Proprietary Meetings with TGT Management

Alert: Deb’s Download: Proprietary Meetings with TGT Management

Key Points:

Our Take — The TGT train continues to steam ahead.  We met with CEO Gregg Steinhafel, CFO John Mulligan, and head of IR John Hulbert at the company’s headquarters.  The company is investing to enhance its omnichannel capabilities and expects to be in a more competitive position for Holiday.  Key initiatives like 5% Rewards and P-Fresh are driving traffic and building basket size, and cost savings (e.g. sourcing, transportation, and labor) should offset some of the gross margin rate pressure.  We also believe that TGT is shaping up to be a compelling free cash flow story in 2014.  We reiterate our Buy rating.

The key takeaways from our meetings with management include:

1. Macro Weighs on Comps — TGT saw the impact of the 2% payroll tax increase on sales almost immediately this year, and it lost discretionary trips as a result.  Pressure has been most pronounced on the low end customer.  One-third of TGT’s sales are to households earning less than $50,000.  However, the economic environment is slowly getting better, and TGT has several initiatives to drive traffic, including new tests in baby, electronics, and health & wellness, better localization, a greater focus on reaching out to Millennials and Hispanics, and growing omnichannel.  TGT remains confident that it can do a 3% comp long-term.
2. Peak Spending on Tech — TGT is investing approx. $0.20-$0.25 per share in technology this year, which is expected to be the peak level of investment.  Spending could drop to $0.05-$0.10 per share next year.  This year, TGT is enhancing its capabilities, such as rolling out buy online, pickup in store for Holiday.  The company is also investing in e-commerce distribution, vendor relationships, and predictive analytics/data management.  This year should be peak spending, and the expected decline in spending in 2014 could meaningfully benefit FCF.
3. Strong Out of the Gate in Canada — TGT saw “white space” and “leaned heavily” towards home and apparel in Canada, and it has paid off so far (but remains early).  Sales out of the gate have been very encouraging, with a strong response to apparel (TGT has seen 10 people in line for its fitting rooms).  Prices in Canada average 15-17% higher than the U.S. due to higher operating costs.  Gross margin in 1Q13 was better-than-expected, as markdowns were very limited and mix was favorable, but the company stressed that margins will normalize over time.
4. Lower Capex in 2014 to Free Up Cash — TGT expects capex in 2014 to be significantly lower YOY at approx. $3.0B ($2.5B U.S. + $0.5B Canada), compared to $3.8B this year ($2.3B U.S. + $1.5B Canada).  This guidance represents $800M in incremental cash flow YOY, and we think that 2014 capex could ultimately be lower than $3.0B.  TGT expects to return this cash to shareholders through a higher dividend (~20% growth per year) and greater share repurchases.
5. Opportunities to Get Better — On the topline, we believe TGT has an opportunity to improve its marketing to REDcard holders.  The company has not sent non-promotional, supplemental mailers or emails to cardholders (they don’t require cardholders to provide an email address).  Management sees margin opportunity through improved sourcing strategies, transportation efficiencies, store labor savings (by being more efficient with signage and fixture changes), price optimization, and private label growth.