Right on Target
In this edition of the Smart Investor newsletter, we examine one of the largest retailers in the country. But first, let’s delve into the latest Portfolio news and updates.
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Portfolio Updates
❖ Arch Capital Group (ACGL) saw its stock surge to a new record as it continued to rally on the back of elevated investor interest following its stellar quarterly results. The stock has strongly outpaced most of its peers this year.
❖ Berkshire Hathaway (BRK.B) has been a net seller of stocks in the past several quarters, closing the June quarter with a record $277 billion in cash. However, in Q2 2024, CEO Warren Buffett continued to buy his own company’s shares for the 24th consecutive quarter, bringing his cumulative purchases to nearly $78 billion.
❖ PayPal Holdings (PYPL) has positioned itself as one of the prospective winners in the digital currency space. The company’s stablecoin PayPal USD (PYUSD) has now surpassed a market capitalization of $1 billion, reaching this milestone less than a year after its launch. PayPal has been actively pursuing partnerships to expand the reach of PYUSD, such as its new collaboration with Anchorage Digital, the only crypto firm with a federal bank charter.
❖ Alphabet (GOOGL) unveiled its new phone models about two months earlier than it had previously done throughout the past eight years. The early rollout of the Pixel 9 phones, which have an on-device AI assistant Gemini Nano, gives the company a headstart over Apple (AAPL), which is expected to unveil the AI-loaded iPhone 16 in September.
❖ General Dynamics (GD) has partnered with Lockheed Martin (LMT), as the aerospace and defense giant LMT seeks to remedy solid rocket motor supply shortages. Under the strategic agreement between the two defense contractors, GD will begin production of these critical parts exclusively for LMT in 2025.
❖ Super Micro Computer (SMCI) fell on the news that the notorious short-seller, Hindenburg Research, accused the firm of an alleged “accounting manipulation.” Hindenburg’s claims should be taken with a grain of salt; acquiring a large short position in a company and then accusing it of various malpractices to bring down its stock seems to be its modus operandi. This was the case with its attack on India’s Adani Group and several other high-profile companies.
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Portfolio Earnings and Dividend Calendar
❖ The Q2 2024 earnings season is drawing to an end, with only one Portfolio company – Dell Technologies (DELL) – scheduled to report its FQ2 2025 earnings this week.
❖ The ex-dividend date for Parker Hannifin (PH) is today; for Dover (DOV) and Interactive Brokers (IBKR) it is August 30th; for ITT Corp. (ITT) and Texas Pacific Land (TPL), it is September 3rd.
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New Buy: Target Corp. (TGT)
Target Corporation is a retail corporation that operates a chain of discount department stores and hypermarkets in all 50 states and the District of Columbia. Its stores offer curated general merchandise, including clothing, electronics, toys, and beauty items, as well as groceries, home furnishings, and more.
Target was founded in 1902 in Minneapolis, Minnesota, and grew over the years through both internal expansion efforts and acquisitions. Today, with almost 2,000 stores across the country, TGT is the sixth-largest retailer in the U.S. by annual sales value. With a market capitalization of $73.4 billion and 2023 revenues of $107.4 billion, it ranks #37 on the Fortune 500 list.
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All-American Growth Story
Target Corp. operates its stores only in the U.S. Nearly 30% of its revenues are derived from beauty and household items, followed by groceries and home furnishings. While over 80% of its sales still occur in physical stores, TGT’s online presence has been growing rapidly in the past several years.
Another rapid (and profitable) change that has been occurring over the past several years is the development of Target’s own brands. Today, almost a third of sales come from over 50 Target-owned brands, many of which are now household names in clothing, home décor, household staples, groceries, and more. These brands can be offered at a much lower price than external ones, and this model of business development has proven itself in terms of customer satisfaction and rising sales volumes.
Groceries have been a significant source of growth for TGT, and this is expected to continue adding to the company’s top line. Over the past four years, food and beverage sales have risen by almost $9 billion to $24 billion, comprising almost a quarter of total annual sales in fiscal 2023. The company’s management sees a significant opportunity in this line of business, saying that it is “still in its early days.” Groceries help Target to achieve higher earnings stability, compensating for more cyclical items like home products and apparel.
Target is also known for its extensive collaborations and partnerships. Thus, it partners with Starbucks and CVS, which operate outlets in Target stores. In addition, it partners with clothing and home décor designers to offer their products at lower-than-average prices, as well as with online retailers like Shopify to further expand its reach. In April this year, Target rolled out a paid membership program, offering members unlimited free same-day delivery and other benefits, which has seen immense success.
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Robust Financials and Operational Excellence
Target’s net debt-to-equity ratio of 81% is considered on the higher side; however, its debt is well-covered by operating cash flow, while interest payments on its debt are covered by EBIT many times over. Besides, leverage is modest in terms of net debt-to-EBITDA and has been declining in recent quarters. The company’s strong financial health has been confirmed by its high credit ratings, having received “A” ratings from both S&P Ratings and Fitch.
TGT’s capital efficiency and profitability ratios compare well to its peers in the industry. Thus, its ROE is in the top 10% for its peers in Retail, while its ROA and ROIC are in the top 20%. The company’s operating, FCF, and net income margins rank in the top quarter of its peers. Target features consistently high liquidity, ending the recent quarter with cash and short-term investments of $3.5 billion.
In the past five years, Target’s revenues grew at a CAGR of 7%, while earnings-per-share growth stood at almost 10%, above the average for its competitors. These numbers include difficult periods in 2022 and part of 2023, which impacted most other retailers. Retail business was strongly affected by changing consumer behavior due to high inflation and high interest rates, which were further exacerbated by macroeconomic uncertainty.
However, Target has succeeded in turning around faster than many of its competitors, with EPS returning to strong year-on-year growth in mid-2023 despite a continued moderation in sales, specifically in discretionary goods spending. This was a result of TGT’s unique positioning as a discounted but differentiated merchandise retailer, as well as its operational excellence and several omnichannel initiatives, which helped reduce customer price concerns and expand service offerings compared to direct competitors.
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On Target for Continued Outperformance
The discount retailer’s Q2 2024 quarterly report smashed expectations. All six core merchandising categories delivered growth in consumer traffic, which grew by 3% in total compared to the previous year. Comparable sales rose by 2% and all margins expanded. Growth was driven by traffic in stores and online options, with a strong boost from double-digit growth in TGT’s same-day delivery services.
While retail rivals like Home Depot and Macy’s reported weak results, Target saw its EPS surge by almost 43% year-on-year, strongly outpacing estimates. These comparisons underscore the fact that TGT’s emphasis on store-label brands and e-commerce expansion, along with other efforts at making shopping more affordable and convenient, is paying off.
As consumers have been hit by the high costs of housing, food, and other necessities, have become much more selective, and Target was on target (ahem) with its decision to cut prices on thousands of groceries and other daily essentials. In addition to the topline boost, price reductions on staples are helping Target to maintain its market share in those categories from rivals like Walmart.
Target derives a much larger proportion of its revenue from discretionary items than Walmart, which has hurt its standing vis-à-vis its main rival during the so-called “retail apocalypse” of 2022-23. While TGT’s price reductions included staples and everyday items, they apparently drove customers to spend more, as categories like apparel and beauty saw strong increases in comparable sales in Q2.
Simultaneously, the bottom line was also strongly supported by increased efficiency of its operations. Target has invested $100 million to develop a web of sortation centers, which now bolster its last-mile delivery capabilities while securing faster deliveries at a lower cost.
Following a blowout quarter, Target raised its earnings guidance. While sounding optimistic about the continued improvement of demand for discretionary items, which would add to the company’s strong operational delivery, the management said they take a prudent stance given an uncertain macroeconomic backdrop but were nevertheless “playing to win.” The company maintained its conservative sales growth outlook of up to 2% for fiscal 2024, while increasing its EPS guidance by 3% at the midpoint – implying faster EPS growth than currently projected by analysts.
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Superb Shareholder Value
Target’s shares surged on the report released on August 21st, strongly rebounding from its August low and finally outpacing the S&P 500 index after a four-month slump. However, the stock is still very attractively valued, featuring a significant discount to the average Consumer Staples PE ratio and coming in at the bottom of the valuation scale for comparable peers. In addition, it appears about 40% undervalued based on future cash flow projections.
It should be noted that Target generously rewards its shareholders through dividends. Having raised its cash payout annually for the past 57 years, the company is a Dividend King. Its dividend yield of 3.11% is considerably higher than the average for the Consumer Staples sector. The more-than-notable dividend adds to the stock’s attractiveness, raising its prospective total yield.
If that’s not enough, Target has repurchased shares worth $155 million in Q2 2024, its first buyback since 2022. The repurchase program, approved in 2021, still has approximately $9.5 billion of remaining capacity.
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Investing Takeaway
Target Corporation has a robust business model, diverse offerings, wide presence, and superb financial management. It has reported a strong recovery, driven by its strategic initiatives and price reductions. Improving logistics and inventory management are projected to continue supporting margin expansion. The strong performance is expected to last, helped by declining inflation and the expected interest-rate reductions. TGT’s low valuation and dividend track record, combined with the company’s return to buybacks, make it an attractive long-term investment.
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New Sell: American International Group (AIG)
American International Group, aka AIG, is a leading global insurance organization, which offers insurance products for commercial, institutional, and individual customers in approximately 190 countries and jurisdictions around the globe.
After a multi-year transformation process that began after the 2008 crisis, AIG is well-capitalized with robust liquidity and very low debt. AIG has made efforts to lessen earnings volatility and strengthen its income streams by reducing catastrophe exposure, using reinsurance, avoiding riskier lines, increasing rates to cover costs of loss and inflation, and controlling expenses. The outcome of these measures was a substantial improvement in operational performance. While the total annual revenue remained almost unchanged in the past five years due to multiple divestitures of non-core businesses, earnings-per-share increased at a strong pace over that period.
That is why AIG’s earnings miss in Q2 2024 came as a surprise. Analyst expectations weren’t too high, as the company had to recognize a large loss on the deconsolidation of its Corebridge Financial life insurance unit. Still, AIG’s earnings-per-share came in significantly below forecasts due to higher-than-anticipated catastrophe losses, particularly at the international level. According to some analysts, AIG has a history of holding barely sufficient reserves for claims, raising concerns about the adequateness of its current reserves.
AIG’s recent underperformance seems to be a temporary setback on its path to a leaner structure, higher cost-effectiveness, and better profitability. With the deconsolidation of Corebridge completed and the sale of AIG’s travel insurance business slated to be finished by the end of this year, the company aims to accelerate its efforts for increasing operational efficiencies.
Still, some details in AIG’s earnings report raised analyst concerns. Thus, its management expects the company’s 2025 combined ratio (the sum of incurred losses and expenses as a percentage of earned premiums) to be about the same as in 2023, much higher than analysts previously projected. This would weigh on the company’s net earnings in the next fiscal year.
AIG is a valuable business that is expected to reward its shareholders in the long term after it has finished rebuilding itself as a “lean and mean”, efficient business. However, in the near term, it may encounter further bumps in the road. With investor sentiment already fragile, this may weaken the company’s stock performance in the quarters ahead. While at the moment we see selling AIG, we may revisit this insurance stalwart in the future.
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Portfolio Stocks Under Review
❖ Applied Industrial Technologies (AIT) announced its FQ4 and full fiscal year results on August 15th. In the quarter, the industrial company surpassed analysts’ revenue and EPS expectations. In FY24, revenue was in line with estimates, while EPS outpaced them. Margins came in historically high as the company maintained operational strength despite a decline in revenues from the previous fiscal year. The reason for putting Applied under review is its weak fiscal 2025 guidance, which projects flat revenues and softer earnings at the mid-point. Although AIT’s peers have seen similar macro headwinds that are expected to continue into the next year, the company’s valuations are somewhat outstretched vis-à-vis its growth outlook, limiting further potential upside. On the other hand, AIT has much less debt than most of its comparable peers, which adds to its ability to perform growth-supporting acquisitions. Moreover, AIT’s supreme cash-generation results increase its potential for additional stock gains supported by buybacks. On the whole, we are positive about the company’s outlook but plan to closely watch the trends concerning investor sentiment, insider trends, and other stock-performance-affecting factors.
❖ Vertex (VRTX) remains under review following its underwhelming Q2 results, which included an EPS miss. The company reported a wider earnings-per-share loss than was expected. Notably, the negative EPS is a one-time event brought on by expenses associated with an acquisition of Alpine Immune Sciences, as well as increased investments to support launches of new therapies. The biopharma giant raised its full-year product revenue guidance, citing growth in sales of its cystic fibrosis (CF) treatment and the soon-to-launch gene therapy Casgevy. The stock fell from its all-time high following Q2 underperformance, though not by a large percentage. However, it quickly bounced back, and its stock price is still elevated compared to its historic levels. As a result, some analysts have cut their outlook on the stock, citing limited near-term upside opportunity given its high valuation. On the other hand, Vertex’s stellar finances and cash-producing capabilities, along with its strong portfolio of existing and prospective treatments, provide a strong argument in favor of the company.
❖ Merck & Company (MRK) is placed under review following the FDA’s announcement about listing several cancer drugs, including MRK’s Keytruda, for discussions regarding potentially limiting the use of immune checkpoint inhibitors. While the impact of this move is far from certain, investors had previously voiced worries over MRK’s dependence on Keytruda, the world’s top-selling drug representing 42% of MRK’s total sales in 2023. The patent on Keytruda ends in 2028, marking the largest expiration in the pharma history. Despite these concerns, most analysts are optimistic on Merck’s prospects. The company has been working to fill the potential revenue gap in the past five years, and its current pipeline includes several cancer, cardiometabolic, and immunology drugs which have the potential to more than cover the prospective hit from the Keytruda patent expiration. In addition, the pharma giant is working on an improved version of Keytruda, which, if successful, would extend the medicine’s financial value well beyond the original’s patent expiry date. The results of the “Keytruda 2.0” trials are expected later this year.
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Smart Investor’s Winners Club
*The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.
Despite the market volatility and the hit suffered by semiconductor stocks, our list of Winners still holds 16 stocks: GE, AVGO, ANET, SMCI, EME, TSM, ORCL, APH, PH, CHKP, HWM, TPL, AMAT, GD, ITT, and VRTX.
The next in line to enter the lucrative club is still REGN with a 28.15% gain since its purchase date. Will it close this minute gap, or will someone else outrun it to the finish line?
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Smart Investor Portfolio
| Portfolio YTD Return |
Portfolio Volatility (Beta) | Portfolio Dividend Yield |
| 20.50% | 1.12 | 0.75% |
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Disclaimer
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