Let's take a trip back to early November 2023.
The holiday season is swiftly approaching. But Target (TGT -0.06%) investors have little to cheer about.
Management is keeping a lean inventory, anticipating low demand. Margins are strained. Target's confidence in consumer spending on discretionary goods is low.
The dividend yield is around 4%, and the company has raised its dividend for over 50 years, making it a Dividend King. The reliable passive income stream is about the only thing working for Target. Shares are around a three-year low. The stock is falling with no end in sight.
But then, something changed. In response to Target's third-quarter 2024 earnings report, the stock staged its largest one-day gain in four years. It didn't stop there.
Target's Q4 2024 earnings report on March 5 kicked the stock into a new gear. In the four-month period from Nov. 6, 2023, to March 6, 2024, Target is up a staggering 56.3% -- almost the same gain as red-hot Meta Platforms. Target looks more like a "Magnificent Seven" stock than a big box retailer.
Here's Target's story, why the stock has been an unbelievable turnaround play, and lessons you can learn to take advantage of similar sell-offs in the future.
Image source: Getty Images.
It's all about margins
Operating margins are the lifeblood of most companies -- but especially retailers.
Some companies go for a high-volume, low-margin strategy. Walmart's margin is usually around 4.5%. Costco Wholesale falls within the 3% to 3.5% range. However, high volume makes for overall successful businesses.
By comparison, high-end retailers, like Williams-Sonoma or RH, tend to have at least 10% margins but lower volume. The sweet spot is a balance between sales and profitability, managing discounts, seasonality, and consumer trends.
Target is somewhere in the middle, typically sporting a 7% to 8% operating margin. It has a more discretionary product mix than Walmart, but not as discretionary as companies like Williams-Sonoma or RH.
Target's margins fell off a cliff in 2022. The company was ill-prepared for high inflation. Its costs went up, and initially, it was unable to offset those costs because consumers were being selective. Target had to issue discounts to move inventory. It was a sloppy execution, and the stock suffered accordingly.
TGT Operating Margin (Quarterly) data by YCharts. EPS = earnings per share.
As you can see in the chart, Target's margins and earnings began improving in late 2022. But since Target had a long way to go to reach pre-pandemic profitability, as well as brand concerns, the market wasn't too optimistic about the stock.
Like Bud Light's parent company, Anheuser-Busch InBev, Target got caught up in social media backlash last spring and summer. Many challenges compounded at once. Impatient investors dumped the stock. Those who believed in the long-term investment thesis and held on were handsomely rewarded.
Target's turnaround
The retailer's improving fundamentals drove a change in sentiment that ensured the stock's turnaround. It booked $2.98 in Q4 2023 earnings per share (EPS) -- 57.6% higher than Q4 2022 and above the forecasted range of $1.90 to $2.60.
Operating margins came in at 5.3% for the quarter, two percentage points higher than the same quarter last year. Just that small difference was enough to boost Target's operating income by nearly $2 billion.
Target improved its margins and lowered its inventory in Q3. That's when the turnaround began. Q4 proved that the turnaround was the real deal.
If you've listened to Target's earnings calls over the last few years, a major theme is growth in its Target Circle loyalty program, which is a direct way to engage customers with promotions through the Target app. Another theme is curbside pickup and delivery. For the most part, the results from Target Circle and non-in-store sales have been encouraging, even during the downturn. But investors were quick to dismiss these positive signs and get caught up in the negative narrative.
Now, sentiment has completely shifted. Target reported a 13.6% increase in same-day services (in-store pickup, curbside, and its Shipt service) for Q4 2023. These services now make up more than 10% of sales. That kind of news can throw fuel on a red-hot stock, which may be part of the reason Target keeps rallying. But just two quarters ago, I would guess the market would have largely ignored these stats.
Filtering out the noise
If you were to look at Target's stock chart, you would think that the company was on the brink of disaster and then did something miraculous. The reality is that the investment thesis has stayed mostly the same for the last few years. There have been challenges and mistakes, points when Target stock deserved to fall but not collapse.
Overall, I'd argue that the investment thesis hasn't changed since 2017, when Target announced a $7 billion investment in digitalization and store renovations. That was a pivotal point in the investment thesis and marked a turning point for the brand. Since then, Target has built upon that investment and is being rewarded with increased engagement from its loyalty program and non-in-store sales. Target has proven its value and resilience to Amazon, which was once an existential threat.
Target is one of the best examples of the importance of understanding the difference between short-term challenges and factors that could break the investment thesis. It also shows how volatile even a generally safe stock can be and how a narrative can dominate the price action of a stock.
A safe and reliable dividend
Target has raised its dividend for 52 consecutive years. But unlike some Dividend Kings that make bare minimum raises to keep the streak alive, Target has made some notable increases in recent years. In fact, the dividend is up 61.8% in the last three years!
Target sports a payout ratio of just 48.6%, which is impressive considering the size of the raises it has made. For comparison, Walmart has a payout ratio of 39.6%, but it yields just 1.3% -- which is half as much as Target's 2.6% yield.
Target's dividend checks all the boxes -- the length of consecutive dividend raises, the size of the recent raises, a low payout ratio, and a quality yield.
Is Target a buy?
So, what is a good price for Target? I would say that Target never deserved to fall as much as it did, but the tear it has been on for four months is also a little overdone. The key is not getting too caught up in either stage of the stock's performance -- the mighty collapse or the meteoric surge. Instead, it's better to find a point where you think Target is a good value.
Target is now at a 22.1 price-to-earnings (P/E) ratio, and the dividend yield is down to 2.6%. Maybe that is good enough for you. Others looking to buy the stock may want a higher yield or a better valuation.
Target is doing well, but the business isn't firing on all cylinders like the price action may lead you to believe. I wouldn't buy Target now. I think the stock is a better value around its 10-year median P/E of 17. For context, Target was a 14.2 P/E four months ago.
If you own shares in Target, it's fine to continue holding them. But just like it would have been unwise to get caught up in last year's sell-off, it could also be a mistake to become enamored with the market's recent infatuation with Target.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon, Costco Wholesale, Target, Walmart, and Williams-Sonoma. The Motley Fool recommends RH. The Motley Fool has a disclosure policy.
