On Nov. 15, Target (TGT 0.18%) stock posted its largest single-day gain since Aug. 21, 2019, after the company crushed expectations for its fiscal Q3 earnings. Wall Street is reacting favorably to Target's improving operating margin and profitability. But zoom out, and the company is still nowhere near its all-time high earnings year in fiscal 2021.
Let's dig into the numbers to find out what Target is doing to turn its business around, and why the dividend stock is still cheap even after its recent rally.
Image source: Getty Images.
Target is executing where it counts
A big mistake investors make when approaching a retailer like Target is assuming its results are just a reflection of the health of the consumer. There's no denying consumer spending has been trending down for a while now. The impact of lower spending on discretionary goods has crushed Target's margins. But retailers still control their loyalty programs, what products they put on their shelves, how they manage their supply chains and inventories, and how they lean into holidays and promotional events.
The difference between last year and this year is that Target has a much more purposeful and streamlined inventory. Its inventory as of the latest quarter was 14% lower year over year. But there are signs Target is still giving consumers what they want. It has in-house brands in apparel and home goods -- two categories that showed sizable rebounds last quarter.
Target also rolled out its new kitchenware brand, Figmint, which was a success. Its partnerships have been working out nicely as well with brands such as Kendra Scott and its collaboration with Ulta Beauty. Beauty continues to be one of Target's strongest product categories. That's not just the consumer paying up for beauty products but a reflection of the choices Target has made. Or as Target's Executive VP & Chief Growth Officer Christina Hennington said on the Q3 earnings call, Target continues to pick its bets.
One of the most insightful portions of the earnings call came toward the end of the question and answer session when Hennington said the following about Target's investment in "newness":
I think the big difference for us this year and this fourth quarter is the amount of newness that we've invested in. If there's one thing that we've seen is in an environment where people are making choices and they might have some constraints with their budget, the motivation to buy is really, is this going to add value to my life? Is this something that is intriguing and feels relevant or is fashion forward or is really for me? And doing more of the same just isn't going to get it done, which is why we've invested in newness.
And you'll see that across the store. You'll see it as you walk in, first thing in our women's set. It's right on trend, it's colorful. The price points are very appealing. You walk around to our seasonal business. Right now, you can get everything, your tree skirt to ornaments at a great value. Continue down the path to toys, you've got over two-thirds of our toys below $25. And then around the corner of our store to food, where you can get not only your Thanksgiving meal for under $25 but all the gifting solutions and special trades for Marks & Spencer, only rounded out at beauty, which has been our strongest business year-to-date and for many years and find gifting solutions at every price point.
In sum, Target is operating with lower costs and lower inventory. The leaner profile puts a lot of pressure on the company to make each decision count because there's less margin for error. However, what we are seeing in Target's results this year, and especially in fiscal Q3, is that it's executing nicely and improving its operating margin. It recognizes that consumers need quality at a lower price, and it's aligning the stores and product offerings to fit that need.
Target also mentioned that while it still sees a lot of weakness in consumer discretionary goods, it still believes consumers are celebrating the holidays with purchases. It saw success with the back-to-school season and Halloween, and it expects the same with the upcoming holiday season. This is just another example of how Target isn't giving up on consumer discretionary spending but being calculated with which areas to invest in and the timing of those investments.
Setting expectations
Target's recovery is finally on track, but investors shouldn't expect the company to rebound to its 2021 peak levels anytime soon. Target stock surged in the summer of 2021 to over $260 per share. At the time, profits were soaring. Years of investment in e-commerce paid off during the worst of the pandemic, and consumers gravitated toward online purchases as services remained limited. The shopping frenzy eventually tripped up the company as fundamentals declined -- Target wrongfully assumed the demand would hold up, but it didn't.
Despite all of the challenges, Target's present results are better than pre-pandemic. And that's the case even with an abysmal 4.7% trailing-12-month operating margin.
Data by YCharts.
The above chart paints an interesting trajectory for Target. As you can see, TTM earnings are well above pre-pandemic levels despite the lower operating margin because sales are so much higher. Target posted a 5.2% operating margin last quarter compared to 3.9% in the year-ago period. If it can get this figure above 6% in fiscal 2024, then the stock is going to look extremely cheap -- Target is trading only slightly higher than where it was at the end of 2019, but its profits are far higher than at that time.
In fact, its price to earnings (P/E) ratio is below its five-year and 10-year median, and its forward P/E ratio sits at just 15.7. That's an inexpensive valuation for a company with the brand power of Target, not to mention the fact Target is a Dividend King with 52 consecutive years of dividend raises and an appealing 3.4% yield.
So even though Target isn't anywhere close to replicating its 2021 performance, it is putting up higher profits despite a lower margin thanks to near record-high sales, which sets the stage for a massive surge on the bottom line (and therefore a lower valuation if margins keep improving in fiscal Q4 and next year).
Target stock looks appealing now
Target's fiscal Q3 performance is a good example of what good decision-making looks like in a challenging macroeconomic environment. Target made it clear there remains immense pressure on the consumer's wallet. So instead of hoping or passively waiting for conditions to improve, Target is taking action through its own brands, partnerships, the specific categories that are working like apparel, home goods, and beauty.
The retailer is on track, and its inexpensive valuation and sizable dividend yield make it the perfect stock for patient investors to buy and hold.
