Target (TGT) Tumbles 12%: What Dividend Investors Need to Know

What Happened?

Target (TGT) reported disappointing fourth quarter earnings results this morning, sending the stock down more than 12%.

Target’s dividend yield now exceeds 4%, well above its five-year average yield of 2.6% and making it one of the highest-yielding dividend aristocrats.

Comparable sales declined 1.5% during the quarter, which was at the low end of management’s previous guidance.

Adjusted earnings per share fell by 4.6% compared to the prior-year quarter, driven by increased promotional activity and changing consumer preferences.

While Target’s quarterly results were disappointing, management’s 2017 guidance is what caused the stock to drop by more than 10%.

Target expects a low-single digit decline in comparable sales and forecasts adjusted earnings per share to drop by roughly 20% in 2017.

The company’s brick-and-mortar operations are under pressure from “rapidly-changing consumer behavior” (i.e. the continued rise of e-commerce), an increasing price war (Wal-Mart (WMT) recently announced it will be lowering prices across a number of product categories), and the bathroom boycott.

In response, Target says it is transitioning to a new financial model and making large investments into its business to try and remain competitive.

Lowering prices is part of the strategy, which isn’t going to help near-term results and doesn’t do much to raise investors’ confidence in the struggling retailer.

Here’s what Target’s CEO Brian Cornell said:

“Our fourth quarter results reflect the impact of rapidly-changing consumer behavior, which drove very strong digital growth but unexpected softness in our stores. At our meeting with the financial community this morning, we will provide detail on the meaningful investments we’re making in our business and financial model which will position Target for long-term, sustainable growth in this new era in retail. We will accelerate our investments in a smart network of physical and digital assets as well as our exclusive and differentiated assortment, including the launch of more than 12 new brands, representing more than $10 billion of our sales, over the next two years. In addition, we will invest in lower gross margins to ensure we are clearly and competitively priced every day. While the transition to this new model will present headwinds to our sales and profit performance in the short term, we are confident that these changes will best-position Target for continued success over the long term.”

Essentially, Target’s report raised more questions about the company’s ability to achieve long-term earnings growth, a concern I have had since my initial thesis on the company in December 2015.

Is Target’s Dividend Still Safe?

Simply put, yes, Target’s dividend remains safe despite the company’s recent struggles. I expect Target’s Dividend Safety Score to fall after its latest results are accounted for but to remain in the “Safe” zone.

Target’s payout ratio was 48% in 2016, and management’s earnings guidance range for 2017 implies a payout ratio between 57% and 63% – far from a dangerous level.

The company will eventually need to stabilize earnings, but management has flexibility to continue reinvesting in the company’s long-term future while maintaining the current dividend.

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 (plus the value of its real estate) buys Target some time as it navigates the evolving retail world.

Target has paid uninterrupted dividends since it went public in late 1967, and I don’t expect that streak to end anytime soon.

With that said, income investors should brace for much lower dividend growth this year.

I don’t think Target’s 7.1% dividend hike in 2016 will be repeated, especially as management steps up long-term investments in the business.

However, just because a company’s dividend remains safe doesn’t mean a stock is a quality long-term holding for effective dividend investors.

Should Long-term Dividend Growth Investors Worry?

There is a reason why I have chosen to avoid investing in almost all of the retail sector – the rapidly-changing consumer landscape is just too hard to get in front of.

The market seems like it has overreacted to Target’s latest report, but I think it is fair to question the company’s ability to achieve profitable long-term growth – especially after Target had already lowered guidance just over a month ago.

Digital is a key growth driver long-term investors must believe in. Target’s digital sales grew 34% in the fourth quarter, contributing 1.8% of comparable sales growth. Without digital, Target’s comparable sales would have been down more than 3%.

Management is stepping up investment in this critical area, but it’s far too early to know what, if any, return Target’s digital operations will be able to earn over the coming years.

I remain skeptical about the long-term profitability of Target’s brick-and-mortar stores and its digital operations, which is enough for me to keep the stock out of our Conservative Retirees dividend portfolio.

Target’s stock now trades at a forward P/E multiple of 14.6 based on the midpoint of management’s 2017 earnings guidance. At a glance, the stock looks “cheap.”

Target’s high dividend yield likely serves as a buoy for the stock as well, but if Target’s decline in earnings fails to reverse course over the next few years and/or industry price pressure intensifies, there is likely further downside ahead.

While it’s hard to find a safe 4%+ yield in today’s market, especially one that is easy to understand and that trades at a meaningful discount to the broader market, Target’s dividend comes with a number of strings attached.

I won’t invest in a company if I don’t believe it can be larger and more profitable 5-10 years from now, so I will remain on the sidelines with Target.

The company’s stores are not at risk of extinction anytime soon, but the bleeding in brick-and-mortar retail isn’t showing any signs of slowing down, and it’s hard to have much faith in Target’s management.