Some investors have shied away from looking at consumer discretionary stocks as the U.S. consumer struggles with inflation pressures and an uncertain timeline as to whether the Federal Reserve will actually sweep in to cut interest rates this year. In addition to this bearish view, U.S. consumer sentiment readings have been lower for another month recently.
As the economy becomes uncertain, investors may want to keep a few things at the top of their filtering process when finding their next potential investment. One of these filters should have healthy – and steady – free cash flow (operating cash flow minus capital expenditures), as this metric typically gives businesses the ability to weather most economic storms.
Shares of Target Co. (NYSE: TGT) have underperformed the broader S&P 500 by over 15% in the past 12 months. This price action is mainly driven by investor worries around the company’s free cash flow in the past couple of years, which has been turbulent at best. However, management plans to compound investor capital, and the next step in that strategy has just been revealed.
Target's Investments: A Catalyst for Stock Growth
Over the past five years, Target’s financials show the company generated roughly $4.8 billion in average free cash flow. Once the COVID-19 pandemic began, the situation changed for the company completely. Management realized that a new path needed to be taken to gain more market share than before the pandemic.
Capital expenditures doubled from $2.5 billion in 2018 to $5.5 billion in 2023. These heavy investments severely compressed Target’s return on investment capital (ROIC) rates, which used to hover around 12%. Today, Target’s ROIC rates have fallen to 8%, but that’s not necessarily bad.
Target has invested in redesigning its locations and distribution centers to improve its logistics processes and customer service quality. More than that, Target locations—virtually everyone—want to partner with Ulta Beauty Inc. (NASDAQ: ULTA) and Starbucks Co. (NASDAQ: SBUX) to have them inside Target stores.
Making these investments improves Target’s in-person experience, which is one thing. However, today’s consumption economy is becoming more digitized. Target will also need to move toward an online presence, and that’s where a new partnership with Shopify Inc. (NYSE: SHOP) comes in.
While these new investments finish setting up, and Target’s ROIC recovers – and potentially surpasses – its pre-COVID levels, exposure to the scale Shopify can provide could cushion investors’ positions.
Wall Street's Take on Target's Latest Strategy
Analysts at Jefferies Financial Group kept their valuations for Target stock at $205 a share, daring the stock to rally by 40.7% from where it trades today. However, those targets were set last quarter, so here’s a more recent assessment for June.
Those at Evercore think Target stock is worth $166 a share, roughly 14% above today’s price. More than that, Wall Street forecasts up to 12.8% earnings per share (EPS) growth for the next 12 months, but that could prove to be on the conservative end of the spectrum.
Why? It is still challenging to project the impact of this new Shopify partnership on Target’s financials. Still, investors can imagine how it could move the needle into expanding margins and revenue growth. Another way to gauge this future partnership is to check how Shopify is doing.
Shopify Stock’s Metrics Show The Value in This Deal
Wall Street wants to see 32.8% EPS growth this year for Shopify, which more closely reflects the company’s future now that it is staring down a partnership with one of America’s favorite retailers.
Here is what investors can write home about. Analysts at Citigroup boosted their price targets on Shopify stock to $96 a share, calling for up to 46.2% upside from where it trades today. What’s more important to note is that this boost came only a day after Target announced its partnership with Shopify.
Gauging the rest of the market sentiment toward Shopify stock helps investors gain another viewpoint on the Target partnership situation. On a price-to-book (P/B) basis, Shopify’s 9.3x valuation will place it above the computer sector’s average 6.5x valuation, or a 43.1% premium.
Another valuation metric, price-to-sales (P/S), proves Shopify to be the superior name in the prepackaged software industry. Shopify’s 11.9x valuation stands 47% above the industry’s 8.1x average.
Stocks typically trade at these sorts of premiums for a good reason, and now investors have a way to tell what this reason may be. Since Shopify is in the spotlight, it is easy to focus on it. Still, Target is really the hidden value play in this partnership.
