Target Corporation DuPont Financial Analysis (2006–2010)

Industry Overview and Macroeconomic Drivers

Target Corporation (NYSE: TGT) is a discount retailer that operates almost entirely in the United States. The company began as Dayton's, but by the 1960s the Target brand 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 are reported across several product categories.

Target competes broadly in the retail industry and more specifically in the discount retail segment. According to the U.S. Census Bureau, the U.S. retail industry was $4.13 trillion in size in 2009 (Farfan, 2011). That year, Target had sales of $65 billion (MSN Moneycentral, 2012). While this represents just 1.5% of this highly fragmented industry, Target is still one of the largest companies in retail, albeit well behind the number-one retailer, Walmart. The high degree of fragmentation belies the dominance of a handful of firms in the segment in which Target operates. Walmart and Kmart are direct competitors; Costco is a close competitor in another discount segment; and category killers such as Home Depot and Lowe's, as well as online giants like Amazon, also compete for consumer spending.

The U.S. retail industry is driven in large part by consumer spending, which is in turn affected by a number of macroeconomic variables. The unemployment rate is an important driver for two reasons. First, the more unemployed people there are, the less money those people have to spend, which naturally exerts a negative impact on retail sales. Second, the trend in unemployment affects consumer confidence. If the unemployment rate is rising, people naturally begin to wonder whether they will be next to lose their jobs and will start reducing discretionary spending as a result. This dynamic can help explain, for example, why Target's sales continued to increase over the past couple of years even though unemployment remained persistently high. When the unemployment rate stabilizes rather than worsening, consumer confidence tends to improve and more people begin spending again.

While the overall level of economic activity is also important, a key driver for a company like Target is the demand for household necessities. This demand is influenced in part by new housing starts, overall home sales, and household mobility. As real estate activity decreases, consumers are able to delay large purchases or simply find less occasion to make them.

Competitive Landscape

Target's competitors are, in general, strong and well-capitalized firms. Most of the companies against which Target competes share similar competitive advantages: substantial market scale, high levels of buying power, extensive geographic reach, and strong brand recognition. Most also maintain solid balance sheets. In general, Target is a medium-to-strong competitor in this industry — though it should be noted that this still places Target among the better-run companies in the United States. Target simply competes against best-in-class firms such as Walmart, Costco, Home Depot, and Amazon.

Financial Performance Summary

Financially, Target has been relatively successful. In fiscal year 2011 (covering approximately calendar year 2010), Target earned net income of $2.92 billion on revenues of $67.39 billion — both figures representing five-year highs for the company. Target maintains a reasonable, if not exceptional, balance sheet. The company carries $15.6 billion in long-term debt against $15.48 billion in equity, indicating a relatively high degree of financial 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 substantially more than usual on share repurchases, a move that often signals management's belief that the stock is undervalued.

Like most retailers, Target faced challenges in the late 2000s as the economic crisis generated high consumer uncertainty, job losses, and rising savings rates that suppressed consumer demand. For Target, however, the company was able to continue growing revenues during this period. Some consumers "traded down" to discount retailers amid the uncertainty, and that shift benefitted Target. The net result was not a revenue decline but simply a slowing of revenue growth. While revenues increased slowly but steadily, net income and cash flow did not increase to the same degree. This points to a company that wavered in terms of operational efficiency and effectiveness, implying mixed financial performance and an uncertain picture for investors.

Conclusion and Investor Implications

Target has had some success in recovering from the economic downturn, and it performed reasonably well during the downturn itself. Examining the ROE figures, Target saw its returns shrink during calendar years 2007 and 2008 even when the broader economy was still relatively strong. Part of the ROE decline during that period stemmed from the company's asset base growing rapidly in relation to its equity base. It is important to recognize that return on equity can be mechanically increased simply by raising the firm's leverage. As Target's assets have grown faster than its equity, this implies increased leverage — and while the result is a higher reported ROE, this is not necessarily a sound long-term financial strategy. A short-term ROE boost is welcome for investors, but if the leverage required to produce it compromises the company's long-term solvency and liquidity, such actions are less positive when viewed in that light.

It is also reasonable to conclude from this analysis that Target has essentially been treading water for the past several years. While revenues have increased slowly and steadily, virtually every other key metric examined here has been mixed — including ROE and the constituent metrics that compose it in the DuPont framework. Target operates in a highly competitive marketplace during an uncertain economic period, but investors would want confidence that the company is improving its ROE in a sustainable way.

The biggest contributor to improved ROE at present appears to be better profit margins, which is precisely the kind of positive signal investors seek. However, some of the improvement is attributable to increased leverage, which is a less desirable source of ROE growth. Improved asset turnover (the sales/assets ratio) has not materialized and is therefore not a contributing factor to the recent ROE gains. As a result, investors have reason only for cautious optimism regarding Target's financial performance in recent years.

References

Farfan, B. (2011). Retail industry information: Overview of facts, research and data 2011. About.com. Retrieved February 20, 2012.

Investopedia. (2012). DuPont identity. Investopedia. Retrieved February 20, 2012.

MSN Moneycentral: TGT. (2012). Retrieved February 20, 2012.

Target.com. (2012). Various pages. Retrieved February 20, 2012.

Target 2010 Annual Report. Retrieved February 20, 2012.