Target Corporation: final valuation

Target Corporation: final valuation By jenniferkellner (Discount, Variety Stores Industry)

Final value Sell As of 4/22/14: $60.32 per share Using FCF, REI and AEIG models, taking out amount owed to debt holders, the value is below what the market tells us it’s worth

How did we get there?

Major influences: • History • Common-size analysis • Reformulation • Primarily, forecasts • Sales, EPM, EATO • Influenced by history, industry, outside information • WACC • Beta • NFL • Industry analysis

Reformulation: • Financial statements expanded, some examples include: • Additional liability • Stock options • Restricted stock • Performance shares • Additional DTA, DTL • SG&A, broken down (Data breach expenses, rent expenseadvertising costs, TD profit-sharing arrangement) • Sales, broken down by category • Household essentials • Hardlines • Apparel and accessories • Food and pet supplies • Home furnishings and décor • Also break down by Canadian and U.S. operations • Sales from new v. old stores unavailable • Adjusted for 53rd week of sales in 2013

Reformulation: a glimpse EA

… EL • Greater detail allows full-information forecasts • Line-by-line forecasts NEA

Similarly: • From this, • Assess historical EPM • Parsimonious forecasts and valuation • Ultimately, full-information forecasts EPAT

WACC: • NFL = amount owed to debt holders, taken out of value to determine equity value per share • Cost of equity capital based on CAPM • Beta, market observables and regression analysis (an average) • Return on the market (rmkt) assumption, 10%

The bulk:Forecasting • Sales forecasts, 2014-2017 and “Thereafter” (basis for valuation, pervasive) • EPM • Line-by-line forecasts • EATO • Line-by-line forecasts • From this, we have the basis for computing enterprise and eventually equity value per share using FCF, REI and AEIG models • Information Sources: • 2009-2013 10k reports • Online articles • Target website, investor relations & general • Earnings conference call transcript* (Key for outlook) • MD&A • More

… • Drivers: • CC revenues • Canadian operations • Income taxes • TD profit sharing arrangement • Overall stability • Use, historical “Common-size analysis” to see what drives EPM& EATO

… • Drivers (of fluctuation) : • CC receivables • Pharmacy, income tax and other receivables • Other current assets • Prepaid expenses • Depreciation • Overall stability • Use, historical “Common-size analysis” to see what drives EPM & EATO

… • Drivers (of fluctuation) : • Project costs accrual • Real estate and other taxes payable

Forecasting:sales Start: • Forecast each segment • Add additional sales by forecasting Canadian operations using full information • CANADA • Relative consistence since 2009 • $1,317 M reflects only ½ year of sales • Poor performance due to • High start up costs • Unanticipated market differences • “One-stop shop” idea not as widely accepted • New management teams • Excess inventory • Breach

… First: Household essentials • From historical analysis and additional information, forecast each division • Includes baby care products • Target is immensely expanding • “Enhanced baby experience" that includes a service desk, iPad, and digital screens. This will be expanded from 30 to 200 stores in 2014, leading to presumably increased revenues • New skincare brands and new assortment of beauty products due to DermStore acquisition Increase household essentials sales • 2014 reflects "muted sales" in the beginning of 2014 (see earnings call) • Very optimistic by 2016 as Dermstoreacqusition and baby care additions mature/flourish

… Second: Hardlines • Includes electronics, movies, music, books, computer software, sporting goods and toys • Historically, both growth and decline • Target is keeping up with times • TargetTicketrolled out in 2013, offering online streaming of movies and TV shows • Unlikely to create much revenue with books given new online sources (kindles, etc.). • Adding "dedicated service" to electronics categories • Music • 2013 Target became the exclusive retailer of Beats Music play list • Earnings call mentions 2013 4th quarter strength in the sporting goods area, as well as sales of mobile phones, tablets and video game hardware and software • Target's hardlines segment appears promising; despite its varied performance in previous years, the outlook ahead is bright. Innovations like TargetTicket,

… Third: Apparel & Accessories • Includes apparel for women, men, boys, girls, toddlers, infants and newborns, as well as intimate apparel, jewelry, accessories and shoes • Target is adding manikins, a wide variety of new brands, and a new and improved mobile and online shopping experience • Target follows clothing trends very well, offering popular items at prices that add value • They enter 2014 with a "clean inventory position”allowing new clothing products • Target, as mentioned above, is revamping and capitalizing on new mothers/ their baby section • People who buy baby appliances and products are also likely to seek clothing at Target stores, increasing sales in this area • New fashion brands getting attention (see Earnings Call) • Overall, nothing drastic going on with Target apparel • With data breach, sales will likely increase but muted in 2014

… Fourth: Food & Pet Supplies • Includes dry grocery, dairy, frozen food, beverages, candy, snacks, deli, bakery, meat, produce and pet supplies • Always making adjustments to keep up with the times (Ex: Organics) • Target has expanded many stores into SuperTargets • Nevertheless, significant competition • General supermarkets, Wal-Mart (lower prices) and Dollar General offering full line food items and produce • NewYorkTimes article: "Target to stock more environmentally friendly products" states that it will expand its organic segmentto keep up with customer demand • Target (April 2014) has also introduced its own Simply Balanced organic and natural products line. • "Target said it saw a 15% above-average growth in the sales of natural and organic products last year”

… Fifth: Home Furnishings & Decor • Includes furniture, lighting, kitchenware, small appliances, home décor, bed and bath, home improvement, automotive and seasonal merchandise such as patio furniture and holiday décor • AcquistionsCHEFcatalog and Cooking.com will expand assortment • Increase in sales • Nothing major going on in this category • Negative initially, 2014 breach year effect and acquisition adjustment

…Canadian operations • $1,317 x 1.95, increased by 1.5% for growth forecast • (Recall, 1,317 in 2013 reflects slightly > ½ year of sales) • Mixed outlooks on Canada: • Conference Call: Expect to double salesin Canada but do expect volatility • Poor 2013 performance- Poor inventory management, high new cycle expenses and low satisfaction. • Target is now in a cleaner inventory position, faces lower expenses and expanded their assortment in Canadian stores, sales should rise • A lot of marketing efforts to go into Canadian sales in 2014 • NewYorkTimesarticle "Target push into Canada stumbles" notes that Target "took on a big challenge.” • Opened up many stores at once in a country in which they don't have history. The locations were more urban and smaller in size than their current U.S. locations, new management teams were employed in every Canadian location. It also came at the time of the breach. Target took a big chance here. The "one-stop-shop" culture is not as prevalent/accepted in Canada as the U.S., as Wal-Mart also learned

Full-information forecasts: Sales, overall • Add each segment • Multiply by ~ 98% (to reflect only U.S. sales, not broken up in 10k) • Add Canadian sales • Sales forecasts • Post 2017 • Sales growth diminishes • Fades over time, can’t expect growth far above inflation (~1.5%) for long • 2.75% in perpetuity, reflects Target’s maturity but still growth …BASIS FOR VALUATION

Forecasting:EPM

… • Some examples, line items: • Cost of Sales • Expect to improve • Target discusses “expense optimization efforts” and thinks its gross margin will improve • Target also believes the Canadian margins will improve, approaching 30% as they enter the year in a much cleaner inventory position and facing less expenses related to beginning first year operations • With new inventory, less markdowns will be necessary and Target seems far better off in terms of COGS for 2014 onward • However, unlikely for COGS to change dramatically, still very high* • Advertising costs • From the 10k, "Advertising costs primarily consist of newspaper circulars, internet advertisements and media broadcast” • Earnings call says Target to focus on mobile and online sales, which will cause rising advertising expense • Also, focus in Canada is on promoting awareness, which will likely raise advertising costs

… • TD profit-sharing arrangement: • Target's related Beneficial Interest Asset on the balance sheet is expected to decline • Expect the receivables to also decrease • SG&A (other, unidentified) • Substantial amount of SG&A unexplained • Earnings report notes, ”flat or slightly up" is the best way to think about SG&A for 2014 • Presumably onwards Total All for EPM…

Forecasting:EAtO • Some examples, line items: • Inventory • Earnings call discusses inventory reduction in 2013 • Other information indicates Target is expanding • Canadian stores, offering > products • CityTargets • NewTargetExpress in the near future • Buildings and improvements • Room to expand • Yet Canadian expansion has ended temporarily • Plans to launch TargetExpress stores, expand CityTarget stores

… • Fixtures and equipment • Will likely increase/decrease at a rate similar to buildings and improvements • Computer Hardware and Software • Target will offer chip enabled cards and install card readers with this technology • In response to the data breach, significant investments in this area • Also likely to increase computer software updates Total All for EATO…

Full-information forecasts • Use Sales, EPM and EATO forecasts to determine horizon results (EPAT & NEA), predict thereafter Now use inputs to value the Company

Full-information:Final value • AEIG model below, enterprise value of Target as displayed on first slide • The same for FCF and REI models (mathematically equivalent) (subject to adjustments, timing of cash flows and information availability) $50,904 (in millions)

Industry analysis • Target on the low end of RNEA, why? • EPM is lower, so is EATO • Costco, unusually high EATO (wholesale retailer)

… • ROE is lowest for Target • What are the ROE drivers? Is Target really performing more poorly than others? • Profitability analysis

Most of Target's ROE is driven by profitability of the firm, RNEA • Target, not getting much of a return from leverage, (0.43%) • Leverage is not concealing poor performance • Could utilize greater leverage • Wal-Mart generating almost half of ROE through debt • Costco also generates most ROE from enterprise operations • Dollar General in the middle • Creates most ROE from RNEA

Overall RNEA best for Target • Due to high EPM • Improved in 2013 through sale of credit card receivables portfolio • EATO considerably higher for Costco (wholesale) • DG, greatest EPM • Lower COGS

Uncertainties/limitations • 2013 first year of Canadian operations • Only in operation ~ 55% of the fiscal year • Influenced by first year operations, data breach • Still expect volatility in Canadian market (Earnings Call) • Data breach • Assume sales will be down in 2014 • How long will it take Target to recover? (Believe it will, but how long it will influence sales is uncertain) • Beyond horizon, Target will benefit from the investments in response to breach • Outcome of litigation is uncertain; could materially influence any quarter/period

To keep in mind: Future Costs, 2013 10k: “We expect to incur significant investigation, legal and professional services expenses associated with the Data Breach in future periods. We will recognize these expenses as services are received. We also expect to incur additional expenses associated with incremental fraud and reissuance costs on Target REDcards.” Effect on Sales and Guest Loyalty, 2013 10k: “We know our guests' confidence in Target and the broader U.S. payment system has been shaken. We are committed to, and actively engaged in, activities to restore their confidence. We cannot predict the length or extent of any ongoing impact to sales.”

Wrap up • Nevertheless, forecasts capture (incorporate) this uncertainty • Equity value per share below the market  Sell • Forecasted value very close to market value, however • Mild, near term market fluctuation couldchange recommendation shortly • Target has positive long-term strategies • Cost of sales is too high • Company needs to reduce COGS given near term sales growth to see notably positive results • Prediction: Eventually, Target will go International • Currently, the market overvalues the Company

Questions?

Target Corporation: final valuation