Target Corp. (TGT)

Group Members: Gefei Civiletti, Xuan Feng, Guanwen Lai, Wei Wang, Hao Zheng

RECOMMENDATION: BUYINVESTMENT THESIs:In January 2016, Target ranked as the top department retailer with 37.4% market share. Different from other competitors like Walmart and Costco, who profit from selling large quantities of goods at relatively low prices; Target, according to its 10-k, employs the strategy of a differentiator by “creating an attractive value proposition through a careful combination of price, merchandise assortment, convenience, guest service, loyalty programs and marketing efforts.”Although Target disposed its Canadian operations and sold its pharmaceutical and clinic business to CVS in 2015; with its solid accounting fundamentals and strong growth in the domestic market, the company managed to arrive at an increased revenue and positive cash flow. Our analysis indicates that the company’s earning quality is of little concern and there is a low possibility of earnings management. In addition, our liquidity and solvency analysis suggests that Target essentially has the ability to pay down its debt; the declined leverage ratio also manifests the fact that Target is gradually shifting from external to internal financing.In conclusion, Target is a company that has stable performance and promising market potential. The listed price of Target is lower than our estimated price based on the company’s intrinsic valuation. As a result, our recommendation is to take a long position of the company’s stocks (buy).

CONTENTS

OVERVIEW OF ECONOMICS, INDUSTRY AND STRATEGY ANALYSIS...................3

ACCOUNTING AND QUALITY OF EARNING ANALYSIS.......................................4

PROFITABILITY ANALYSIS.............................................................................7

LIQUIDITY, SOLVENCY AND CASH FLOW ANALYSIS.........................................8

EXPLANATION OF KEY FORECASTS.............................................................10

VALUATION USING DCF AND RI MODELS......................................................12

SENSITIVITY ANALYSIS..............................................................................13

REFERENCE...............................................................................................14

EXHIBIT....................................................................................................14

OVERVIEW OF ECONOMICS, INDUSTRY AND STRATEGY ANALYSISThe Industry at a Glance

Industry Structure

     

Life Cycle Stage Decline Regulation Level Light

Revenue Volatility

Low Technology Change Medium

Capital Intensity Low Barriers to Entry MediumIndustry Assistance

None Industrial Globalization Low

Concentration Level

High Competition Level High

     data provided by IBISWorld Report 2016

Department stores retail a broad range of general merchandise, such as apparel, jewelry, cosmetics, home

furnishings, general household products, toys, appliances and sporting goods. This industry includes

discount department stores, which retail similar lines of goods at low prices. According to IBISWorld’s 2016

report, the Department Stores industry will continue its long-term decline over the five years to 2016, with

revenue expected to fall at an annualized 3.7%, reaching at $164.6 billion (p. 5). Meanwhile the industry’s

value added contributions to the overall economy is expected to decline at an annualized rate of about 3.0%,

this industry is considered to be in the declining phase of its life cycle (p. 12).

The key driver of this declining trend is the increasing number of major players that expanded their product

range to include groceries. Big-box retailers have offered groceries and transformed their department stores

into supercenters, which transferred their revenue to the Warehouse Clubs and Supercenters industry. In

2015, Walmart and Costco dominate the Warehouse Clubs and Supercenters industry with a respective

69.4% and 18.0% shares of the market.

Industry Overview: Competition

Right now, the industry’s product market is highly saturated. Most of companies and stores in this industry

offer broad lines of goods. Therefore, the competition within the industry is intense, which puts a great

pressure on industry’s profit margin and individual company growth. Besides, the increase competition from

e-commerce stores also causes limited demands for discount stores. E-commerce stores provide much more

convenience to customers, and since it saves a large space cost, online price is more competitive than that of

regular stores.

The two dominate players in this industry are Target and Sears Holdings Corporation, with market share of

37.4% and 13.2% respectively (IBISWorld Report 45211, 2016, p. 4). Other competitors like Costco and

Wal-Mart aggressively added groceries as part of their general merchandise stores’ product categories during

past years, which made them capture more consumer dollars by providing a complete one-stop shopping

experience (p. 24).

To analyze Target Corporation’s business performance and its competitiveness, Wal-Mart (WMT),

Amazon.com (AMZN) and Costco (COST) are used as comparable industry competitors. In the profitability

analysis and liquidity and solvency analysis discussed below, our group will use these three competitors as

our benchmarks.

Target Corporation Strategy

Target’s 2016 10-K indicates strategic incentives to improve its competitiveness:

Differentiation

Customer services

Price

Digital channels

The corporation indicates that, its continued success is achieved “by differentiating our guests’ shopping

experience through a careful combination of price, merchandise assortment, store environment” (Target

Corporate 2016 10-K, p. 6). It provides a wide range of merchandise with differentiate price points, which

caters to customers within multiple demographic markets. To expand its merchandise assortments, the

company also added “full line of food items” in its large stores, which “allowed the retailer to capture more

consumer dollars by providing a complete one-stop shopping experience” (IBISWorld Report 45211, 2016,

p. 24). Besides, the company adopted a price-match policy to encourage customers to “shop with

confidence”. In 2015, the company increased its list of competitors in order to provide much more space of

price comparisons.

The super guest service is another main competency of Target. The corporation believes that a relevant and

reliable experience for guests keeps the customer loyalty and helps to build the brand, which further

improves its competitive advantage. The main point to keep this customer-friendly environment is to quickly

respond to customers’ requirements of changing consumers. Such quick anticipation and response rely on

the company’s effective management of merchandise stocks.

Target also strives to build its digital channels to make the shopping more convenient for customers. With

the increasing number of e-commerce websites, customers can largely involve in the shopping process,

making the corporation enjoys more competitive advantages. Target takes advantage of technical

improvements by establishing mobile apps, the online store and other social media to offer more avenues for

customers. Although its online store is not that familiar compared with others like Amazon.com and Wal-

Mart, it still contributes to company’s total sales with an increasing growth rate year by year.

ACCOUNTING AND QUALITY OF EARNING ANALYSISRevenue recognition

Basically there are two major streams of the revenue, merchandise sales (including stores and digital

transactions) and gift card breakage. Target earns revenue at the point of sale. However, for those customers

purchasing online, revenue will be recorded when the good is shipping to them. Because of the 90-day free

return policy, the final recognized revenue will be those minus the expected return from customers. Gift

cards breakage revenue also contributes a proportion of revenue, meaning that a stable percentage of gift

cars that are never be redeemed will be ultimately recognized by the company.

From year 2013 to 2015, the sales increase of 2.1% and 1.3% respectively. Although in year 2015 Target sell

its pharmaceutical operations to CVS, it still enjoys a revenue increased because of the increased new stores

expansions in the same year. The revenue is dominantly contributed by stores selling channels; only 3.4% of

the total revenue in year 2015 is explained by the online digital channels. However, Target are now reaching

out its business into e-form in order to expand its market.

Discontinued operations

The discontinued operations refer to the exit of the Canada businesses. The reason why Target makes this

decision is due to the consistently decreased earnings gain from the Canadian market. In year 2014, net

income is negative. Target still indirectly owns 100% of the common stock of the Canada Subsidiaries

without controlling interests. The loan previously made from Target to Canada to support its operations will

be treated as related party transactions and has already been recognized. All the assets in the Canada

subsidiaries have already been valued using the liquidation price after netting the liquidation process fees.

Pharmacies and clinic transactions

Company makes a substantial change in terms of their pharmacies and clinic sections in December 2015.

Prior to that, Target has pharmacies and clinics in 1672 and 79 stores. Because of its increasing weaker sales

occurred in the fourth quarter of 2013, Target decides to sell this portion of the business to CVS. This

decision helps it better promote itself, making the operation more effective. Target ultimately gets a total

$1.9 billion in exchange for the business. There is also a perpetual operating agreement between Target and

CVS. No profit sharing agreement exists between two sides of the parties. However, CVS needs to make

annual occupancy payments to Target, starting from $ 20 - $ 25 million.

Accounting adjustment:

1. We first adjust the operating lease to capital lease because 1) the total amount of the operating lease is

significant to the company (compared with total assets figure); 2) these leases including the retail

locations, warehouses, distribution centers, etc. al, are closely related to the company core operations.

2. We then adjust the transitory item including two specific parts. The first one is the Canada exit on Jan

15, 2015. The second one relates to the pharmacies and clinics transactions. These two parts will only

affect fiscal year 2015 and will not influence future performance.

Hence, we eliminate all the accounts related to the discontinued operations, pharmacies and clinic businesses

and transfer the operating lease into capital lease. Based on that, we derive our new adjusted financial

statements (listed in Exhibit). All our following analysis will rely on these adjusted financial statements.

Quality of earnings:

TATA Ratio

All TATAs in the past four years are negative, meaning that the earning quality of the Target in general is

high. All net incomes are supported by enough operating cash flow. However, from year 2013 to year 2015,

the company comes across the increased TATA ratios. This is because in year 2014, the discontinued

operations make huge losses, giving company a negative net income. This negative net income drives the

TATA lower than expected. After we adjust this part, the TATA will become more reasonable.

EPS History

The recent EPS history shows that during the past one year, there are two quarters highly beat and one

quarter barely meet analyst forecast. This additional difference is ranging from 9.9% (maximum) and 0

(minimum). All these three quarters show an indication of earning management, which needs future

investigations by M-score and executive compensation. However, in the first quarter of 2016, company

misses the analyst forecast by 0.02 cent per share. This is explained by selling pharmacy and clinic

transactions, which could give market a signal that the company may have some problems in doing business.

Beneish M-Score

The M- Score in fiscal year 2015 and 2014 are -3.858 and -4.071, which are both smaller than -1.78. In year

2015, all the eight parameters are below the control average. This is a good sign for the company, proving

that there is a low possibility of fitting the manipulator profile. The difference between two M-Scores is

mainly lies in the change in Asset Quality (AQI) and TATA. However, all ratios’ differences relate to

company specific operational strategy alteration, mainly be explained by the huge decrease of the

discontinued operations in Canada. This operation exit make Target earn less earnings, maintain less total

assets and correspondingly less depreciation compared with year 2014.

Executive Compensation

The various type of compensations will be divided into two parts: salary, change in pension value, all other

compensation will be categorized into the fixed compensation. Bonus, stock awards, option awards and non-

equity incentive plan compensation are all incentive compensation. From the result the incentive

compensation of CEO, CFO and CIO in 2015 are all weighted over 80% of the total compensation scheme.

These huge temptations could give executives a possibility of earning management.

Taken it as a whole, Target has little concerns in manipulating its earnings. All those signals which could

show a possibility of earning management have reasonable company’s policies and strategies to explain. As

a result, the earning quality of the company is relatively high.

PROFITABILITY ANALYSIS

Note from the above discussion, Target considers itself as a “differentiator”. The execution of the

company’s strategy is also in line with our expectations. We calculate the company’s original profit margin

for 2015 to be 5.11%; yet we also notice that the company has exited the Canadian market in 2015, and has

liquidated its operations in Canada. Correspondingly, part of the earning in 2015 can be explained by the

disposal of the company’s Canadian business. Our adjusted profit margin for 2015 decreases from 5.11% to

4.54%, which is still higher than the profit margins of its competitors. Relatively high profit margin is a

significant character for a “differentiator”. The change in profit margin during the period of 2014 to 2015 is

attributed to the following three factors: discontinued operations, gain on sale, and interest expense. By the

end of 2015, Target has completed the transaction of its pharmacy and clinic businesses to CVS and reported

a gain on sale of $620 million. Target Canada Co. and its subsidiaries were in the process of deconsolidation

in 2015 and recorded an income from discontinued operation of $42 million, after considering exit costs.

The decrease in net interest expense is caused by the reduction in debt, which will be further discussed in

cash flow analysis.

It is important to note that Target’s ATO is much lower than that of Walmart and Costco, although slightly

higher than Amazon’s level (the difference is almost negligible). Walmart and Costco define themselves as

“cost leader” and are known for offering large quantities of goods at relatively low prices, hence the high

asset turnover ratio; Target is a major provider for appliances, furniture and electronics and it follows the

business model of a “high-end” discount retailer, which allows the company to charge a higher price per

transaction. Higher profit margin per transaction compensates Target’s low asset turnover ratio, and

contributes in the relatively high ROA/ROE among its competition. In addition, Target has the potential to

maintain its high profit margin. The company has been heavily promoting its online store by using

aggressive discounts and complimentary shipping services; the company’s intention is to trigger more visits

to its physical stores (where sales are more profitable) by developing the online website. Although the

company’s online promotions are eroding its profit margin in the short-term, Target is gradually focusing on

selling expensive items online to compensate its temporarily high operating expenses, which can be reduced

once the online store has established its market place. 

LIQUIDITY, SOLVENCY AND CASH FLOW ANALYSIS

Liquidity and solvency analysis

Liquidity Analysis

Although Target presents a consistent trend of current ratio greater than one, its quick ratio is far below the

absolute benchmark, which raises concern of the company’s financial health. Further, we look at the

company’s inventory turnover, which turns out to be much lower than the peers’ level. According to Target’s

10-K (Item 1), the company’s operation largely depends on successfully maintaining a certain level of

inventory to meet the demand of core products. High level of inventory poses a threat to the company’s

ability of covering its short term liabilities. Cash conversion cycle describes how many days are needed to

convert resources into liquid cash. Although Target’s cash conversion cycle is negative, the magnitude is still

much smaller than that of competitors. As a result, in the short run, company does face a problem of

converting high level of inventory into liquid cash.

Solvency Analysis

Compared with all three competitors, Target has a high debt to equity ratio, which is also demonstrated in its

high financial leverage (FLEV). Despite this fact, Target’s income based ICR and cash based ICR are both

higher than one, proving that the company has ability to pay back all the interests incurred from borrowing

debt. The company’s operating cash to growth expenditure is higher than its peers’ level, which indicates

that the company the ability to internally generate enough resources to support its growth. According to

Yahoo! Finance, the market assigned beta is smaller than Amazon and Costco, which suggests that market is

not too concerned with company’s solvency risk.

In general, the company is not generating sufficient resources to cover its short term liability. But in the long

run, as we have discussed in profitability analysis, the company displays a high potential future growth.

Furthermore, the company is gradually paying off its debt. All of the above factors attribute to a relatively

low solvency risk.

Cash Flow Analysis

Target is doing well in keeping sufficient operating cash flow. From year 2013 to year 2015, company

generates a relative stable positive operating cash flow. Meanwhile, the negative TATA ratio in the section

Accounting Analysis shows that net incomes are adequately backed up by operating cash flow during past

few years.

Sources of cash

The largest source of the cash is the operating cash flow generated from daily operations. Company has a big

policy change in 2015 because of the Canada Exit. The huge amount of the disposal assets in the

discontinued operations weigh much more than investment in PPE, making the cash from investing activities

become the major source. From all the investing activities, the proceeds from sales of business do occupy

the biggest amount. However, compared with 2014, company has a quite different situation. During that

time, the main cash source largely relies on the operating cash flow instead of the investing proceeds.

Uses of cash

In 2015, financing activities is the largest use of cash due to the repayment of long-term debt, dividend

payout and stock repurchase. Situations are the same in financing activities in year 2014 except that there is

no huge stock repurchase, the financing of the Target will mainly rely on the long term debt borrowing in

recent years. This stream of debt financing has been terminated in 2015. This result is matched with

financing policy of the company, which indicates that Target in the future will heavily rely on the internal

resources rather than externally. In terms of the investing activities in year 2015, Target does invest a lot of

money on the PPE, but it is far less than the money gained from dealing with the disposals, making it a

source rather a use. However, in year 2014, company invests a lot in Capex, resulting in a cash outflow of

the investing activities.

Life cycle stage

From the analysis above, company is currently having a positively stable operating cash flow. What is more,

instead of borrowing a lot from debt holders and issuing cash, Target now starts to repurchase stock from the

capital market and to repay debt to debt holders. The most obvious change should be the cash inflow of the

investing activities. For companies that have the positive CFI, they must sell some of their PPE in order to

maintain the daily operations. These companies should at the declining stage of their life cycle. However,

the exit of the Canadian Market does not affect Target’s operations in U.S market, which means that the

crucial parts of its business are still operating very well. Hence, we cannot make a rush conclusion say that

Target is in the decline stage. The strong and stable performance of its operations and financing suggest that

Target is experiencing the mature stage. In the following years, we could closely monitor the performance of

the company, especially the investing the activities in order to further accurately decide the life cycle of the

company.

EXPLANATION OF KEY FORECASTS

Sales Forecasts

Target’s main sale comes from it stores channel, which contributes to its total sales about 97% in past three

years. In the meanwhile, the digital channel gradually made increasing contribution to the sale, with growth

rate of 2.0%, 2.6% and 3.4% in 2013, 2014 and 2015. In 2015, the number of stores remodeled during the

year is 9 (Target Corporate 2016 10-K, p. 23). Comparing to its total beginning stores of 1790, this change in

number of stores is tiny.

In December 2015, Target Corporation sold its pharmacy and clinic businesses to CVS, which results in the

deceasing of the sale of pharmacy. While this transaction impacts every store and the digital channel, 10-K

does not provide the pharmacy-related detail information of stores and digital channels. Therefore, the

forecast of sale is based on Target’s five product categories’ sales growth.

We estimated the sale of every product category based on the data from 2015 and 2014. The revenue growth

of “Household essentials” is adjusted by removing the proportion of pharmacy, which are 5%, 6% and 6% to

the Household Essentials in 2015, 2014 and 2013, respectively (p. 19),

The short-term growth rate over next five years to 2020 is reasonably forecast based on the first year’s

growth rate, and the terminal year’s growth rate is represented by the nominal GDP of the United States,

which is 1.5% in December 31st, 2015.

Based on the above assumption, future years’ sales forecasts over a finite horizon and the terminal year are

presented as following:

Other items in the Financial Statements and assumptions

To forecast the Income statements and Balance Sheet, the Depreciation and Amortization is at a percentage

of PP& E in 2015, and the Interest Expense is at a percentage of Debt at 2015 as well. The Long-term Debt

is forecasted by Debt/Asset ratio of about 31.88% in 2015. The tax rate is assumed to be same as the last

year. Other line items in the Pro-Forma Income statements and Balance sheet are developed based on the

percentage of total sales. The Pro Forma Cash Flow statement is conducted based on the information of the

other statements.

All the Pro-forma financial statements, including Income Statement, Balance Sheet and Cash Flow

Statement will be attached in the Exhibit.

VALUATION USING DCF AND RI MODELSOur group uses five-year time period plus one terminal year Pro-forma to value Target through both

Discounted Cash Flow Method and Residual Income Model. We first get the value on the balance sheet date

(01/30/2016) which is $89.17 per share. After adjusting the date, the price we have on 05/02/2016 becomes

$90.92 per share. However, the price listed on 2 May is $ 80.12, which is lower than what we have got. This

$10 per share gap can be explained by the following two factors:

1. Market expectation for Target future performance is tuned down by the company’s recent actions of

liquidating parts of its operations (Canadian Businesses and Pharmacies and Clinic operations);

2. Target is currently promoting its online stores by providing heavy discounts and free shipping services.

Recently, Target focuses on selling high profit margin items (like furniture, children apparels and

electronics) to cover up the high operating expenses. We believe that Target’s strategy of using online

website to boost the sales of physical department stores (by steering customer’s attention back to

physical stores), will eventually help the company to resume and maintain its margin and growth rate.

Our valuation is conducted based on our analysis of the company’s solid accounting fundamentals, as

well as its potentials of tapping into the online selling market.

Hence, the low market expectation represented by low list price and high margin sales represented by high

valuation price can both adequately explain this $ 10 gap.

All the assumptions and details in deriving the valuations are showing below:

Discounted Cash Flow Method

Residual Income Model

SENSITIVITY ANALYSISFrom the chart lists below, we can find out various prices under the different combinations of long term

growth rate and the cost of equity. The long run growth rate (nominal long term GDP growth) is currently

staying at a relative low level compared with past two years. If this rate will increase in the future, it can be

find out that the price will have a dramatic increase, holding others constant.

We use the CAPM model to calculate the cost of equity. Both risk free rate and market risk premium will

affect out result to some extent. For risk free rate, we use the 30 years U.S. treasury bond yield rate, which

has been persistently decreased in the past years. As a result, the cost of equity may have some fluctuations,

especially being turned down in the future. The same situations will also be applied to the market risk

premium factor. Based on different combinations of these parameters, the value of Target may vary a lot.

REFERENCE1. Britanny Carter. (2016). “IBISWorld Industry Report 45211 Department Stores in the US.”

Retrieved from: <http://clients1.ibisworld.com/reports/us/industry/default.aspx?entid=1090>

2. Britanny Carter. (2016). “IBISWorld Industry Report 45291 Warehouse Clubs & Supercenters in the

US.” Retrieved from:<http://clients1.ibisworld.com/reports/us/industry/default.aspx?entid=1090>

3. Target Corporation. (2016). Annual Report 2016. Retrieved

from:<http://investors.target.com/phoenix.zhtml?c=65828&p=irol-sec>

4. Yahoo! Finance: <https://ca.finance.yahoo.com/q/ae?s=TGT>

EXHIBIT (Including historical financial statements and pro-forma financial statements)