My Recent Target Experience and How The Chase for E-Commerce Market Share is Killing Retailer Margins

There is a Target (TGT) store very close to my house that my family visits frequently. We even keep a shopping list on the fridge labeled “TGT” to simplify our trips.

Given the vast selection of products Target carries, sometimes it is harder to find something in the store than you would think, even if you are very familiar with the layout. To minimize the time we meander up and down various aisles, I have the Target app installed on my phone, which will tell me which aisle each product is located at my local store.

In recent months I have noticed that the prices on the app for many categories are materially cheaper than they are in store. This becomes obvious when you lookup the location of something on the app, see the price, and then 30 seconds later you pick it off the shelf and see a clearly higher price. I would say the discounts average about 10% (just a guesstimate) and are focused on certain categories such as toiletries and cleaning products.



After several trips of noticing the pattern, I became pretty annoyed. If my bill totaled $100 I invariably felt like I was getting ripped off by shopping in-store, even if only to the tune of $10 or so. I looked up Target’s online price matching policy and sure enough, they will match their online pricing for in-store purchases.

The process for collecting the difference is far from helpful, though. Rather than visiting the customer service area and having them scan your receipt or something easy like that, you need to show evidence of the lower price online while the cashier rings up your purchases. So if you have a dozen items that are cheaper online, you need to show the cashier each item on your phone app individually and they will then manually enter the cheaper price for each item. Not only is this time consuming, but it will make the check-out experience awful for the people in line behind me, as they wait for me to bring up each and every item on my phone. As a result, I refuse to do this and am ticked off that I need to in the first place.

The other day I decided that I could have the best of both worlds. Even though the store is right down the street from my house, I can order the items online, have them delivered in 2 days, and save money on top of that by getting the lower online prices. So I fired up the app and began adding items to my cart.

Without a Target Red Card, there is a $35 minimum order to get free 2-day shipping. I was short of that level initially, so I decided to see if they would actually deliver cat litter for free (many retailers have weight limitations for free shipping). I thought it was a long shot since each box of litter weighs over 25 pounds, but sure enough, cat litter is eligible for free shipping. By adding 2 boxes I reached $36 and submitted my order.

Two days later a large flat shipping box was left on my porch by UPS. The box was nearly coming apart, as both boxes of litter had been placed flat/sideways in the shipping box, with some soap and toothpaste tossed in as well without much in the way of padding. I have no idea how much UPS charged Target to deliver this 50 pound box to me in 48 hours, but I would have to say somewhere between $5-10, right? There is no way Target made a profit on this online order and I am not paying them an annual membership fee (like Amazon Prime) to help cover the cost.

Why am I telling this boring retail story? Because when we consider the economics of the decisions Target is making here, it makes no sense. My local Target store has high fixed costs. They should want me to drive to the store, pick my own items off the shelves, go through the self-checkout lane, and drive home. That route will maximize their profit by leveraging their fixed costs and minimizing labor expense, which is only rising (and is now $15 per hour here in Seattle).

Instead, they are offering me higher prices if I visit the store, and that is made obvious to me when the lower online prices are shoved in my face whenever I use the smartphone app (which they encourage me to use in-store to boost the shopping experience). From an economic perspective, they should be trying to coax me into the store by offering perks for doing so. Instead, they are almost begging me to order online, where they will likely barely earn a profit on each order, if at all.

And on the flip side, they are offering cheaper prices online, with free 2-day shipping, and including products such as 25 pounds of cat litter in the free shipping offer. At least make me drive to the store to pick up the cat litter!!!

So, here I am planning to order more of my Target purchases online, which will crush their margins both on the retail side (as store traffic declines) and on the online side (where 2-day shipping via UPS will eat their already reduced margin).

The result is that Target succeeds in their goal of keeping my business and not donating it to Amazon (AMZN) or Wal-Mart/jet.com (WMT). Okay, great, your same store sales will hold up nicely in a very competitive retail world. And your margins will erode quickly, resulting in the same absolute profit dollars earned on higher volumes. Seems like the opposite of what should be happening (keep prices low and make it up on volume).

In fact, there are some items at Costco (COST) that are cheaper in store than they are online, even though this flies in the face of what chains like Target are doing. And that pricing strategy is from a company that chooses volume over per-item margin all the time. In fact, Costco marks up their items (from their cost) the least of any retailer I am aware of. Smartly, they are not getting sucked into this notion that to compete online and keep their stock price up, they need to give away products through the e-commerce channel.

Call me crazy, but some of these hybrid online/in-store business models don’t seem very well thought out, and surely won’t benefit shareholders much in the long run. I love shopping at Target, but it is hard to see how they are going to materially increase per-share profit.

Full Disclosure: No position in Target, long or short, just baffled by the pricing dynamics they currently have in place and believe it reinforces that we are now seeing retailers focus on same store sales and not profits, even at mature, established companies which clearly are not second-comings of Amazon.

U.S. Stock Market Seems Like An Obvious Buy For First Time In A Long Time

With the S&P 500 index now down roughly 18% from its peak reached about three month ago, for the first time in years it appears the U.S. stock market is severely oversold and pricing in worse than likely economic conditions. In the two weeks since my last post discussing valuation, the S&P trailing price-to-earnings ratio has dropped by more than a full point and now stands at just above 15x.

I have previously posted that we should expect P/E ratios of between 16x and 17x with the 10-year bond yielding in the 3-5% range (current yield: 2.75%). Given that 2018 corporate profits are pretty much in the books already, the current valuation of the S&P 500 assuming ~$157 of earnings is 15.3x (at 2,400 on the S&P 500).

Let’s consider what this valuation implies. First, it presumes no further earnings gains, or put another way, 2018 is the peak of the cycle for profits. Could that be possible? Sure it could, but right now that is the base case. And even with that base case, stocks are 5-10% below the 16-17x P/E we would expect to see.



One could also make the argument that U.S. stocks are pricing in a mild, normal recession. Let’s assume a typical 6-9 month recession occurs over the next 12-24 months, and as a result, S&P 500 profits drop 11% to $140. If a normalized P/E ratio would be 16-17x, I would guess stocks would fetch about 18x trough earnings during a recession (investors often pay higher multiples on depressed earnings). If we assign an 18x multiple on $140 of earnings, we get an S&P 500 target of 2,520, or 5% above current levels.

If we take a more bearish stance and assume a normalized P/E (16.5x at the midpoint, given low interest rates) on that $140 profit number, we would peg the S&P 500 at 2,310, or less than 4% below current levels.

I am not in the game of predicting short-term economic paths or stock market movements. All I can say now is that stock prices for the first time in many years are pricing in several of the most likely economic outcomes (normal recession or materially slowing GDP growth). Furthermore, it appears that the S&P 500 will close out 2018 at the lowest valuation since 2012.

Given those conditions, I am aggressively buying stocks with the majority of current cash balances in the accounts of those clients who are aiming for more aggressive, long-term, growth-oriented investment strategies. Put simply, I am seeing a ton of bargains right now and am not content waiting for further downside to pounce. For those who have excess cash on the sidelines, now could turn out to be a great time to add to your equity exposure, assuming that fits with your risk tolerance and investment goals.

Johnson & Johnson Stock Not Discounted Much After Renewed Talc Media Blitz

Shares of healthcare giant Johnson and Johnson (JNJ) have come under pressure in recent days as media reports have once again resurface, suggesting that the company has potentially hid evidence that trace amounts of asbestos have been found in the talc powder products over multiple decades.


Whenever news like this hits, especially with large dominant franchises with plenty of free cash flow to cover possible legal verdicts (think BP earlier this decade), it pays to see if investors are getting a short-term bargain, enough to compensate them for what is likely to be plenty of headline risk over the coming weeks and months.

With JNJ shares only down about 15% from their highs (not much more than the S&P 500 index), no such bargain seems to have presented itself yet. I estimate JNJ is likely to report free cash flow of around $6.75 for 2018, which gives the stock a current multiple of 19.3x on a trailing basis.

While such a price is not sky high by any means, it is probably about right for a company of JNJ’s size. Looking back over the last five years, we can see that JNJ has closed out each of those year’s with a trailing free cash flow multiple of between 18.3x and 21.6x. Therefore, the market seems to agree with my conclusion about a fair valuation.

For me to get interested in playing JNJ as a short-term contrarian, long-term investment play, I would probably have to pay around 15x free cash flow, or near $100 per share. We are far from there at this point, and unless some impressive jury awards play out in plaintiffs’ favor, or the media finds evidence that is a bit more damning, we probably won’t see the stock get that low.

With The Elevated Valuation Issue Solved, 2019 Earnings Growth Takes Center Stage

With S&P 500 profits set to come in around $157 for 2018, the trailing P/E ratio for the broad market index has fallen from 21.5x on January 1st of this year to 16.5x today. Surging earnings due to lower corporate tax rates have allowed for such a significant drop in valuations despite share prices only falling by single digits this year, which is a great result for investors. Normally, a 5 point drop in multiple requires a far greater price decline.

With sky high valuations now corrected, the intermediate term outlook for stocks generally should fall squarely into the lap of future earnings growth in 2019. On that front, there are plenty of headwinds. With no tariff relief in sight, the steady inching up of interest rates, a surging federal budget deficit, and no incremental tax related tailwinds next year, it is hard to see a predictable path to strong profit growth from here.



Even if 10-year bond rates go back into the 3’s, market valuations should stabilize in the 15-18x range, so stocks today appear to be fully priced for a relatively stable economic environment. Although current profit estimates for 2019 are quite high (double digit growth into the $170+ area), I suspect those figures will come down meaningfully once companies issue 2019 guidance in late January and into February (analysts don’t often go out on a limb so they will wait for companies to tell them what to expect).

Putting all of this together and we are unlikely to make new highs in the market anytime soon, in my view. We probably have 10% downside and 10% upside depending on various economic outcomes over the next few quarters. In the meantime, there are plenty of cheap stocks to accumulate and hold for the long term, until attractive exit points present themselves. Goldman Sachs (GS) is a perfect example, at it inexplicably trades for $176 today, below tangible book value of $186 per share.

Full Disclosure: Long GS at the time of writing, but positions may change at any time.

Facebook Sell-Off Hard To Ignore From A Contrarian Perspective

Shares of Facebook (FB) are dropping below $130 today as the high-flying tech sector continues a sharp correction in the market.

After such a punishing drop, it is hard for me to look away because there is a bullish fundamental story buried here, and the valuation is becoming quite undemanding.

From the business side, FB continues to offer a return on investment for small businesses that is unrivaled in the media industry. Couple that with a huge user base, that can make any successful new product launch (dating service, streaming TV, anything else they come up with later on, etc) inherently materially incremental to profits over the long term, and there are reasons to believe that the company’s business model is far from broken.

From a valuation perspective, investors are getting FB’s operations for about $113 per share (net of $14 per share of cash in the bank). With GAAP earnings of roughly  $7 likely for 2018, and a path to EBITDA of $30 billion in 2019, the metrics look meager on both a trailing and forward basis, despite slowing growth and falling profit margins. I understand that FB is dealing with many operational challenges, but 16x trailing twelve-month earnings? 11x next year’s EBITDA, net of cash? At a certain point, the price more than reflects those challenges. It appears we have reached that point, so I cannot help but take notice.



There is still a bear case that deserves to be considered; namely that the business is permanently impaired and that revenue cannot continue to grow double digits. Essentially, the existing business is peaking and new offerings will fall flat (the new Portal hardware device?). Without growth, a near-market multiple would roughly be appropriate.

However, if the core story remains the same; rising revenue will be met with even-faster rising expenses, resulting in lower operating margins and slower profit growth, it appears the stock already more than reflects that outcome. Put another way, if GAAP earnings don’t stop at $7 and instead go to $8 in 2019 and $9 in 2020, etc, the stock is not going to stay in the 120’s for long.

Full Disclosure: I have begun to build FB long positions in client accounts that have seen fresh cash deposits in response to the most recent market decline and those positions could very well grow over the near to intermediate term based on market conditions

The Dizzying Ride That Is Wynn Resorts Stock Is Not Slowing Down

Since I first wrote about gaming and hospitality company Wynn Resorts (WYNN) three and a half years ago the stock performance has been nothing short of an intense roller coaster. For a large cap company with a relatively simple business, you are unlikely to see more volatility in the equity markets. Such wide gyrations are great for investors, especially those willing to be contrarian and buy when things look the bleakest, but the exercise can admittedly become tiring while also predictable.

Fast forward from May 2015 to today and I am still a rider on this roller coaster. Although I bought stock at low prices and sold much of it at high prices, I failed to sell everything near the top and we are now stuck in a down cycle for the shares, despite the fact that the company is doing just fine.

Below is a five-year chart of Wynn Resorts shares that shows just how dizzying the ride has been:

I was buying the stock in 2015 after the prodigious collapse from the 2014 highs and began trimming positions in late 2017 and well into 2018, but the long-term outlook (still very bright in my view) caused me to hold onto to a smaller position even as the stock reached the $200 level. And now we are left with an interesting question; what to do now?

Given the stock chart above, you would probably guess that Wynn’s business is in trouble, but you would be wrong. In fact, company EBITDA this year is likely to come in right around their previous best two years ($1.68 billion in 2013 and $1.61 billion in 2017) and could even reach $1.7 billion, a new company record. As is usually the case, the financial markets extrapolate current results and value the business based on those  near-term figures, ignoring both longer term historical track records and the future outlook a year or two down the road.

That trend is playing out now, as Wynn’s business has gotten soft in recent months and is unlikely to bounce back quickly in the near term. Never mind that their Boston property will open in June 2019 and offset weakness seen elsewhere in their property portfolio. Never mind that the company is in the process of designing new additions to their properties in both Las Vegas and Macau that will grow profits over time.



What happens when near-term stock valuations are based mostly on near-term financial results is that prices and investor reactions overshoot in both directions. When things are great, the stock reflects that and analysts have high estimates for future profits and use high valuation metrics due to those rosy outlooks. The opposite is seen as well. This week, as near-term profit expectations come down for WYNN, the multiples used to determine Wall Street price targets will also come down, undoubtedly justified in their minds “to reflect the near-term weakness of the business.”

From a valuation perspective, the value of a dollar of profit should not change based on near-term trends. The notion that WYNN should be valued at 15x EBITDA one quarter and 12x the next makes little sense, if indeed we believe that the stock should reflect the discounted present value of all future profits in perpetuity.

To illustrate this phenomenon, let’s look at Wynn’s stock price and financial results since 2013. The 2018 revenue and EBITDA figures shown are my firm’s internal estimates.

As you can see, the stock price reacts far more violently, in both directions, than the actual financial results of the business. In each and every year, the stock move is more aggressive than the year-over-year (yoy) change  in sales and profit. Interestingly, the stock today is 50% below the level of year-end 2013, even though EBITDA is roughly the same.

Generally speaking, this is why it makes sense to many of us in the industry to have a portion of one’s investment portfolio allocated to active managers; to try and take advantage of such mispricings in an inefficient marketplace.

In hindsight, it would have been nice to sell every share earlier this year and buy back each of those shares today. In actually, I am quite pleased that I bought it low and sold a portion when I did. While the roller coaster ride that is Wynn Resorts stock can be frustrating at times, there is no reason to jump off now. If my investment thesis is right (the Boston property does well and the legacy resorts in Las Vegas and Macau grow revenue and profits over the long term, despite short-term bumps along the way) then investors will surely get another chance to sell at a fair price in the future, just as they get chances to buy at attractive prices periodically.

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

IBM: Damned If You Don’t, Damned If You Do

 

 

 

For years investors have been clamoring for IBM (IBM) to transform their business via acquisition, as tech infrastructure moves to the cloud and away from IBM’s legacy businesses. Despite some very small deals, the company instead opted to buyback stock and pay dividends with its prodigious free cash flow.

To put this capital allocation decision in perspective, consider that between 2010 and 2017 IBM spent $34.4 billion of dividends and repurchased $82.4 billion of stock, for a total of $116.8 billion of profits that were not reinvested in the business over and eight year period. Compare that with IBM’s current equity market value of $110 billion. Wow.

Thew result has been a stagnant business from a numbers standpoint ($15 billion of free cash flow in 2010 versus $13 billion in 2017), and a larger lead for the new age/cloud-based competition.



When we learned yesterday that IBM had agreed to buy Red Hat (RHT) for $34 billion, or $190 per share, a stunning premium of 63% compared with the prior closing price, you could have a few different reactions (or combination thereof). One, “it is about time they make a big move.” Two, “well, oh well, it’s five years too late.” Three, “great move, but why on earth pay such a steep price?”

IBM stock went down yesterday, which makes sense when taking a short term view (the deal is dilutive in the early years), but seems strange with a long term view (could IBM possibly be worth less on a per-share basis with RHT onboard?).

The way I see it is that if IBM was valued at 9x free cash flow without Red hat, it should not be worth less than that with it. But that begs the question, can RHT really make a dent in IBM’s massive business? If IBM’s valuation multiple is going to expand on the heels of this deal, RHT needs to show up in the numbers.

So let’s go through the numbers. RHT adds $3.3 billion of revenue, $650 million of EBITDA, and $775 million of free cash flow to IBM. If we assume IBM uses $10 billion of cash and borrows $24 billion at 5% to fund the $34 billion acquisition, debt costs will rise by roughly $1.2 billion pre-tax. Call it $1 billion annually after-tax. There goes the added free cash flow generation from RHT… completely negated (and more) from the added debt load.



IBM said that they would suspend share buybacks until 2022, so let’s assume they use 100% of free cash flow after dividends (roughly $6 billion per year) to repay 50% of the RHT-related debt in 2020 and 2021. At that point, perhaps the RHT business is generating $1 billion of free cash flow and debt service on the remaining $12 billion of incremental RHT debt is $500 million after-tax. The result in 2022 is a deal that is accretive to free cash flow by $500 million, or roughly 4% vs 2018 financial results ($12 billion free cash flow guidance for 2018).

Does this Red Hat deal add risk to IBM? Unlikely. Does it materially change the growth rate and underlying profits of the business? Unlikely. Does it mean IBM stock should go down? Unlikely. Could it result in a 10x or 12x free cash flow multiple longer term, vs 9x today? Perhaps.

Add in a dividend yield north of 5% and IBM stock around $120 per share seems likely to be able to put in a floor, assuming the RHT deal does not spur competing bids. Given the price being paid, it will likely not result in a surging IBM stock price, but from a risk/reward perspective, I would conclude that IBM is a meaningfully more attractive deep value/income-producing stock with RHT than it was without it.

Full Disclosure: No position in IBM at the time of writing, but holdings may change at any time

As Coastal Housing Markets Cool, 2017 IPO Redfin Is Worthy Of A Watchful Eye

For all of the business model evolutions and technology-led disruptions throughout the service economy in recent memory, the 6% realtor sales commission (a truly obscene amount for higher priced homes) for the most part has been unscathed. Tech upstarts like Redfin (RDFN) are trying to make a dent and are making progress, albeit slowly.

Public for less than 18 months after their IPO priced at $15, RDFN is using technology to save home buyers and sellers money. The company has been expanding its 1% sales commission structure rapidly, which can cut home sellers commission expense by 33% (4% vs 6%). Like Zillow (Z), RDFN also strives to offer customers ancillary services, such as mortgages.

RDFN stock had been trading pretty well, relative to the $15 issue price, up until recently:

The issue now is that RDFN was started in Seattle and focused initially on higher priced big cities for its lower sales commissions. The reason is pretty obvious; taking a 3% cut on a $200,000 home in Spokane is equivalent to taking a 1% cut on a $600,000 Seattle listing because each will take roughly the same labor hours. The idea that said Seattle seller would pay $36,000 to sell their house is a bit nutty, but that structure has largely survived in the industry.

Fortunately for RDFN, the coastal housing markets have been on fire, including double-digit annual gains in their home Seattle market for many years now. The result has been a strong revenue growth trend for the company, with 2018 revenue expected to top $475 million, versus just $125 million in 2014.

With those same markets now showing clear home price deceleration and inventory stockpiling, RDFN should see pressure on its near-term financial results, and likely similar headwinds for the publicly traded shares.

Long term, however, RDFN’s future appears bright as it continues to expand its business across the country, taking aim at the traditional 6% sales commission structure. The company’s market share reached 0.83% as of June 30th, up from 0.33% in 2014. While that figure is tiny, it shows you just how much business is out there for newer players to steal.



To be a long-term bull on RDFN, one needs to believe that over the next 10-15 years they can continue to grow market share and perhaps reach 5% penetration of a market worth tens of billions per year. The good news is that the company has enough money to try and get there. After a recent convertible debt offering, RDFN has about $300 million of net cash on their balance sheet, compared with an equity value of roughly $1.65 billion. That cash is crucial, as the company is purposely losing money now to grow quickly (cash burn has been in the $20-$30 million per year range).

It is hard to know what a normalized margin structure for RDFN could look like, and therefore assigning a fair value is not easy. With nearly $500 million in revenue and $300 million of cash, the stock does not appear materially overpriced today if one thinks they can earn 15%-20% EBITDA margins over time and therefore trade for 1.5x-2.0x annual revenue.

That said, if coastal markets continue to cool over the next few quarters, RDFN could dial back financial projections for Q4 and 2019, which would likely put pressure on the stock short-term, despite it being a long-term story for most investors. Accordingly, I think RDFN is an interesting stock to watch, especially for folks looking for growth without having to pay a huge premium for it.

Rising Interest Rate Shock: 2019 Edition

Back in February I published the table below to show investors where the S&P 500 index would likely trade if interest rates normalized (10-year bond between 3% and 5% is how I defined it):

Published 2/27/18

The point of that post was to show what the typical equity valuation multiple was during such conditions (the answer is 16x-17x and we don’t have to go back too far to find such conditions). Now that 2018 is coming to an end and earnings are likely to come in at the high end of the range shown in that table ($157 is the current consensus forecast), let’s look ahead to 2019.

I have added a gray section to the chart (see below) to include a range of profit outcomes for 2019. The current forecast is $176 but I believe there is more downside risk to that than upside, so I did not add any outcome in the $180+ area.

As you can see, the equity market today is adjusting rationally to higher rates, with a current 16.1x multiple on consensus 2019 profit projections. The big question for 2019, therefore, is not huge valuation contraction. Rather, it comes down to whether earnings can grow impressively again after a tax cut-powered 26% increase in 2018. If the current consensus forecast for earnings comes to fruition, the market does not appear to be headed for a material fall from today’s levels.



Given that the long-run historical average for annual earnings growth is just 6%, assuming that in the face of rising rates the S&P 500 can post a 12% jump in 2019 seems quite optimistic to me. Frankly, even getting that 6% long-term mean next year – resulting in  $166 of earnings – would be solid.

For perspective, at that profit level, a 16x-17x P/E would translate into 2,650-2,825 on the S&P 500, or 3% lower than current quotes at the midpoint. Add in about 2% in dividends and a flattish equity market overall seems possible over coming quarters if earnings fall to post double-digit gains next year and valuations retreat to more normal levels.

Many Gaming Related Companies Are On Sale

I have written enough about Wynn Resorts (WYNN) in recent years that much more in the way of commentary is likely unnecessary. Investors are once again getting a unique buying opportunity with the shares down a stunning 30 percent on very little news:

Even if they wind up selling their under-construction Boston property prior to opening, the haircut for shareholders would likely be less than $5 per share (a 20% gain on the $2.5B cost is just $500M). Although Macau revenue growth is slowing, the August figures are still well into the double digits.

Other leading gaming related stocks are also selling off and warrant special attention. Two notable ones are lottery and slot machine giant International Game Technology (IGT) and video game behemoth Electronic Arts (EA). 

IGT is a global leader and despite low single digit revenue growth (most markets are mature), the business is minimally cyclical and the company’s valuation seems extremely reasonable at 10 times 2019 earnings estimates and a dividend yield north of 4 percent.

EA has been riding the coattails of a transition from packaged software sales to cloud-based digital sales, and the higher gross margins such a distribution model affords. A recent profit warning, due in large part to a delay in the upcoming release Battlefield 5, has helped the stock fall about 25% from its highs. While not dirt cheap (low 20’s multiple to earnings), continued revenue growth, margin expansion (digital sales still represent less than 70% of the total, which could reach 90% over time), and a stellar balance sheet should be accretive to shareholder value over the intermediate term.

No matter your investing style, and despite the market near all-time highs, there are plenty of gaming investments worthy of consideration right now.