Target (TGT -0.54%) stood out from rivals as one of the best-performing retailers during the COVID-19 pandemic. Sales and earnings surged to unprecedented heights, as consumers shifted spending to goods rather than in-person experiences and gravitated to convenient "one-stop shopping" options.
This business momentum helped Target stock double between the beginning of 2020 and late 2021, ultimately peaking above $260 last November.
Sales growth has continued in 2022. However, Target's profit margin is crashing back to earth. As a result, Target stock has plunged more than 40% from its November 2021 high, with most of the drop coming in the last month. This has created a good entry point for long-term investors.
Two years of plenty
Target's comparable sales surged 19.3% in fiscal 2020 as the company capitalized on an abrupt shift in consumer shopping habits during the pandemic. Comparable sales grew another 12.7% in fiscal 2021. This boosted total revenue by nearly $28 billion -- a 36% increase -- from $78 billion in fiscal 2019 to $106 billion last year.
The rapid growth in Target's top line enabled the company to become much more efficient, as it significantly reduced its operating expenses as a percentage of revenue. This caused Target's operating margin to expand from 6% in fiscal 2019 to 7% in fiscal 2020 and 8.4% in fiscal 2021.
The combination of surging sales and substantial margin expansion caused earnings per share (EPS) to more than double within two years. Adjusted EPS reached a record $13.56 in fiscal 2021 -- up from $6.39 two years earlier.
Reality sets in
A year ago, when Target stock had already surpassed $200, I suggested that the company's recent level of success probably wasn't sustainable. But Target's profitability has deteriorated even faster than I expected, due to a combination of inventory miscues and inflationary pressures.
Last month, Target reported that comparable sales grew 3.3% in the first quarter of fiscal 2022 but that its operating margin had plummeted to 5.3% from 9.8% a year earlier. While Target had cautioned investors that its operating margin would decrease, the Q1 results fell well short of management's expectations. The retail titan attributed the weakness to "gross margin pressure reflecting actions to reduce excess inventory as well as higher freight and transportation costs."
Target Operating Margin (Quarterly), data by YCharts.
Indeed, while Target's total sales rose about 4% last quarter, sales declined in discretionary merchandise categories like apparel, electronics, and home. In recent quarters, Target had been working to increase inventory in those categories to meet booming demand. The abrupt change in spending patterns forced Target to ramp up clearance discounts to sell excess inventory.
In light of its Q1 results, Target reaffirmed its full-year sales guidance but cut its operating margin forecast to around 6% -- in line with fiscal 2019 -- from its original projection of 8% or higher.
Unfortunately, management underestimated the extent of the shift in consumer spending. Last week, Target announced an aggressive plan to right-size its inventory. That will cause its operating margin to plunge to around 2% this quarter, more than 3 percentage points worse than the guidance released just a few weeks ago. Target expects its operating margin to recover to around 6% in the second half of fiscal 2022. That implies a full-year operating margin of approximately 5%.
Image source: Target.
Now what?
Wall Street analysts have dramatically slashed their near-term earnings estimates for Target over the past month. The analyst consensus currently calls for adjusted EPS of $8.59 in fiscal 2022, down from $14.61 just a month ago.
Target stock has lost a third of its value over the same period. Based on its Friday closing price of $149.67, it trades for 17.4 times the average analyst estimate for fiscal 2022.
This may not look especially cheap at first glance. But over the next couple of years, Target's profitability will likely recover as costs normalize and the retailer pushes through price increases to cover permanent changes in its cost structure. I'm skeptical that Target can generate an 8%-plus operating margin over the long run, but 7% -- better than its pre-pandemic results but worse than its 2021 performance -- seems achievable.
Assuming modest revenue gains and share buybacks, this would point to EPS rebounding to between $13 and $14 by fiscal 2024. In other words, Target stock trades for just 11 times its potential earnings two years down the road. Considering the company's substantial long-term growth prospects and its solid moat, Target shares suddenly look very intriguing.
