Target: Still In Second But Still Performing

May.16.13 | About: Target Corporation (TGT)

The purpose of this article will be to discuss Target Corporation (NYSE:TGT) and its attractiveness as an investment option. To do so I will look at Target's recent performance, its annual reports, and then attempt to determine where the stock may be headed in the future.

First, a little about TGT. TGT is a leading U.S. retailer and operates in three segments, which include U.S. Retail, U.S. Credit Card, and Canadian. Its U.S. retail segment operates in 49 states and the District of Columbia, as well as online. Its U.S. Credit Card Segment offers credit to customers through its branded credit cards, and its Canadian Segment is a result of its purchase of Zellers, Inc. in Canada. TGT competes domestically with major companies such as Wal-Mart, J.C. Penney, and other grocery chains and discount or dollar stores. TGT competes in a competitive environment but does not compete solely on price, such as companies like Wal-Mart. Instead, TGT has attempted to build up brand loyalty among consumers by offering some of its own brands and working with designers to offer fashionable clothes and merchandise in order to gain a competitive advantage over solely low-cost players.

Recently, the stock has performed strongly. TGT is currently trading at $70.11/share and it is up over 18% year to date and over 27% in the past 52 weeks. The company pays a quarterly dividend of $.36/share, which translates to an annual yield of 2.05%. While WMT is the leading U.S. retailer, TGT realized early on that it would not be able to compete on price with the retail giant, and has instead focused on niche areas and segments, which has allowed it to earn higher margins on its products. While TGT does not have the size, negotiating power, or global reach that WMT has, it has managed to deliver immense value to shareholders by narrowing its focus. With consumer spending on the rebound and unemployment declining, I see TGT as a company that is poised to benefit from these trends, especially as consumers trade up from the dollar and discount stores that they flocked to during the recession.

To get a better sense of how the company is performing, I reviewed TGT's most recent annual report and found some encouraging trends. First, total revenues have risen every year since 2007, including a 4.9% rise year over year from 2011-12. Secondly, and more importantly, net earnings have also been rising steadily. While there was a drop during the 2007-08 time period, TGT has rebounded nicely, seeing a rise in net earnings each year since 2008, including a 2.4% increase from 2011 to 2012. TGT has thus managed to improve its earnings during a very difficult economic period, with consumers focusing relentlessly on cost and value. Clearly, they are finding value in TGT's products.

One area in the annual report gives me some concern. Cost of sales are increasing at a higher rate than sales. While sales were up 5.1% from 2011-12 time period, cost of sales increased by 5.7%. This means that TGT is spending more to earn each dollar of sales, which would hurt its overall gross margin. This is indeed the case, as TGT reported a 29.7% gross margin rate in 2012, compared with a 30.1% gross margin rate in 2011, a decline of 1.3%. Since the gross margin rate has declined for TGT over the past two years (it was 30.5% in 2010), this is a metric I want to keep a vigilant eye on to see if the company can reverse this trend, otherwise the stock could face problems in the future. However, this gross margin rate is still a positive number. I recently wrote an article on Wal-Mart, which has a gross margin rate a little over 24%. Therefore, TGT is in a good position relative to its industry, so in my opinion it simply needs to hold its current position and the stock will perform strongly in the near term. However, with TGT set to report earnings next week, this is a measure I will look at closely.

One of the reasons for the decline in the gross margin rate has been a large increase in the number of credit and debit cards offered by the company. Cardholders then become more frequent shoppers, and they receive a 5% discount on most items purchased in TGT's retail stores. Sales made via a Target credit card were 7.9% in 2012, compared with 6.8% in 2011, and sales made with a debit card totaled 13.6% in 2012, compared with 2.5% in 2011. While this has had the short-term effect of lowering gross margins, I am actually encouraged by this trend. Expanding its own brand of credit and debit cards is helping TGT build brand loyalty among consumers, which is clearly working since these cardholders are making more purchases at TGT stores each year. This should increase sales in both the short and long term and impose some switching costs on these consumers who may look to other retailers. Additionally, it provides another stream of revenue for the company as consumers open these accounts and accrue interest on any outstanding balances. As credit cards continue to become the predominate form of payment, in the U.S. and around the globe, TGT is capitalizing on this trend expertly.

While overall it appears TGT is in good shape, the company is not without risks. For one, TGT is heavily reliant on the U.S. economy, especially when compared with its main competitor, Wal-Mart, which operates in numerous countries around the globe. If consumer spending drops or consumers continue to shop solely on price, TGT will see sales decline and will see its gross margin rate erode further. Additionally, TGT is relying on a strategy of differentiation since it cannot compete solely on price. If the company is not able to stay ahead of new trends in apparel, consumer electronics, or household items, the company will have a hard time providing value to consumers. However, since the U.S. economy has been resilient, sales have risen consistently, and TGT is working to grow its brand loyalty through the use of credit cards and other means, for now these risks seem muted.

Bottomline: Target is a strong company and its investors have been rewarded handsomely over the long term. TGT's brand is one many consumers are increasingly loyal to, and the company has delivered to investors by increasing its dividend payout consistently over time. With TGT set to report earnings next week, I largely expect these results to be positive and would encourage investors to begin to initiate holdings in TGT.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TGT, WMT over the next 72 hours. 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.