traded down" to discount retailers as a result of the uncertainty, and that benefitted Target. The net result, therefore, was not revenue decline but simply a slowing of the revenue growth rate. The following chart highlights the company's growth in three key metrics: net income, cash flow from operations and revenue.

As we can see, the company has steadily increased its revenues, but net income and cash flow have not increased to the same degree. This points to a company that has wavered in terms of its efficiency and effectiveness. For investors, this implies mixed performance that makes for an uncertain investment. A DuPont analysis should bear this out -- mixed financial performance, mixed ROE and no particular trends in the numbers.

Dupont Analysis

The Dupont Analysis seeks to break down the return on equity (ROE) into three component parts: the profit margin, the total asset turnover and financial leverage (Investopedia, 2012). The formula for the DuPont identity is as follows:

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

The following table illustrates the calculation of the DuPont identity for Target for each of the past five years:

Target DuPont Analysis

2010

2009

2008

2007

2006

Profit

Sales

67390

65357

64948

63367

59490

Profit/Sales

0.04333

0.038068

0.034089

0.04496

0.046848

Total Assets

48447

45499

42996

43705

44949

Sales/Assets

1.391005

1.436449

1.510559

1.44988

1.3235

Total Equity

15264

15106

15230

15487

14879

Assets/Equity

3.173939

3.011982

2.823112

2.822044

3.020969

ROE

19.13%

16.47%

14.54%

18.40%

18.73%

When examining what the source is of the company's recent improvements in ROE, it is evident that the company has improved its profit margins over the past two years, and this is a significant contributor. In 2010, the company increased its leverage and that also boosted the ROE slightly. The higher the sales/assets ratio, the lower the ROE seemed to be.

Conclusion

Target has had some success in recovering from the economic downturn, but the company performed reasonably well during the downturn anyway. If we examine the ROE figures, Target saw its returns shrink during the 2006 and 2007 calendar years when the economy was strong. Part of the decline in ROE was that the company's assets were growing rapidly in relation to its equity. It is worth considering the importance of ROE to shareholders at this point. The ROE can be increased simply by increasing the firm's leverage. As the firm's assets have increased faster than its equity, this implies increased leverage. The result is a higher ROE, but this is not necessarily sound financial strategy in the long run. A short-term ROE boost is nice to see for investors, but if increasing leverage to make this happen compromises the company's long-term solvency and liquidity then such actions are not as positive when seen in that light.