There's no question about it. Target's (TGT 0.43%) first-quarter earnings report was a rough one.
The stock had its worst single-day drop since 1987, plunging 25% as the big-box chain badly missed both its own guidance and analyst estimates on the bottom line. It posted adjusted earnings per share of $2.16, down from $3.69 in the quarter a year ago, a result that was propelled by stimulus spending and the pandemic driving increased spending on discretionary goods, and it also missed estimates at $3.06. Similarly, it slashed its bottom-line guidance for the year.
Target's results were plagued by a wide range of factors, including inflation and supply chain pressures, weak results in discretionary categories as consumers shifted their spending from goods to services, and the company's own misreading of consumer trends. Much like other pandemic winners like Peloton did, Target overestimated the durability of the pandemic tailwinds, not realizing how quickly consumer spending would normalize to pre-pandemic levels.
As a result, Target was forced to mark down merchandise, and higher inventory led to other carrying charges as the company explained on the earnings call.
While 2022 profits are going to be significantly weaker than the company had originally expected, this isn't a broken company. Here's why Target stock is still a buy despite the current challenges.
Image source: Target.
Short-term problems
Most of the headwinds the company is facing are temporary in nature. Issues like inflation, supply chain constraints, and higher freight costs should eventually resolve themselves, and the macroeconomic climate will normalize at some point. That may take higher interest rates from the Federal Reserve, which could tip the country into a recession, bringing its own set of risks, but the current environment is highly fluid and uncertain, making the factors that impacted the company most in the first quarter a bad reason to sell the stock.
Management did make some unforced errors in the first quarter, including overstocking product categories, like kitchen appliances, in which spending was slowing. However, Target wasn't the only retailer to experience such headwinds. Walmart's results were similar, with profits falling even as sales increased as inflation and wage pressure weighed on Walmart's profits. It's likely that several other retailers will have reported similar results by the end of earnings season.
Long-term strengths
For years, it seemed like Target could do no wrong as it outperformed its peers and the stock delivered multibagging returns. The first-quarter earnings disaster means that Target's invincible aura is gone, but that's no reason to doubt the company's long-term strategy.
Target occupies a unique niche in the retail industry. It only has a handful of competitors in multicategory retail, essentially Amazon, Walmart, and Costco, and it's the only one of those four that's deeply penetrating cities with a range of brick-and-mortar stores. Target has also taken a singular approach to e-commerce, using its stores to handle most of its online orders with the help of same-day fulfillment services. That makes the company more profitable than its closest competitors because it isn't paying as much for shipping or warehouses.
Target has also cultivated a unique "cheap chic" image that has made it an attractive partner for brands like Disney, Ulta, and Levi's. Its success in developing owned brands, with at least 10 billion-dollar owned brands, helps build customer loyalty and deliver higher margins than brand-name merchandise. And Target is still opening stores, making a push with small-format locations that are well suited to underserved urban neighborhoods and college towns.
The first-quarter results gave no reason to doubt the wisdom behind any of those strategies, and they should help Target return to its winning ways once the macroeconomic volatility shakes out.
Though the company cut its operating margin for the year from at least 8% to around 6%, over the long term, it's still calling for at least an 8% operating margin with a mid-single-digit revenue growth rate. If Target can return to an 8% operating margin next year, that guidance would translate into $7 billion in net income next year, equal to a price-to-earnings ratio of less than 11 after Wednesday's plunge.
For a top-notch retailer with an excellent track record, that looks like a very fair price.
