A little over a year ago I penned an article on Target (TGT) titled: Time to Take Aim? Within this commentary I made a reasonably bullish case for TGT; especially in comparison to fast growing corporations like Chipotle (CMG) for example. I was inspired to write the article because it occurred to me that - unlike high P/E companies - a company like Target didn't have to do anything that spectacular to provide solid return results. Specifically, I concluded that if TGT could grow slower than its industry, pay out less than 40% of its profits and be priced at a below-average multiple in the future, then an investor could still nominally double an investment in half a decade.
When I wrote that article, Target was trading around $63 a share.
Here we are one year later - and after a foray into the low $70 range - Target is once again trading around $63 a share. In effect, not much has changed. Well, except for the fact that TGT increased its dividend from $1.44 annually to today's $1.72 mark (a 19% increase) and if you bought in to what I supposed a year ago, then Target looks even more attractive.
Granted the recent price decline was a result of weaker consumers and worries that the Canadian expansion might not go quite as well as planned. A genuine concern for the short term and I'm certain a priority - if not the priority - for Target executives. But personally, I find that short-term apprehensions often lead to longer-term opportunities. Take my recent experience with Walgreen for instance. Or as Warren Buffett once said about the rationale of not liking an investment due to short-term distractions: "there's always a reason."
Today, you have reasons to not like Target. You might think that the company won't increase revenues very quickly, or that the Canadian expansion is in jeopardy or perhaps you even believe that Wal-Mart (WMT) will simply dominate and instead of saying that you're "going to the store" you'd be forced to declare "I'm going to Wally World." There's always a reason to not like a company. Investments are risky, that's why we're compensating for partnering with even the best companies in the world.
Yet despite those reasons - along with the 17 other risk factors listed in the company's 10-K - I'm about to ease those fears rather quickly.
It's always prudent to calculate a downside case. Ben Graham did this perhaps better than anyone by figuring out a company's liquidation value and then demanding that the price he paid was reflective of the value he received. Now I'm not going to create quite as large of a "margin of safety" for Target - great companies rarely sell for a deep discount. But I would like to provide the following illustration: Target doesn't have to get better to be a good investment.
Allow me to be more specific. In viewing Target's most recent 10-K one would find annual revenue of just over $73 billion, earnings of roughly $3 billion and approximately 657 million weighted average shares outstanding. Said differently, that equates to an earnings per share number of $4.57. In viewing the most recent 10-Q one could see that the weighted average shares outstanding now sits at about 635 million. So here's where my downside case comes in - according to fastgraphs.com, 21 analysts reporting to S&P come to a consensus estimated earnings growth rate of 11%. A quick check to Zack's and Yahoo shows very similar results. Yet instead of a growing company, let's assume that Target isn't able to grow at all. But we're not just going to say that earnings stay flat for this year and next, let's assume that Target makes that exact same $3 billion in profits for the next 20 years. I think two decades worth of absolutely no growth is reasonably conservative.
So what happens in this scenario? Well I'm glad you asked, I happen to have a chart for that:
|Earnings||Shares||EPS||Price||DivPS||Tot. Div||Sh Rph||Sh Rtd|
Note that I tried to condense the chart titles and numbers to create a sensible viewing area. With the exception of earnings, price and dividends per share, all of the numbers are in millions. So, for example, working through the 2013 line we see earnings of $3 billion, 635 million shares outstanding, EPS of $4.72, a price of $70.87, dividends per share of $1.72, total dividends paid by Target of $1.092 billion, total share repurchases made of $857.80 million and total shares repurchased of 12.1 million. Additionally, it should be noted that the price was based on a P/E multiple of 15 and consequently share repurchases were as well. I acknowledge the problem with assuming static multiples and pricing, but without doing unnecessary Monte Carlo simulation I believe these assumptions work just fine for a thought experiment.
Further, the remaining portion of the chart should be briefly expanded upon. As described, we're making an assumption of no growth for the next two decades - or earnings of $3 billion each year. In turn, Target is overwhelmingly unlikely to keep all of these profits as a cash hoard. Instead, it's more likely that management would return value to shareholders via dividends and share repurchases. To calculate what this might look like I assumed that 65% of Target's earnings would go to rewarding shareholders - or about $1.95 billion each year. This amount stays fixed, while the other $1.05 billion would be used for capital expenditures and the like. Finally, I allowed the dividend to increase at such a rate (roughly 3.27515% for the sticklers our there) so that at the end of year 20 the dividend payout ratio would equal 50%.
What's interesting to me is that earnings per share actually increase by about 1.5% a year, despite overall earnings remaining stagnant. Obviously this is a direct result of the company's successful share repurchase program, which has shown a propensity to effectively build up long-term shareholders' ownership stakes:
Just because a company's earnings are sluggish, or in our example flat, this doesn't necessarily mean that your overall profit claim will be as well.
Perhaps more impressive are the returns generated by the growing dividend. Given a low payout ratio to start, Target would actually be able to increase its dividend by a little over 3% a year. Surely nothing to text home about, but remember that's two decades of inflation matching income from a company that doesn't grow at all. Put together, an investor would accumulate $47.53 in dividends - or about 75% of his or her money back in the form of cash payments. Add that to an ending price of $95.18 and you find a compound total return growth rate of about 4.35%. Again, nothing to stand up and cheer about, but personally I find it motivating to know that Target could literally not grow earnings at all for 20 years and my investment might still return over two times the initial capital deployed.
Just think about what could happen with some "normal" assumptions - i.e. companies making more money in the future as they usually do - in place! Actually, you don't have to think about it, you could just go to my previously cited article. But the point is that there's something to be said for owning solid companies for the long term. I can't tell you what the market will do next week, year or decade. But I can tell you that as long as great companies make more money in the future (or in our example even if they don't) the shareholders will likely be just fine in the long term.
Even in the short term, as expressed by modifying the F.A.S.T. Graphs Estimated Earnings and Return Calculator to include an intermediate-term growth rate of 1%, an investor would likely still be okay.
In my view it's much more likely that Target will be able to grow its dividend at a robust pace for the next half a decade or so and then payouts will basically mirror earnings growth over time. And consequently, I also presume that the sustainability of the payout ratio will remain intact such that profits continue to rise. Further, these assumptions would then almost certainly lead to capital appreciation given enough time. But the takeaway is that even if this doesn't happen - even if Canadian shoppers are rebellious and another U.S. recession is around the corner - then it should be comforting to know that TGT doesn't need to grow at all for two decades in order to make you more money. The market can get so wrapped up in the FED's decision on Tuesday or Chinese GDP numbers - day to day fluctuations. My suggestion is to put the commotion aside, think about the individual company and determine a reasonable long-term downside. If your calculations of "returning shareholder value" still shine through, then I would advocate that you've found an interesting potential partnership.