Ackman Unveils Revised Proposal for Target Corp

KEY POINTS:

But a longer-term view suggests that worse earnings may be worse for valuation a year or two from now, but at some point, really awful earnings might actually be better because of what it implies about the competitive landscape… which might allow higher sustainable ROIs later… though the challenge of offering a desirable alternative to Wal-Mart will not get easier.

In our 10/14/08 report, How Bad Could It Be, And What If It’s Worse?,

available here

we offered alternative scenarios, a sharp consumer contraction with recovery beginning in mid-’09, and an “Armageddon” severe contraction with a slower and later recovery. We’d love to have strong
reasons to prefer one or the other (or something else), but doing so with a straight face is far beyond our theatrical abilities.

With this month’s comps down as much as 10% (blame the later Thanksgiving for about 5%), even a flattish December (with “extra” pre-Christmas days) could lead to a “mid-single-digit” decline for the quarter that management warned could produce EPS of $0.90-1.00, well below last year’s $1.23. Like cyclical companies going into a downturn (or prudent ones now), Target is conserving cash and has suspended its share repurchase.
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Fresh lows....

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Target does appear to be gaining share in apparel and home categories whose sales may be declining even faster elsewhere than at Target. Management’s description of strength of less-discretionary food-and-consumables suggests that Target is gaining share there, as well. Because Target does appear to be increasing share—doing less badly than most, if you will—we think the company
will emerge from the current period with enhanced potential profitability and we continue to rate the shares Buy.

Despite below-plan sales, Merchandising controlled profitability well and exceeded expectations (ours, anyway)… Credit’s write-offs still soaring… and may not peak for another couple of quarters… according to consultations with some experts in analysis of credit portfolio… and some experts with Ouija boards.

Merchandising managing through tough times (that are about to get tougher)… The consolidated (and uninformative) P&L is shown below; compared to last year and to our estimates. The more informative P&L showing Merchandising as if it were stand-alone, shows a very well controlled gross margin (where improved margin within categories, like apparel and home) more than offset the negative
mix-shift to foods, household chemicals, and HBA) and well-controlled expense, too. (Expense would have looked a lot better if the company had achieved flat or better comps.)

How bad could it be?

What would earnings be like if down mid-single-digit comps persisted into mid- year? That happens, now, to be our base case, and it also assumes that write-offs worsen, and peak in the first quarter and provisions peak in the second. If the economy—and earnings—are beginning to firm up in the back half, the market could begin to anticipate recovering earnings (and returns) and to pay
for them. Base-case assumptions might look like this. (A discussion of how this leads to a price target of $50 is in the Valuation section, below.)

If the environment is worse, comps are weaker in the current quarter and deteriorate further into next year, earnings will be worse, of course. But if the economy is beginning to give some hints of firm up toward year-end, the market could begin to anticipate some earnings recovery, a little less robust than the base case, but might value them this way.

Ah, but worse still may not be worse for investors…

If the environment is even worse, comps are weaker in the current quarter and deteriorate further and remain negative through 2009, next year’s earningswill be terrible, of course.

BUT, if the environment in 2009 is that bad—and Target suffers like this—much of the rest of the retail industry would be in even more serious trouble; many companies would be recapitalizing, restructuring, reconsidering, or simply liquidating. While it doesn’t take that much to eliminate “over-capacity” as it may currently appear (depending on the “segment,” it could be as little as 3%… or 5%), the very concept of “retail capacity” depends critically on the level of retail spending…

A lower level of overall spending will mean lower earnings for Target, for a while, but a more severe downturn that endures would, after a time, also mean more shrinkage of competitive capacity.