Target Stock: Buy, Sell, or Hold?

There was a time when shares of Target (TGT -0.32%) were handily beating the S&P 500. But pandemic-induced inventory issues have caused the giant retailer to veer off its mark. Since the earnings announcement for its fiscal 2022's first quarter (ended April 30), when the inventory issues were revealed, the stock has slumped 37%. Compare that to the S&P 500's 14% gain over the same time frame.

In recent quarters, some of Target's financial results have slowly started to improve, even as its stock price has continued to struggle. So how should investors think about Target as an investment today? Was last year's inventory-fueled sell-off overdone, or does Target still have more to prove before investors should buy in?

Inventory challenges are in the past

Issues with the sales mix appear to have caused the inventory challenge that Target faced in early 2022. The company expected the pandemic-induced spending for some items, notably bulkier items like televisions and patio furniture, to remain elevated for longer. This left stores with excess items that needed to be heavily discounted in order to get them sold. 

Target's inventory issues remained for most of 2022 before moderating in the last two quarters. The $12.6 billion of inventory in fiscal Q1 2023, ended April 29, represented a 16% decrease year over year, prompting management to say the inventory concerns were behind the company.

Data source: Target.

Margins are improving, but slowly

Target's inventory issues put pressure on the company's margins. In Q1 2022, the company's gross margin was 25.7%, down 4.3% from a year earlier. While this was partially due to supply chain issues, inflation, and higher shipping costs, most of the impact came from inventory issues. 

In the most recently reported period, Q1 2023, the gross margin recovered to 26.3%. While this 60 basis point improvement over Q1 2022 was encouraging, management pointed to another headwind -- theft -- as having stolen a full percentage point of gross margin for the quarter. Unfortunately, Target anticipates this continuing into the second quarter of the year.

It's important to note that prior to the pandemic, Target's gross margin was routinely around the high 20% to low 30% range. It seems the short-term headwinds will prevent the company from returning to this previous benchmark in the foreseeable future.

Profits and cash flow are headed in the right direction

Despite the inventory and margin challenges, there has been some progress over the past year when it comes to the bottom line and cash flow. After bottoming out at $183 million in Q2 2022, net income has increased in each quarter since, reaching $950 million in Q1 2023. 

There's a similar trajectory on the cash flow front. Prior to the spring of 2022, Target consistently generated positive operating and free cash flow. In Q1 2023, Target generated $1.3 billion in operating cash, an enormous improvement from the $1.4 billion of negative operating cash flow in Q1 2022. This is something investors should keep an eye on. 

Target's valuation is compelling

Considering the challenges Target is facing, it's not a surprise that by some valuation metrics, the stock is historically cheap. Target's price-to-sales ratio is 0.6, which is not only below its 10-year historical average, but also not far from its 10-year low of 0.4. Target also trades for 9.3 times operating cash flow, which is right at its 10-year average. 

These depressed multiples make sense, but they also provide an opportunity for patient investors. Considering its brand strength and long-term track record of success, I think Target is a buy at today's valuation. A conservative allocation makes sense considering there's still a lot to prove, but the risk vs. reward is worth it in my view.