Investment Thesis For Target

In my recent article quantitatively screening the Dividend Kings, based on my criteria I identified four stocks that are currently potentially interesting for Dividend Growth Investors. One of these was Target Corporation (TGT). The company is a relative newcomer as a Dividend King, having paid a growing dividend for 51 straight years. Importantly, it is the only general retailer that is a Dividend King. Even Walmart (WMT) has only paid a growing dividend for 46 years.

Target has a dividend yield over 3%, a P/E ratio (fwd) of 13.7, which is below the broader market average, a fairly conservative balance sheet, and a long history of growing dividends. Target has faced some recent difficulties. In 2017 the stock price was trading in the low $50s and the dividend yield was over 4%. The company’s top line and bottom lines are now rebounding as has the stock price. But having said that, Target is in a very competitive environment. I think that at the moment the company is making the right moves for opening new markets and for e-commerce, but margins are declining. I think that Target could be a suitable addition to some Dividend Growth Investor portfolios at the right price. However, the stock is fairly valued and there are better choices for investing in Dividend Kings at the moment.

Source: target.com

Overview of Target Corporation

Target is a leading general retailer in the U.S. The company operated 1,851 stores at end of Q1 2019. The company also operates the fourth most visited retail website in the U.S. with roughly 25 million unique visitors per month. About 93% of sales are from the physical stores and about 7% of sales are from the e-commerce channel. Target derives almost all of its revenue from the U.S. The company divested its operations in Canada in 2015.

Currently, the company has 272 stores of 170,000 sq. ft. or more, 1,501 stores of 50,000 to 169,999 sq. ft., and 272 stores of 170,000 sq. ft. or more. Interestingly, Target owns most of its stores. Target only slowly increases the store count and is focusing on expanding its small store size (49,000 sq. ft. or less) format. Notably, Target has a much lower store count than its main competitor Walmart and lacks the geographic scale of its larger competitor.

Target sells products across a broad range of categories as seen in the chart below. Target sells about 75,000 to 80,000 different SKUs in its stores. But the company derives much lower percentage of sales from groceries than Walmart does. The company’s stores generate only about $310 of sales per square foot, lower than Walmart’s $470 of sales per square foot. Target also has many private label brands and some exclusive brand deals.

Target Sales by Category

Target Sales By Category

Source: Target 2018 Annual Report

Target Is Expanding In Urban Areas and Growing Online Sales

Target is facing intense competition due to larger competitors in both the brick-and-mortar and online spaces. To date, it has not yet been a victim of the so-called retail apocalypse, but still the company is facing margin pressure as discussed below. Target faces larger competitors in Walmart and Amazon (AMZN). It also competes against Costco Wholesale Corporation (COST), a company with an enduring business model. Even dollar stores such as Dollar General Corporation (DG), which is rapidly growing across the country and is recession resistant, are competitors. Target has responded to changing retail landscape by renovating stores, opening smaller format stores in urban areas, and using its existing stores to fulfill online orders.

Importantly, Target is growing and expanding its store base. This is unlike many competitors that are reducing their store count in response to the rapidly changing retail landscape. Target is growing in urban areas by adding smaller stores. This is likely due to higher real estate costs. The company only opens a handful of stores per year. The company is slated to open 11 stores in 2019 and 26 stores in 2020. The majority of these will be in urban or more densely populated areas, such as New York City, Los Angeles, and Washington, DC, with the small store formats. Some stores will be in college towns with a college small store format. This strategy brings Target to markets where it previously had minimal presence. Furthermore, the strategy allows Target to expand its e-commerce fulfillment to urban areas. In addition, Target is remodeling roughly 300 stores per year.

Target’s online sales are growing rapidly. In Q1 2019, they grew 42% on year-over-years basis. This was on top of a 28% increase in the prior year. This rapid growth has caused the percentage of digital sales to increase to 7.1% at end of Q1 2019 from 5.2% at end of Q1 2018. Target is using its brick-and-mortar stores to fulfill online orders by offering same-day delivery, curbside pickup or order pickup. Target offers same-day delivery through its Shipt platform for an annual fee, which is essentially a service similar to that offered by Amazon Prime. Curbside pickup is available in some 1,250 stores and same-day delivery is now available in around 1,500 stores.

Target Online Order Fulfillment Strategy

Target E-Commerce Fulfillment Strategy

Source: target.com

Target’s strategy has some secondary benefits. Curbside pickup brings customers to the store who may buy more items once they are inside. In fact, same-store traffic grew 4.3%. Furthermore, Target is leveraging the existing store base, likely leading to increasing sales per square foot in the stores over time. It also avoids the cost of building and operating large distribution centers and the associated shipping costs. Target states that shipping from stores has over 40% lower unit cost and curbside pickup is 90% lower average unit cost. Target’s online strategy has been successful. The company’s online sales grew faster in Q1 2019 than Amazon’s and Walmart’s, albeit from a lower base. Amazon’s sales grew ~23% and Walmart’s online sales typically grow between 30% to 40% each quarter.

Target’s Margins Are Under Pressure

The rapidly changing retail landscape is pressuring gross, operating and net income margins of many retailers. Target is not an exception, as seen in the chart below. Gross profit margins were over 30% until 2013 when the dropped to the 29%-to-30% level. They have remained in that range ever since. Similarly, operating margins have declined from a range of 7% to 8% and are now generally between 5.5% and 7%. Importantly, the company’s net profit margin has been more consistent in the past 10 years, ranging from 3.8% to 4.6%.

Target’s Revenue and Profitability

Target

Source: Source: Dividend Power Calculations Based on Data from Morningstar.com

This slightly downward trend in margins is likely due to greater competition from both Walmart and Amazon. Notably, 2013 was about when Amazon and Walmart started to ramp up online grocery services. Since then competition in both the brick-and-mortar space and the e-commerce space has only gotten more intense. Looking forward, I believe that Target will continue to face margin pressure day to rising costs. Online sales fulfillment by same-day delivery and curbside pickup is costly. It requires a higher level of capital expenditures, and operational costs are higher. In addition, Target’s gross margins are declining due to lower pricing and promotions resulting from more competition. Another consideration is that retailer compensation costs are rising. The minimum wage was raised in many states in 2013 and 2014, increasing labor expenses. In addition, Target raised the minimum hourly wage to $11 in 2017 and it is slated to increase to $15 per hour in 2020. Due to the low unemployment rate, labor expense will likely continue to increase for the foreseeable future.

Is Target’s Dividend Safe

Target’s dividend is very safe from the perspective of both the payout ratio and free cash flow (FCF). The current payout ratio is a very conservative 43.7% based on an expected 2019 dividend of $2.60 per share and expected 2019 EPS of $5.95. Target’s payout ratio has historically been relatively low. But the company was raising the dividend at a double-digit rate until 2016 rapidly increasing the payout ratio. Since 2016, the payout ratio has decreased at low-single-digit rates. But forecasting a 6% EPS growth rate and 5% dividend growth rate out for the next several years the payout ratio will remain between 40% and 45%. This is a very conservative value and below my threshold criteria of 65%.

From the perspective of FCF, the dividend is also well covered. In 2018, Target’s operating cash flow was $5,973 million and capital expenditures were $3,516 million, giving FCF of $2,457 million. The dividend required $1,335 million, giving a dividend-to-FCF ratio of 54%. This is well below my threshold of 70%. Note that FCF has declined relative to the previous few years due to rising capital expenditures. This is likely to be the case for 2019 and 2020 as the company continues to remodel stores and invest in new small stores and digital initiatives. But, with that said, Target should still have sufficient FCF to pay the dividend.

Target’s balance sheet is also reasonably conservative and does not seem to present a risk to the dividend. The company has adequate liquidity with a current ratio of 0.88 and $1,173 million in cash and cash equivalents on hand. Additionally, interest coverage is high. Hence, Target can pay its obligations. The D/E ratio is about 1.02 and less than my threshold criteria of 2.0. Hence, long-term debt does not seem to place the dividend at risk. Importantly, long-term debt has been trending down from over $15 billion in 2009 to just over $11 billion in the most recent quarter.

Target Balance Sheet and Debt Metrics

Target Balance Sheet and Debt Metrics

Source: DP Research and Calculations Based on Data from Q1 2019 Earnings Release and Morningstar.com

Risks

As a general retailer Target is in a very competitive environment and faces risks to both top-line and bottom-line growth. Although Target seemingly has a successful brick-and-mortar strategy and online strategy at the moment a lot depends on execution. The company faces continuous competition for customers and sales with Walmart, Amazon, Costco, Dollar General, grocery stores and may other companies. Target does not have the scale of Walmart, the business model of Costco, or the small-town focus of Dollar General. Target also lacks the scale of some grocery stores. But on a positive note, low-margin groceries make up a lower percentage of sales compared with that of Walmart. Lastly, Target lacks the online heft and execution of Amazon.

Another risk is increasing labor expense pressuring not only margins as discussed above but also EPS growth. However, this risk is muted right now as Target is paying its hourly employees quite a bit more than the national minimum wage of $7.25 per hour. Target also faces risks in data breaches and resulting greater financial costs. Large retailers with databases of customers and credit card information have been victims in the past. In fact, Target experienced such as breach in 2013.

Target’s Valuation

Now let’s examine Target’s valuation. I use an expected 2019 adjusted EPS of $5.95, which is slightly higher than the midpoint of current company guidance. For P/E ratio I use 14.0, which is slightly lower than the company’s average 10-year valuation multiple of 14.5. I discount the multiple due to intense competition.

Applying a sensitivity analysis using P/E ratios between 13.0 and 15.0 I obtain a fair value range from $77.35 to $89.25. The current stock price is around 91% to 104% of my estimate of fair value. The current stock price is about $80.79, suggesting that the stock is essentially fairly valued.

Estimated Current Valuation Based On P/E Ratio

P/E Ratio

13.0

14.0

15.0

Estimated Value

$77.35

$83.30

$89.25

% of Estimated Value at Current Stock Price

104%

97%

91%

Source: Dividend Power Calculations

How does this compare with other valuation models? Let’s take a look at the Gordon Growth Model, using 2019’s expected dividend of $2.60. Assuming a dividend growth rate of 5.0% and a desired return of 8% gives a fair value of $86.67. Morningstar is known to use a fairly conservative discounted cash low model and provides a fair value of $76. An average of these three models is some $82 and thus we can comfortably say that Target is trading pretty much near its fair value at the current stock price. I personally would view a stock price below around $65 as good entry point. The stock has traded below this price as recently as early 2019. A slowdown in organic sales growth would likely pressure the stock price.

Final Thoughts On Target

Target is an iconic retailer with a national presence. The company has a well-known brand and loyal customers. Currently, the company is executing a seemingly successful strategy for both its physical stores and e-commerce. Additionally, the yield is above the broader-market average and is well covered. Debt is also decreasing over time. However, competition is intense, and margins are under pressure. Additionally, the stock is fairly valued at the current price. Hence, I view this stock as a hold.

(Tipranks: Hold TGT)

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Disclosure: I am/we are long DG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-08-07