Friday, March 17, 2017

Target: An Attractively Valued Dividend Champion on Sale

Target Corporation (NYSE:TGT) operates general merchandise stores in the United States and Canada. Target is a dividend champion, which has paid dividends since 1965 and raised them every year for 49 years in a row.

The most recent dividend increase was in June 2016, when the Board of Directors approved a 7.10% increase in the quarterly dividend to 60 cents/share.

The company's largest competitors include Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST) and Amazon (NASDAQ:AMZN).

Over the past decade this dividend growth stock has delivered an annualized total return of 1.60% to its shareholders. Future returns will be dependent on growth in earnings and dividend yields obtained by shareholders. More recently, the stock price has been hammered by a decline in earnings expectations. This is why I wanted to take another look at Target.

The company has managed to deliver a 3.60% average increase in annual EPS over the past decade. Target is expected to earn $4.01 per share in 2018 and $5.80 per share in 2019. In comparison, the company earned $4.09/share for fiscal year 2017.

Between 2005 and 2016, the number of shares outstanding has decreased from 912 million to 582.5 million. The decrease in shares outstanding through consistent share buybacks adds an extra growth kick to earnings per share over time. I do not like the fact that the net income between 2007 and 2017 decreased from $2.787 billion to $2.669 billion.

Target focuses on affluent consumers with its upscale stores. Its customer base is somewhat different than that of competitor Wal-Mart. Many of Target's customers enjoy shopping there, and are attracted by the appeal of offerings and overall atmosphere within the stores. Target's stores are generally more appealing than those of Wal-Mart, and are cleaner. In addition, Target manages to retain shoppers with its RedCard. Shoppers who use the Target Card get a discount, but also tend to spend more than the average purchaser. In addition, the company has been able to drive more traffic with sales of grocery/food items.

What is the competitive advantage of Target? I believe that the company offers a unique shopping experience that competitors like Wal-Mart do not offer. I also believe that Target looks for a certain type of consumer, who does not like the assortment of goods and the experience that Wal-Mart provides, yet still wants to get a bargain. The company has been able to offer fashion chic items, which draw the specific type of shopper they target. The company also offers convenient locations for shoppers, who come to Target for its quality merchandise. I believe that shares could deliver a very good return to investors who are willing to weather near-term turbulence at the company.

Growth for Target could be driven by expansion of number of stores in the US, growth in same-store sales, as well as expanding online sales. The company is targeting cost cuts, in order to boost margins. I am more interested in increasing the number of stores, in order to increase penetration in the US. Relative to the number of Wal-Mart stores in the US, I still believe there could be areas of new store development for Target, as long as this is executed in a smart way of course. Unfortunately, the number of stores has gone nowhere since 2010.

Despite the issues that Target experienced with its Canadian expansion in 2013-2015, I think that the company may have an opportunity to expand internationally. This is a driver which could propel earnings per share forward for the next 20 years. It has to be executed better than the Canadian store fiasco however.

Another driver for future growth could be the CityTarget stores, which are smaller, but provide the option to locate in densely populated areas. Those stores could have better productivity due to higher potential traffic and higher inventory turnover because of that.

One risk that may or may not be overblown is the competition from the likes of When you have a competitor that sells at cost, bundles their sales service with other complementary products for a portion of customers, and whose customers do not pay sales taxes in most states, you are at a disadvantage. That being said, it is highly unlikely that retailers like Target will be driven away from online competitors. I know that it is very fashionable to forecast the demise of the traditional brick and mortar retailer today. I do not subscribe to the popular opinion of the day. It is very likely that Target would keep expanding its online presence, and offer something to consumers a service which Amazon does not offer today - the online to store shipment method. I also believe that not everything is worth purchasing online, nor are online sales a good venue to do convenience shopping. When a customer gets to a store for one thing at a physical location, they are very likely to buy something else on their journey throughout the store. It makes sense to purchase items right away, rather than wait for days or weeks for them to arrive. Some items are much better to personally try and touch, rather than have someone else deliver them for you. The value of repeatability and those customers who do their weekly/monthly visits to the Target stores is very powerful force for Target as well. That being said, Target is working on expanding its online presence, which would actually be good for the business overall. However, it may result in near term pressure on margins and profits. So just because Target has a higher amount of online sales growth, and invests billions to accomplish that, there is no guarantee that this investment will pay off. In fact, this investment in the online sales channel will depress margins and profits in the near term.

The annual dividend payment has increased by 20.50% per year over the past decade, which is much higher than the growth in EPS. This was achieved mainly because the company decided to pay a higher portion of earnings to shareholders in the form of dividends. Future growth in dividends will be much lower than that however, and will be limited by the growth in earnings per share in the future. Given the lack of earnings growth over the past decade, and competitive pressures in the retail industry, I would expect a sluggish dividend growth going forward.

A 20% growth in distributions translates into the dividend payment doubling every three and a half years on average. If we check the dividend history, going as far back as 1986, we could see that Target has managed to double dividends almost every six years on average.

In the past decade, the dividend payout ratio has increased from 13.20% in 2008 to 50.70% by 2016. The quadrupling in the dividend payout ratio explains the rapid growth in dividends per share. I believe that long-term growth in earnings per share will determine future dividend growth. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

The return on equity has generally remained between 15% and 19% over the past decade, with the exception of the drop in 2014 when Canadian operations were losing money. Once Target earnings rebounded by 2016, this indicator went up to 24%. I generally like seeing a high return on equity, which is also relatively stable over time.

Currently, Target is cheap at 13.70 times forward earnings and yields 4.30%. I took advantage of the drop last week in order to add a little to my position in this retailer. I believe that the press release didn’t seem to warrant such a large decline in the share price. This was definitely driven by the animal spirits of fear, which is something I want to take advantage of. On the other hand, it is possible that the stock price goes down from here. This is why I try to buy a little on the way down, in order to reduce the impact of errors in case I am wrong in my assessment. As an investor, my goal is to reduce the impact of errors in trying to catch a falling knife. This is how I managed to accumulate a position in 2014, when the company was rocked by scandals.

I grew concerned that Target's net income was flat, which is why I sold a large portion of my stock in 2015 and another block last summer. Given the lack of earnings growth, the only reason to buy is as a play on the market overreaction to bad news. Otherwise, I view Target as a long-term hold. Without growth in earnings per share, we won’t be able to enjoy much in terms of dividend growth and growth in intrinsic value. That being said, even if earnings were flat for the next decade, a 4% yield and attractive valuation today may generate a return that would be comparable to that of the broader market during that time frame.

Full Disclosure: Long TGT and WMT

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