Target corporation capital budgeting case study solution

UV1057 Rev. Mar. 22, 2016

This case was prepared by David Ding (MBA ’08) and Saul Yeaton (MBA ’08) under the supervision of Kenneth Eades, Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

Target Corporation

On November 14, 2006, Doug Scovanner, CFO of Target Corporation, was preparing for the November meeting of the Capital Expenditure Committee (CEC). Scovanner was one of five executive officers who were members of the CEC (Exhibit 1). On tap for the 8:00 a.m. meeting the next morning were 10 projects representing nearly $300 million in capital-expenditure requests. With the fiscal year’s end approaching in January, there was a need to determine which projects best fit Target’s future store growth and capital- expenditure plans, with the knowledge that those plans would be shared early in 2007, with both the board and investment community. In reviewing the 10 projects coming before the committee, it was clear to Scovanner that five of the projects, representing about $200 million in requested capital, would demand the greater part of the committee’s attention and discussion time during the meeting.

The CEC was keenly aware that Target had been a strong performing company in part because of its successful investment decisions and continued growth. Moreover, Target management was committed to continuing the company’s growth strategy of opening approximately 100 new stores a year. Each investment decision would have long-term implications for Target: an underperforming store would be a drag on earnings and difficult to turn around without significant investments of time and money, whereas a top- performing store would add value both financially and strategically for years to come.

Retail Industry

The retail industry included a myriad of different companies offering similar product lines (Exhibit 2). For example, Sears and JCPenney had extensive networks of stores that offered a broad line of products, many of which were similar to Target’s product lines. Because each retailer had a different strategy and a different customer base, truly comparable stores were difficult to identify. Many investment analysts, however, focused on Wal-Mart and Costco as important competitors for Target, although for different reasons. Wal-Mart operated store formats similar to Target, and most Target stores operated in trade areas where one or more Wal-Mart stores were located. Wal-Mart and Target also carried merchandising assortments, which overlapped on many of the same items in such areas as food, commodities, electronics, toys, and sporting goods.

Costco, on the other hand, attracted a customer base that overlapped closely with Target’s core customers, but there was less often overlap between Costco and Target with respect to trade area and merchandising assortment. Costco also differed from Target in that it used a membership-fee format.1 Most of the sales of these companies were in the broad categories of general merchandise and food. General

1 Sam’s Club, which was owned by Wal-Mart, also employed a membership-fee format and represented 13% of Wal-Mart revenues.

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merchandise included electronics, entertainment, sporting goods, toys, apparel, accessories, home furnishing, and décor, and food items included consumables ranging from apples to zucchini.

Wal-Mart had become the dominant player in the industry with operations located in the United States, Argentina, Brazil, Canada, Puerto Rico, the United Kingdom, Central America, Japan, and Mexico. Much of Wal-Mart’s success was attributed to its “everyday low price” pricing strategy that was greeted with delight by consumers but created severe challenges for local independent retailers who needed to remain competitive. Wal-Mart sales had reached $309 billion for 2005 for 6,141 stores and a market capitalization of $200 billion, compared with sales of $178 billion and 4,189 stores in 2000. In addition to growing its top line, Wal-Mart had been successful in creating efficiency within the company and branching into product lines that offered higher margins than many of its commodity type of products.

Costco provided discount pricing for its members in exchange for membership fees. For fiscal 2005, these fees comprised 2.0% of total revenue and 72.8% of operating income. Membership fees were such an important factor to Costco that an equity analyst had coined a new price-to-membership-fee-income ratio metric for valuing the company.2 By 2005, Costco’s sales had grown to $52.9 billion across its 433 warehouses, and its market capitalization had reached $21.8 billion. Over the previous five years, sales excluding membership fees had experienced compound growth of 10.4%, while membership fees had grown 14.6% making the fees a significant growth source and highly significant to operating income in a low-profit- margin business.

In order to attract shoppers, retailers tailored their product offerings, pricing, and branding to specific customer segments. Segmentation of the customer population had led to a variety of different strategies, ranging from price competition in Wal-Mart stores to Target’s strategy of appealing to style-conscious consumers by offering unique assortments of home and apparel items, while also pricing competitively with Wal-Mart on items common to both stores. The intensity of competition among retailers had resulted in razor-thin margins making every line item on the income statement an important consideration for all retailers.

The effects of tight margins were felt throughout the supply chain as retailers constantly pressured their suppliers to accept lower prices. In addition, retailers used off-shore sources as low-cost substitutes for their products and implemented methods such as just-in-time inventory management, low-cost distribution networks, and high sales per square foot to achieve operational efficiency. Retailers had found that profit margins could also be enhanced by selling their own brands, or products with exclusive labels that could be marketed to attract the more affluent customers in search of a unique shopping experience.

Sales growth for retail companies stemmed from two main sources: creation of new stores and organic growth through existing stores. New stores were expensive to build, but were needed to access new markets and tap into a new pool of consumers that could potentially represent high profit potential depending upon the competitive landscape. Increasing the sales of existing stores was also an important source of growth and value. If an existing store was operating profitably, it could be considered for renovation or upgrading in order to increase sales volume. Or, if a store was not profitable, management would consider it a candidate for closure.

Target Corporation

The Dayton Company opened the doors of the first Target store in 1962, in Roseville, Minnesota. The Target name had intentionally been chosen to differentiate the new discount retailer from the Dayton

2 “Costco Wholesale Corp. Initiation Report,” Wachovia Capital Markets, September 18, 2006.

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Company’s more upscale stores. The Target concept flourished. In 1995, the first SuperTarget store opened in Omaha, Nebraska, and in 1999, the Target.com website was launched. By 2000, the parent company, Dayton Hudson, officially changed its name to Target Corporation.3

By 2005, Target had become a major retailing powerhouse with $52.6 billion in revenues from 1,397 stores in 47 states (Exhibit 3 and Exhibit 4). With sales of $30 billion in 2000, the company had realized a 12.1% sales growth over the past five years and had announced plans to continue its growth by opening approximately 100 stores per year in the United States in the foreseeable future. While Target Corporation had never committed to expanding internationally, analysts had been speculating that domestic growth alone would not be enough to sustain its historic success. If Target continued its domestic growth strategy, most analysts expected capital expenditures would continue at a level of 6% to 7% of revenues, which equated to about $3.5 billion for fiscal year 2006.

In contrast with Wal-Mart’s focus on low prices, Target’s strategy was to consider the customer’s shopping experience as a whole. Target referred to its customers as guests and consistently strived to support the slogan, “Expect more. Pay less.” Target focused on creating a shopping experience that appealed to the profile of its “core guest”: a college-educated woman with children at home who was more affluent than the typical Wal-Mart customer. This shopping experience was created by emphasizing a store décor that gave just the right shopping ambience. The company had been highly successful at promoting its brand awareness with large advertising campaigns; its advertising expenses for fiscal 2005 were $1.0 billion or about 2.0% of sales and 26.6% of operating profit. In comparison, Wal-Mart’s advertising dollars amounted to 0.5% of sales and 9.2% of operating income. Consistent advertising spending resulted in the Target bull’s-eye logo’s (Exhibit 5) being ranked among the most recognized corporate logos in the United States, ahead of the Nike “swoosh.”

As an additional enhancement to the customer shopping experience, Target offered credit to qualified customers through its REDcards: Target Visa Credit Card and Target Credit Card. The credit-card business accounted for 14.9% of Target’s operating earnings and was designed to be integrated with the company’s overall strategy by focusing only on customers who visited Target stores.

Capital-Expenditure Approval Process

The Capital Expenditure Committee was composed of a team of top executives that met monthly to review all capital project requests (CPRs) in excess of $100,000. CPRs were either approved by the CEC, or in the case of projects larger than $50 million, required approval from the board of directors. Project proposals varied widely and included remodeling, relocating, rebuilding, and closing an existing store to building a new store.4 A typical CEC meeting involved the review of 10 to 15 CPRs. All of the proposals were considered economically attractive, as any CPRs with questionable economics were normally rejected at the lower levels of review. In the rare instance when a project with a negative net present value (NPV) reached the CEC, the committee was asked to consider the project in light of its strategic importance to the company.

CEC meetings lasted several hours as each of the projects received careful scrutiny by the committee members. The process purposefully was designed to be rigorous because the CEC recognized that capital investment could have significant impact on the short-term and long-term profitability of the company. In addition to the large amount of capital at stake, approvals and denials also had the potential to set precedents that would affect future decisions. For example, the committee might choose to reject a remodeling proposal

3 The Dayton Company merged with J. L. Hudson Company in 1969. After changing its name to Target, the company renamed the Dayton-

Hudson stores as Marshall Field’s. In 2004, Marshall Field’s was sold to May Department Stores, which was acquired by Federated Department Stores in 2006; all May stores were given the Macy’s name that same year.

4 Target expected to allocate 65% of capital expenditures to new stores, 12% to remodels and expansions, and 23% to information technology, distribution, etc.

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for a store with a positive NPV, if the investment amount requested was much higher than normal and therefore might create a troublesome precedent for all subsequent remodel requests for similar stores. Despite how much the projects differed, the committee was normally able to reach a consensus decision for the vast majority of them. Occasionally however, a project led to such a high degree of disagreement within the committee that the CEO made the final call.

Projects typically required 12 to 24 months of development prior to being forwarded to the CEC for consideration. In the case of new store proposals, which represented the majority of the CPRs, a real-estate manager assigned to that geographic region was responsible for the proposal from inception to completion and also for reviewing and presenting the proposal details. The pre-CPR work required a certain amount of expenditures that were not recoverable if the project were ultimately rejected by CEC. More important than these expenditures, however, were the “emotional sunk costs” for the real-estate managers who believed strongly in the merits of their proposals and felt significant disappointment if any project was not approved.

The committee considered several factors in determining whether to accept or reject a project. An overarching objective was to meet the corporate goal of adding about 100 stores a year while maintaining a positive brand image. Projects also needed to meet a variety of financial objectives, starting with providing a suitable financial return as measured by discounted cash-flow metrics: NPV and IRR (internal rate of return). Other financial considerations included projected profit and earnings per share impacts, total investment size, impact on sales of other nearby Target stores, and sensitivity of NPV and IRR to sales variations. Projected sales were determined based on economic trends and demographic shifts but also considered the risks involved with the entrance of new competitors and competition from online retailers. And lastly, the committee attempted to keep the project approvals within the capital budget for the year. If projects were approved in excess of the budgeted amount, Target would likely need to borrow money to fund the shortfall. Adding debt unexpectedly to the balance sheet could raise questions from equity analysts as to the increased risk to the shareholders as well as to the ability of management to accurately project the company’s funding needs.

Other considerations included tax and real-estate incentives provided by local communities as well as area demographics. Target typically purchased the properties where it built stores, although leasing was considered on occasion. Population growth and affluent communities were attractive to Target, but these factors also invited competition from other retailers. In some cases, new Target stores were strategically located to block other retailers despite marginal short-term returns.

When deciding whether to open a new store, the CEC was often asked to consider alternative store formats. For example, the most widely used format was the 2004 version of a Target store prototype called P04, which occupied 125,000 square feet, whereas a SuperTarget format occupied an additional 50,000 square feet to accommodate a full grocery assortment. The desirability of one format over another often centered on whether a store was expected to eventually be upgraded. Smaller stores often offered a higher NPV; but the NPV estimate did not consider the effect of future upgrades or expansions that would be required if the surrounding communities grew, nor the advantage of opening a larger store in an area where it could serve the purpose of blocking competitors from opening stores nearby.

The committee members were provided with a capital-project request “dashboard” for each project that summarized the critical inputs and assumptions used for the NPV and IRR calculations. The template represented the summary sheet for an elaborate discounted cash flow model. For example, the analysis of a new store included incremental cash flow projections for 60 years over which time the model included a remodeling of the store every 10 years. Exhibit 6 provides an example of a dashboard with a detailed explanation of the “Store Sensitivities” section. The example dashboard shows that incremental sales estimates, which were computed as the total sales expected for the new store less the sales cannibalized from Target stores already located in the general vicinity. Sales estimates were made by the Research and Planning

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group. The R&P group used demographic and other data to make site-specific forecasts. Incremental sales were computed as total sales less those cannibalized from other Target stores. The resulting NPV and IRR metrics were divided between value created by store sales and credit-card activity. NPV calculations used a 9.0% discount rate for cash flows related to the store cash flows and a 4.0% discount rate for credit-card cash flows. The different discount rates were chosen to represent the different costs of capital for funding store operations versus funding credit-card receivables.

The dashboards also presented a variety of demographic information, investment-cost details and sensitivity analyses. An important sensitivity feature was the comparison of the project’s NPV and IRR to the prototype. For example, the P04 store had an NPV of about $10 million and an IRR of 13%.5 The sensitivity calculations answered the question of how much a certain cost or revenue item needed to change in order for the project to achieve the same NPV or IRR that would be experienced for the typical P04 or SuperTarget store.

The November Meeting

Of the 10 projects under consideration for the November CEC meeting, Doug Scovanner recognized that five would be easily accepted, but that the remaining five CPRs were likely to be difficult choices for the committee. These projects included four new store openings (Gopher Place, Whalen Court, The Barn, and Goldie’s Square) and one remodeling of an existing store into a SuperTarget format (Stadium Remodel). Exhibit 7 contains a summary of the five projects, and Exhibit 8 contains the CPR dashboards for the individual projects.

As was normally the case, all five of the CPRs had positive NPVs, but Scovanner wondered if the projected NPVs were high enough to justify the required investment. Further, with stiff competition from other large retailers looking to get footholds in major growth areas, how much consideration should be given to short-term versus long-term sales opportunities? For example, Whalen Court represented a massive investment with relatively uncertain sales returns. Should Scovanner take the stance that the CEC should worry less about Whalen Court’s uncertain sales and focus more on the project as a means to increase Target’s brand awareness in an area with dense foot traffic and high-fashion appeal? Goldie’s Square represented a more typical investment level of $24 million for a SuperTarget. The NPV, however, was small at $317,000, well below the expected NPV of a SuperTarget prototype, and would be negative without the value contribution of credit-card sales.

As CFO, Scovanner was also aware that Target shareholders had experienced a lackluster year in 2006, given that Target’s stock price had remained essentially flat (Exhibit 9). Stock analysts were generally pleased with Target’s stated growth policy and were looking for decisions from management regarding investments that were consistent with the company maintaining its growth trajectory. In that regard, Scovanner recognized that each of the projects represented a growth opportunity for Target. The question, however, was whether capital was better spent on one project or another to create the most value and the most growth for Target shareholders. Thus Scovanner believed that he needed to rank the five projects in order to be able to recommend which ones to keep and which ones to reject during the CEC meeting the next day.

5 These NPV and IRR figures exclude the impact of the credit card.

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Exhibit 1

Target Corporation

Executive Officers and Capital Expenditure Committee Members

Timothy R. Baer Executive Vice President, General Counsel, and Corporate Secretary Michael R. Francis Executive Vice President, Marketing John D. Griffith Executive Vice President, Property Development CEC Jodeen A. Kozlak Executive Vice President, Human Resources Troy H. Risch Executive Vice President, Stores CEC Janet M. Schalk Executive Vice President, Technology Services and Chief Information Officer Douglas A. Scovanner Executive Vice President and Chief Financial Officer CEC Terrence J. Scully President, Target Financial Services Gregg W. Steinhafel President CEC Robert J. Ulrich Chairman and Chief Executive Officer CEC

Chairman and CEO Bob Ulrich, 62. Ulrich began his career at Dayton-Hudson as a merchandising trainee in 1967. He advanced to the position of CEO of Target Stores in 1987 and to the position of Dayton-Hudson’s CEO in 1994.

EVP and CFO Doug Scovanner, 49. Scovanner was named Target CFO in February 2000 after previously serving as CFO of Dayton-Hudson.