Target (TGT) Lowers 2016 Guidance. What About the Dividend?

Target (TGT) reported disappointing second-quarter earnings results this morning, sending the stock down more than 5%.

The company lowered its full-year guidance and, like many other brick-and-mortar retailers, remains challenged as it tries to navigate the evolving consumer landscape.

With Warren Buffett recently reducing his stake in Wal-Mart by nearly 30%, many dividend investors are wondering if Target offers value or is a trap.

As the company struggles to generate sustainable growth, the health of its dividend is worth revisiting as well.

Let’s take a closer look at Target’s earnings results and whether or not the stock is attractive for conservative income investors.

Investors interested in a deep-dive on Target’s business can review my earlier thesis here.

Target’s Second Quarter Results & Outlook

Target’s comparable sales declined 1.1% (down from 1.2% growth last quarter), and adjusted earnings per share were close to flat compared to the prior-year quarter.

Digital sales grew 16% year-over-year and contributed 0.5% to comparable sales growth. However, Target’s pace of e-commerce growth continues decelerating and was down from 23% growth last quarter.

Considering the company’s small mix of e-commerce sales (3.3% of total revenue), Target will need more than double-digit digital growth to get back on track.

As seen below, Target’s decline in comparable sales was its first since 2014 and continues the decelerating trend that started in late 2015:

Source: Bloomberg

The company is preparing for a “challenging” back half of the year and lowered its full-year adjusted earnings guidance by approximately 6% to $4.80 to $5.20 per share.

It’s hard to say what is impacting Target the most – weather, volatile consumer spending habits, rising e-commerce competition, the transition of its in-store pharmacies to CVS, or even the infamous bathroom boycott that gained momentum earlier this year.

Misery loves company, and Target certainly isn’t the only consumer-focused retailer reporting challenges. Macy’s, Nordstrom, and Wal-Mart are among other retailers reporting sluggish business results this year.

If I had to guess, retailers’ current pain is death by a thousand cuts. For one thing, consumers are spending more on experiences instead of stuff.

Most notably, however, consumers are increasingly buying more of the products they need online rather than visiting traditional brick-and-mortar retailers to meet their needs.

Department store sales are down 3.9% year-to-date while retail e-commerce sales are growing at a double-digit clip.

Earlier this year, Target noted that less shopping is happening in its stores for smaller purchases, which are likely more susceptible to competition from giants such as Amazon which can deliver same-day shipping in some cases.

E-commerce is fundamentally changing the way consumers shop, and there is little mass merchandise retailers and department stores can do to quickly adapt. However, they have to try.

Target is investing heavily in its Signature merchandise categories (home decor, apparel, baby, kids, wellness), which are growing faster than the company average.

Management is aggressively taking cost out of the business as well (on pace to exceed goal to save $2 billion over the two-year period ending in 2016).

What does all of this mean for Target’s dividend, especially if growth remains stagnant? Is the dividend still safe and able to grow?

Dividend Safety Analysis: Target

The good news for conservative income investors is that Target’s dividend payment remains very secure.

To assess the safety of a company’s dividend, I look at factors such as current and historical EPS and free cash flow payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more. Target’s most important dividend and fundamental data can be seen by clicking here.

These metrics are all analyzed to generate a Dividend Safety Score. A score of 50 is average, 75 or higher is considered excellent, and 25 or lower is considered weak.

Most companies that end up cutting their dividends score below 25 prior to announcing their dividend reduction.

Kinder Morgan, Potash, BHP Billiton, and ConocoPhillips all scored below 20 for Dividend Safety before announcing their dividend cuts.

Target’s Dividend Safety Score sits above 90, indicating that the business still pays one of the safest dividends in the market.

Management even raised the company’s dividend by 7.1% in early June. 2016 will mark Target’s 45th consecutive year of dividend increases and continues the company’s streak of uninterrupted dividends since the business became publicly held in October 1967.

Dividend growth has been exceptional. Target’s dividend has increased by 14.3% per year over the last 20 years and by 20.8% annually over the last five years.

Very few companies have paid dividends as reliably as Target, and that won’t change anytime soon. Despite sluggish earnings, Target maintains healthy payout ratios.

Target reported adjusted earnings of $1.23 per share during the quarter, more than double the 60 cents per share dividend paid. Based on the company’s lower full-year earnings per share guidance of $4.80 to $5.20, the company’s forward-looking EPS payout ratio sits at a reasonable 48%.

While Target’s dividend payout ratio has expanded over the last decade it still remains at a healthy level, especially considering the company’s stability (sales grew each year during the financial crisis).

Source: Simply Safe Dividends

Dividend safety is further boosted by Target’s excellent free cash flow, which is needed to pay and grow dividends on a sustainable basis.

Year-to-date, Target has generated over $800 million of free cash flow compared to $666 million of dividends paid. As new store capex continues to decline and Target’s cost savings initiatives flow through, cash flow can head even higher – just like it has over the last decade:

Source: Simply Safe Dividends

The company’s balance sheet also remains in good shape. Target ended the quarter with $1.5 billion in cash on hand and maintains an investment grade credit rating.

Simply put, Target’s dividend remains extremely safe thanks to the company’s healthy payout ratios, stable business model, excellent free cash flow generation, reasonable balance sheet, and proven commitment to paying higher dividends over time.

Closing Thoughts on Target

While some of Target’s weakness is likely due to the cyclical nature of consumer spending, real change is happening in the retail sector that shouldn’t be ignored.

Personally, I avoid virtually all consumer retail companies except for a select few (including TJX Companies, which is owned in our Long-term Dividend Growth portfolio).

The pace of change is simply too fast (consumers are very fickle), and I certainly cannot predict tomorrow’s winners.

The rapid ascent of e-commerce is also structurally changing consumers’ shopping habits (in my view), presenting more challenges than opportunities for many brick-and-mortar businesses – including Target and Wal-Mart – as it becomes harder to differentiate from the pack and provide value.

While this dynamic could change going forward, it is enough to keep me out of these businesses for the time being, if not forever. I prefer to invest in time-tested, high quality businesses that have numerous opportunities for moderate long-term earnings growth.

While these businesses have certainly proven to be durable, it’s hard to make a case that the U.S. needs more Targets and Wal-Marts. Until greater traction can be demonstrated on the e-commerce side of things, I view both of these companies as mature (but gradually decaying / stagnating) cash cows that will continue paying safe dividends for many years to come.

There’s no shame in harvesting safe dividend income from these businesses, but I wouldn’t expect the last decade of growth to repeat itself over the next 10 years. Company valuations are beginning to reflect this new reality.

TGT’s stock trades at just 14.1x forward earnings guidance and offers a dividend yield of 3.4%, which is higher than the stock’s five-year average dividend yield of 2.4%.

The stock’s relatively low valuation appears to recognize that Target is a company that is treading water at best and gradually shrinking at worst (for comparison’s sake, Wal-Mart trades at about 17x forward earnings).

No one can accurately forecast the future or know where Target’s stock could trend over the next 12 months. However, as a buy-and-hold investor, I see enough warning signs in brick-and-mortar retail to keep my capital positioned in other safe high dividend stocks that offer greater long-term potential for earnings and dividend growth.