Target (TGT) is a popular holding across many dividend growth investors’ portfolios.
After all, few companies can match Target’s impressive track record.
With over 100 years of operating history, Target has proven to be one of the most durable companies in the world.
The company also holds the title of being a dividend aristocrat, rewarding shareholders with 49 consecutive years of payout raises. You can view analysis on all of the dividend aristocrats here.
Despite Target’s impressive history, the company has fallen on hard times recently. Once fourth quarter results are finalized, Target’s revenue will have declined year-over-year for five consecutive quarters.
Target’s stock has disappointed investors as well, trailing the S&P 500 by more than 20% over the last year.
After dropping by 8% since revising its guidance earlier this week, Target’s shares offer investors a yield above 3.7% and trade for less than 14 times 2016 earnings – a large discount to the broader market.
Let’s take a closer look at the issues impacting Target to determine if the stock might make sense for our Conservative Retirees dividend portfolio, which seeks to preserve capital and deliver a very safe, above average dividend yield.
Target’s Updated Fourth Quarter Guidance
Target announced disappointing traffic and sales trends in its stores for the fourth quarter, joining other brick-and-mortar retailers such as Macy’s (M) and Kohl’s (KSS) that reported similarly unsatisfactory holiday results.
Target expects same-store sales to be down 1.5% to 1% in the quarter and reduced fourth quarter earnings guidance by about 9%.
Despite recent weakness, Target still expects to generate non-GAAP earnings per share of about $5 in 2016, which would be an all-time high for the business.
Like most other value-tilted investors, I get excited when I come across a well-known business that has fallen on hard times.
Some of the best investment opportunities arise when quality dividend growth stocks go on sale for reasons that have nothing to do with the companies’ long-term earnings power.
Sure, an argument could be made that consumer spending is unpredictable and will one day come back for big box stores. However, I’m not so sure that the issues impacting Target are transitory in nature.
Rather than serving as a convenient, low-cost place to shop with almost every piece of merchandise you could ever need available, big box stores have become more of a hassle today, in my opinion.
Shopping online is just so much easier – it saves time, gives me access to every unique piece of merchandise under the sun, costs less in many cases, and makes for a convenient shopping experience from the comfort of my home (or on the go).
Brick-and-mortar retailers better have a darn good value proposition to continue drawing the masses to their stores, and traditional big boxes such as Target and Wal-Mart (WMT) are seeing their core value propositions erode.
Just take a look at the chart below, which shows the market share of total retail sales enjoyed by non-store retailers (white line) and department stores (blue line) since 1992.
Non-store retail sales (i.e. e-commerce players such as Amazon) surpassed department stores in the mid-2000s and haven’t looked back. Meanwhile, department stores have seen their share of total retail sales steadily decline from 9% in 1992 to less than 3% today.
Department store operators aren’t resting on their laurels (at least not anymore). They realize the potentially existential threat to their business from e-commerce and shifting consumer shopping preferences.
They are scrambling to catch up with Amazon and others, but e-commerce sales account for a relatively small portion of most of their businesses.
Omni-channel darlings Nordstrom and Macy’s have lost their luster with investors since the middle of 2015 as well. Take a look at their stock prices, which have been chopped in half.
E-commerce operations require substantial investments in distribution centers, technology, and more. The long-term profitability of these initiatives is largely up in the air, and the jury is still out if most of these brick-and-mortar firms can really nail the online shopping experience to be a preferred choice for digital shoppers.
Target’s mix of business is different than department stores (e.g. about 20% of Target’s revenue is from groceries), but it faces many of the same pressures.
The company’s digital sales grew 40% last quarter, but they aren’t (yet) helping Target’s bottom line. Here’s what Target’s CEO said:
“While we significantly outpaced the industry’s digital performance, the costs associated with the accelerated mix shift between our stores and digital channels and a highly promotional competitive environment had a negative impact on our fourth quarter margins and earnings per share.”
As seen below, there is really no need for additional big box stores in the U.S. Target’s new store growth has dried up, placing ever-increasing importance on its ability to profitably drive same-store sales higher. E-commerce initiatives need to be successful, but it’s going to take time and there are no guarantees.
Profitable growth in the mass merchandise industry is proving to be hard to come by thanks to a combination of market saturation (there is no need for more 130,000+ square-foot stores), rising labor costs, and intense competition from low-cost e-commerce businesses.
Target faces an additional headwind as well. Over 1.4 million people have signed a boycott over Target’s transgender bathroom policies. Many of these boycotters are females, Target’s core customer. Some of the company’s weak sales results has likely been caused by this issue. Winning back these customers will be very difficult, if not impossible.
If pressure on brick-and-mortar retailers intensifies and growth in Target’s digital operations is unable to offset the weakness, what will happen to Target’s dividend?
Impact on Target’s Dividend Safety & Growth
Declining fundamentals are typically bad news for a company’s dividend safety and growth profile. However, each case needs to be examined individually to draw any conclusions.
Despite the ongoing malaise in brick-and-mortar retail, Target’s dividend remains extremely safe with decent growth prospects for now.
Target’s Dividend Safety Score is 98, indicating that its dividend payment remains one of the safest in the market. Investors can learn more about how Dividend Safety Scores are calculated and view their real-time track record by clicking here.
Assuming Target delivers $5.00 in earnings per share this fiscal year as management expects, the company’s payout ratio for the year will be 48%.
While it’s true that Target’s payout ratio has meaningfully increased over the last decade (see below), its current level is very healthy.
Target’s business is also recession-resistant because consumers still need to purchase essentials such as groceries when times get tough. The company’s sales actually grew during the financial crisis, and Target’s earnings per share only dipped by 14% in 2009.
It seems very unlikely that Target’s business would experience a steep and sudden downturn that would push its payout ratio to dangerous levels (earnings would need to be cut in half to get Target to a 100% payout ratio).
Equally important, Target has taken steps to improve its cash flow generation going forward. The company is in the middle of a $2 billion cost improvement plan (a meaningful sum when compared to the $1.4 billion in dividends Target paid out last year) and, as we previously saw, has dialed back its spending on new store openings.
These two factors should help ensure that Target remains a cash cow for many years to come, even if same-store sales growth remains elusive. Free cash flow has grown over the last decade and should remain at a healthy level for the foreseeable future.
Target’s balance sheet also suggests its dividend will remain very safe even if growth challenges persist. As seen below, the company could cover its entire debt using cash on hand and just two years’ worth of earnings before interest and taxes (EBIT).
Target also maintains an “A” credit rating from S&P and has a $2.25 billion revolving credit facility it can tap, if needed. The company’s strong financial position buys Target some time as it navigates the evolving retail world.
Of course, one of the clearest signs of a safe dividend is a dividend increase. Target boosted its dividend by 7.1% in June 2016, extending its dividend growth streak to 49 years. The company has paid uninterrupted dividends since it went public in late 1967.
Future dividend growth will likely be in the mid-single digits, continuing the mild deceleration we have seen in Target’s dividend growth rate over the last two decades (see below).
The company’s accommodative payout ratio, excellent free cash flow generation, and sturdy balance sheet all support a dividend growth rate that should at least keep pace with the rate of inflation, protecting purchasing power.
To conclude, Target’s dividend remains very secure and still has room to moderately grow despite the disappointing performance of its stock over the last year.
The company’s earnings growth outlook remains challenged, but its store are not at risk of extinction any time soon because of the variety of essential merchandise items they sell.
Closing Thoughts on Target
It’s no new news that e-commerce is fundamentally changing how consumers shop. The real question is what role will big box stores have in 5-10 years from now?
In my view, mass merchandise stores will always be relevant for a number of consumers, but it’s hard for me to imagine that their slow bleeding and inability to find sources of profitable growth will cease any time soon.
I’m not sure where their demand floor is or if their digital investments will have success restoring profitable growth. The jury is still out and likely will be for at least several years, but I’m not optimistic about big boxes’ long-term earnings power.
My preference is to invest in easy-to-understand businesses that I believe will be larger, more profitable enterprises 10 years from now. Very few brick-and-mortar retailers seem to pass that test (the one retailer I do own is TJX Companies).
Target’s relatively high dividend yield remains very safe with at least average dividend growth potential, which could be attractive for conservative investors living off dividends in retirement.
The company is certainly still valuable thanks to its underlying real estate and superb free cash flow generation as well. However, what should investors be willing to pay for what could be a zero-growth business going forward?
Target’s stock trades for 13.2 times forward earnings estimates, and its 3.7% dividend yield sits well above its five-year average dividend yield of 2.6%. The company’s valuation looks pretty undemanding today, assuming earnings do not experience a quick decay from here.
Since a reasonably well diversified dividend portfolio doesn’t need more than 20-40 holdings, I don’t foresee myself ever scooping up shares of Target (or most other brick-and-mortar retailers) when there are other high-yielding stocks I feel more confident in for the long term.
However, I would give Target another look at a price below $60 (current price: $65), which would represent a dividend yield in excess of 4%.