The Long and Short
An attractive new issue concession on Target
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 has started the New Year by tapping the primary market for 10- and 30-year debt, with the longer tranche looking particularly attractive. Despite the order book oversubscribed by five times, the 30-year tranche priced 25 bp behind the existing on-the-run 30-year bond while the 10-year priced right on top of secondaries. The new 2053 bond still represents an attractive entry point into the credit since it looks set to collapse closer, if not on top of, the 2052 bond.
Exhibit 1. TGT Bond Curve
Source: Bloomberg TRACE; APS
Leverage high but expected to return to normalized levels
Last year proved to be a difficult year for TGT as rapidly changing consumer behavior left the company with excess inventory, much of it in bulky categories such as outdoor furniture, kitchen appliances and TVs, forcing management to aggressively clear the items. Coupled with higher-than-expected freight and transportation costs, margins came in well below expectations, translating to increased leverage. TGT entered last year with lease-adjusted leverage of approximately 1.3x and saw leverage climb over a turn, to 2.4x at end of 3Q22. Leverage is now above the thresholds for the current ratings, but the rating agencies are allowing some time for TGT to improve its inventory position which will help to support EBITDA recovery. That said, leverage should decline closer to the 2.0x area as we move through the year.
Management’s historical conservative financial policies, which has seen TGT reducing debt in times of EBITDA declines, are still in play. While debt has increased this past year, TGT backed off its pace of share repurchases relative to the prior year, in an effort to preserve cash. In fact, the company did not repurchase any shares in the last quarter due to its financial performance and capital investments. TGT has historically viewed share repurchases as its third priority for excess cash, after reinvesting in the business and supporting the dividend. Management, however, will only repurchase shares within the limits of its mid-single A ratings.
Ratings (A2 (p)/A/A) were affirmed on the deal announcement based on the company’s strong market position, historically strong cash flow generation and conservative financial policies. Omnichannel initiatives have generated market share gains, while private and exclusive merchandise has helped to set TGT apart from peers. TGT’s “Favorite Day” brand has been one of the fastest growing private label brands in 2022. EBITDA is expected to rebound in 2023 as the company clears through excess inventory and moves back towards more normalized promotional levels. Additionally, free cash flow is expected to return to positive territory due to a combination of EBITDA stabilization and capital spending returning to previous levels (~$3bn annually).
Holiday season expected to be highly promotional
TGT is expected to report fiscal fourth quarter earnings in early March. While no preliminary results have been released, management did note on the last earnings call that growth at the back end of the third quarter was much softer than the beginning of the quarter. Customers were exhibiting increased price sensitivity as we approached the holiday shopping season and were less inclined to pay full retail for items. While the fourth quarter tends to be a promotional quarter (Black Friday/Cyber Monday), management had felt that purchasing power was stretched thin as customers had already been relying on borrowings and savings to manage their weekly budgets.
In response, TGT increased their percentage of exclusive holiday offerings to support their value proposition. TGT once again partnered with FAO Schwarz for an exclusive assortment of more than 120 toys. Furthermore, TGT collaborated with Disney to feature an exclusive line of Black Panther merchandise and toys. Exclusive products are similar to private label in that they tend to carry higher margins. Additionally, exclusive items can be traffic drivers both in store and online. The success of these offerings could help the EBITDA margin come in ahead of consensus, which stands 6.7% for the quarter.
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