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Corporate credit: A diamond, or more precisely, a Target in the rough

| May 24, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Target (TGT) credit looks like a good defensive play within the retail sector.  The consistent same store sales performance coupled with operating margin growth despite higher costs improves the likelihood that management will be able to weather the impending tariff storm better than peers.

TGT outshines peers

Following multiple earnings misses in the retail sector and downward revisions to guidance (KSS and LOW), TGT outshined its retail peers this week turning in a solid quarter underscored by strong same store sales and traffic growth.  TGT posted its eightth consecutive quarter of positive sales (up 4.8%), which was largely driven by increases in traffic both in store and online.  TGT has effectively improved its price perception and merchandise assortment through its private and exclusive offerings, which remains a good traffic driver.   Online sales grew an impressive 42%, which was off of solid 28% growth in the year-ago period.  Management noted that the digital sales growth contributed 2.1% to TGT’s overall sales growth for the quarter.  Disciplined cost control led to operating income growth of 9% (to $1.14bn), translating to operating margin growth of 20bps yoy (to 6.4%).   Management remains confident that they can deliver mid-single digit operating income growth for the full year.

Exhibit 1: Quarterly same store sales, traffic and pricing

Source: Company Reports

Convenience and price

TGT’s investments in Omnichannel, particularly same day fulfillment, are paying off.  Same day fulfillment services including: pickup in store, drive up and Shipt represented over half of the online growth for the quarter.  That said, these three services drove more than a quarter of TGT’s total 1Q sales growth.  Importantly, management noted that the new fulfilment services (drive up and Shipt) are leading to incremental customer trips given the added convenience.  As these new fulfilment options take hold, it helps to save on shipping costs, thereby benefitting the gross margin.

Furthermore, TGT’s private and exclusive offerings continue to be successful and remain another important element of traffic growth.  Not only have these brands improved price perception but they create merchandise offerings that can only be found at TGT.  TGT has long been successful with designer collaborations and its most recent collaboration with Vineyard Vines may be its most successful to date.  The collection included 300 items including apparel, accessories and swim for the entire family with the majority of items priced below $35.  With that price point, the collection sold out almost instantly leaving only a handful of items left online.

Balance sheet remains solid

TGT ended the quarter with total debt/EBITDA of 1.9x and lease adjusted leverage of 2.1x, both down nearly 2 ticks sequentially.  We note that TGT already refinanced its upcoming $1bn June debt maturity with its issuance in March.  Therefore, leverage is set to decline further when that bond matures.  TGT maintains a very manageable debt maturity profile after 2019 with $1.1bn due in 2020, $49mm due in 2021, $1.1bn due in 2022, nothing due in 2023 and $1.1bn due in 2024.

Current tariffs baked into guidance

Given the better than expected 1Q results, TGT reaffirmed full year guidance of a low-to-mid-single digit increase in SSS, mid-single digit growth in operating income and adjusted EPS in the $5.75-$6.05 range. Management noted that its current guidance includes existing tariff increases to 25% (expected to become effective in June), as they have plans in place to mitigate the impact of those increases. However, full year guidance does not include proposed increases on all imports and management indicated that further increases will likely lead to higher prices, echoing similar comments made by Walmart Inc. (WMT).

Relative value

TGT credit looks like a good defensive play within the retail sector.  The consistent same store sales performance coupled with operating margin growth despite higher costs improves the likelihood that management will be able to weather the impending tariff storm better than peers.  While higher tariffs will likely lead to higher prices, TGT has demonstrated over the past two quarters that increased prices did not come at the expense of sales growth.  That looks like a function of TGT’s merchandise assortment, price perception and improved fulfillment capabilities.  Furthermore, the strong balance sheet and real estate portfolio aids in credit quality.  There’s value in the 10-year part of the TGT curve as TGT 3.375% 4/15/29 bonds are currently offered at 78 bp (79 g-spread) which is roughly 7 bp behind HD 3.9% 12/6/28 bonds.  Note that in the 7-year part of the curve, TGT 2.5% 4/15/26 trade roughly 10 bp (g-spread) through HD 2.125% 9/15/26.

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