Last week, Target (NYSE:TGT) delivered third-quarter numbers that missed on revenues, comparable sales and earnings. Management also gave an uninspiring holiday guide. Those worse-than-expected numbers came against a bearish market backdrop, as investors are growing increasingly concerned about bigger tariffs and higher rates triggering a material slowdown in the U.S. economy. As such, following the Q3 report, TGT stock dropped 20% in just a few days.
TGT stock has rebounded about 4% from its post-earnings lows. But, in light of strong Black Friday and Cyber Monday data, this selloff in Target stock still seems way overdone. Clearly, the American consumer isn’t dead. The economy isn’t slowing by that much yet. Target’s comparable sales growth is as good as it’s been in several years. The company has a ton of digital momentum. And, the stock’s biggest headwind, falling margins, could turn around soon.
In the big picture, there is still a lot to like about TGT stock. This is especially true considering the recent selloff has bought the forward multiple down to 12 (versus a five-year average above 15) and the trailing dividend yield up to 3.7% (versus a five-year average below 3.2%).
All in all, this is a really cheap stock with still-favorable growth fundamentals and a lot of operational momentum heading into its most important time of year. That sort of setup implies that Target stock should be able to bounce back over the next few months.
Target’s Operational Momentum Is Indisputable
On the top line, everything is firing on all cylinders for TGT heading into what has started out as a really strong holiday season.
Last quarter, comparable sales at Target rose 5.1%. Granted, that slightly missed analyst expectations for a 5.3% increase. But, a 5.1% rise in comparable sales driven by 5.3% comparable traffic growth is still very healthy. Those numbers also follow 6.5% comparable sales growth in Q2 (which was the company’s best mark in 13 years) and 3% comparable sales growth in Q1, which was driven by decade-best traffic growth.
Importantly, the big driver of this growth is Target’s red-hot digital segment, and that is where all the sales are happening this holiday season. Last quarter, comparable digital sales at Target rose a whopping 49%. That is an industry best mark that tops digital growth at Amazon (NASDAQ:AMZN) and Walmart (NYSE:WMT). It also follows 41% growth in Q2, and 28% growth in Q1, so there is a clear upward trend here in Target’s digital sales growth trajectory.
Overall, it is tough to dispute that Target has a ton of operational momentum right now. Comparable sales and traffic growth are running at decade highs, and the company’s digital business has gone from below-average growth to industry-best growth. All of this is happening ahead of what has started out as a very strong holiday shopping season.
If this strength persists over the next few weeks (and it should given sky-high consumer confidence, rising wages, high credit scores, low unemployment, so on and so forth), then Target will likely be a big winner this holiday season.
Margin Compression Should Moderate
Bears will be quick to point out that it isn’t revenue growth which has caused TGT stock to drop. It’s margins.
They are right. The big worry with respect to TGT stock has been and continues to be margins. Margins have been a problem for a while as wage hikes plus higher direct-to-consumer expenses have created a drag on profitability. Both gross and operating margins have been in a multi-quarter slump. But, in Q1 and Q2, we started to see some gross margin stabilization from Target.
That stabilization evaporated in Q3. Whereas first-quarter and second-quarter gross margins were down between 10 and 20 basis points year-over-year, Q3 gross margins dropped 90 basis points year-over-year due to higher DTC expenses. This headwind won’t slow anytime soon. The norm in e-retail used to be a minimum purchase order to qualify for free shipping. That is changing this holiday season. Everyone is giving away free shipping on all order sizes. Thus, Target’s DTC expenses will likely keep rising in the near-term, and gross margins could keep falling.
But, the positive read on margins from Q3 is that for the first time in several quarters, the SG&A rate was flat year-over-year. This rate has consistently been climbing due to higher wages and in-store investments. Those pressures seem to be largely in the rear-view mirror. As such, despite 90 basis points of gross margin compression in Q3, operating margins fell back just 40 basis points.
Thus, in the event that gross margins start to stabilize after this deep discounting holiday period, operating margins should actually start to expand. If that happens, TGT stock will rise by a whole bunch because the valuation today is simply too cheap at 12X forward earnings and with a 3.7% dividend yield against the backdrop of decade-best comparable sales growth.
Bottom Line on TGT Stock
Near $90, Target stock was trading at an above-average valuation with a below-average yield. Despite robust revenue growth, that valuation was unsustainable because of persistent margin compression headwinds.
Now, the converse is true. Right around $70, TGT stock is trading at a below-average valuation with an above-average yield. Despite persistent margin headwinds, that valuation is equally unsustainable because of robust revenue growth.
All else equal, TGT stock should trade in-line with its historically average 15 forward multiple. Next year’s earnings estimates sit around $5.60. Applying that 15 forward multiple to $5.60, one can reasonably assume that Target stock deserves to trade above $80 by the end of the year.
As of this writing, Luke Lango was long TGT, AMZN, and WMT.
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