Sunday, May 24, 2009

Your Target should be managing risk

There is a different way for Target shareholders to manage what they own. It's called risk management. It's not a matter of which board will be "better" for the firm. It's the board that will be in a better position to manage risk - which is clearly Ackman's (Pershing Square) guys - that will make a differences for the shareholders.

Here is why. As a Target shareholder you thought you bought a retailer. But you actually own a retailer, a commercial real estate firm, and thousands of credit card loans worth billions. Is that what you really want to own in your portfolio - some CMBS and ABS? The chart below tells the story of risk. Over the past 2 years Target shares traded between Wal-Mart and a REIT ETF (ticker: ICF - a portfolio of real estate trusts). The violent downside moves of Target shares followed the volatility of commercial real estate. Wal-Mart shares showed a much more subdued correlation to real estate, achieving a better risk adjusted return.

Not a surprise. Target owns 96% of it's real estate, while Wal-Mart owns 58%. It makes sense to shave off some 30% of Target's real estate into a separate REIT. If the current shareholders want to keep the firm "intact", they can hold both the shares of the "new" Target and the new REIT. It also make sense to actively manage the credit card portfolio. Risk management after all is about holding exposures you want and reducing/selling exposures you don't.

Taxes are another reason to spin off the real estate. Target's tax liabilities would decrease significantly as it starts paying rent to the REIT. That should improve cash flow and increase earnings. The REIT on the other hand would be exempt from income taxes as long as it distributes 90% of it's income as dividend.

The only way to make the current board understand these issues is to simply replace some of them. They are enTRANCHEd fat cats afraid to rock the boat. Target needs more of that activist investor stuff.

Pershing Square proposal to the shareholders:

For the updated story see Bloomberg

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