Should I Do It? Target Misses Mark

Target(TGT) is the nation's second largest discounter behind Wal-Mart(WMT), operating approximately 1,400 stores in 47 states.

The company has been held in high regard by Wall Street, even getting a pass for a weak first quarter. But there's ample reason to believe this company's performance will be off the mark for some time to come.

On May 15, Target announced that first-quarter profit rose 12%, just shy of estimates. More important, selling, general and administrative (SG&A) expenses were higher than expected, and cut gross margins by 18 basis points to 32.1%. Shares declined 8% on the news and at a recent $48.68 they're trading about 20% off their 52-week high of $60, set back in July.

To make matters worse, Wal-Mart posted better-than-expected first-quarter results one day later. The company attributed its strong quarter to reduced costs, better sales and improved inventory management. Analysts at Bear Stearns and J.P. Morgan, while acknowledging the poor showing, reiterated their ratings and remain optimistic on the stock, but the report indicates to me that Target's poor performance was company-specific, not industry-specific.

Looking into the numbers, Target attributed its bad quarter to unfavorable cost leverage in both payroll and utility expenses, and the timing of start-up costs. The timing of start-up costs may be a one-time event, but higher expenses related to employment and energy prices are not.

Energy prices have been in a steady uptrend over the past five years. Today, crude oil is trading at $72 a barrel, or 250% higher than January 2002 when it was at $20 a barrel. The economy has grown along with wages during this time, and retailers, along with other businesses, have been able to pass these costs on to the consumer.

But today, with short-term interest rates rising and gasoline prices at record levels, these costs are bound to cut into consumers' wallets, and thus into Target's profits. Evidence of this could be found in Wal-Mart's same-stores sales for May, announced Tuesday, that were at the low end of estimates.

This number should come as no surprise because Wal-Mart said on its May 17 conference call that its results could be hurt by factors outside of its control, such as higher gasoline prices and rising interest costs.

Competition could also begin to weigh on Target's shares here. Wal-Mart recently announced that it will remodel 1,800 stores to focus on higher-paying consumers, a demographic that Target is known for attracting. This will be a primary concern for Target, which offers more upscale apparel through exclusive brands at premium prices. Furthermore, the company is facing tough comps over the next two quarters.

The company is trading at 15 times 2007 estimates, below the 19 times forward estimates the stock has averaged over the past five years. Although valuations appear cheap at the current level, these three risks could weigh on shares in the short term.

Should you invest in Target at these levels? I wouldn't.

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