Is Target's Credit Card Breach the Precursor of Its Downfall?

The past few weeks haven't been kind to Target (NYSE: TGT  ) . On Dec. 19, the company released an announcement affirming that an unknown party breached its systems and that up to 40 million users had some form of credit card data taken. Since the announcement, management has been researching the issue. On Friday, Jan. 10, the company stated that it believed an additional 70 million consumers could be affected, bringing the total to 110 million.

No news has broken that suggests the full impact of the breach, but investors don't appear to be overly concerned about any fallout. From Dec. 18 through Jan. 10, the company's market cap has declined only 1.4% from $40.2 billion to $39.6 billion. This performance is worse than the 1.8% increase by the S&P 500 over the same timeframe, but far from how a company's shares would react to a crisis situation. Still, it's possible there will be new developments surrounding the breach, so is it possible that Target's situation could become materially worse?

Debt is a big portion of Target's game plan!
In business there are three ways to grow; equity, internal cash flow, and debt. It's the last of these that Target has been reliant on over the past several years. As of its most recent fiscal quarter, the company's long-term debt-to-equity ratio stood at 78.4%. This means, for every dollar in equity (assets less all liabilities) the company had $0.784 in long-term debt. In Target's defense, the company has made significant ground in its fight to reduce its debt over time. Since 2009, the retailer has seen its load decline from $17.49 billion, a time when its long-term debt-to-equity ratio stood at a jaw-dropping 127.5%.

In comparison, rival Wal-Mart  (NYSE: WMT  ) has a slightly lower long-term debt-to-equity ratio of 61.7%. This measure, is certainly better than Target's. Meanwhile, Costco Wholesale  (NASDAQ: COST  ) , has a long-term debt-to-equity ratio of 44.4%, well in the range of what you should be looking for.

Despite the high level of debt, there is some good news. As opposed to some debt covenants, which can be called by the creditors at will, some of Target's debt cannot be called while the rest of it requires two hard-to-meet conditions. First, the company must undergo a change in control (meaning that someone achieves a controlling stake in it); and second, the company's debt must be downgraded or be put on watch to be downgraded to junk status. Due to the size of the retailer and the fact that its debt ratings stand in the A range at the three big rating agencies, none of these appear likely.

The real risk for Target!
Given the outsized amount of debt on the retailer's books, the real risk is that it might not be able to meet its financial obligations. If sales and profitability stay strong, Target will likely pay down its debt. That's because it generates a significant amount of cash flow.

For the company's fiscal year ending Feb. 2013, management reported cash flows from operating activities of $5.33 billion. At 7.3% of sales, those results aren't stellar, but they are markedly higher than the 5.5% margin earned by Wal-Mart and the 3.3% reported by Costco. After adjusting for capital expenditures but subtracting the cost dedicated toward new stores (which equates to capital expenditures necessary to maintain the business and make necessary upgrades), the company's cash flows were $4.24 billion, still higher than both competitors.

Foolish takeaway
With that level of profitability, and Target's $706 million in cash and $2.25 billion revolving credit facility, it looks as though meeting its average obligations of $2.7 billion per year for the next five years should not be a problem. But, if sales plummet as a result of consumers losing faith in the company, the situation could turn very quickly.

The primary point that you should keep in mind is whether a significant drop in sales is likely. This is difficult to answer with such limited data, but even a small drop in sales might be the beginning of something far worse.

Target's not the only big retailer that may be in trouble
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.


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