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Summary

  • Target's earnings have been essentially flat, but buybacks have given the appearance of earnings growth.
  • Target's free cash flow has amply covered growing dividends, but not both dividends and buybacks.
  • Despite the buyback strategy, the stock price is right where it was seven years ago.

Preface: This article covers seven years of financial results. Before getting started, it is appropriate to briefly discuss fiscal year 2013, an eventful and extraordinary year. Fiscal 2013 stands out as extraordinary for two reasons:

The public is well aware of the November 2013 breach that compromised the security of customer credit card information. The immediate impact was an unknown amount of lost sales and profits in the 4th fiscal quarter; the longer term impact is also unknown at this time. It should be noted that well before the event, Target's profits for the first 9 months of the year were 28 % less than the comparable period of fiscal 2012.

More significant from a cash flow standpoint was the bulk sale of Target's accounts receivable on March 13, 2013. The company received proceeds of $2.703 billion for receivables originated at Target. These proceeds increased operating cash flow and hence free cash flow ("FCF") by the same amount. (The company received an additional $3 billion of proceeds for receivables originated at 3d parties. These proceeds were recorded as an investing activity, had no effect on the calculation of free cash flow, but of course increased the company's cash. Of the $5.7 billion of total proceeds, $3.4 billion was used to reduce long-term debt.)

Note: financial data in this article are obtained from official company documents, including the 10-K reports covering the years reviewed, various 10-Q reports, proxy statements and transcripts of quarterly conference calls, all of which can be found at sec.gov or the company website, investors.target.com

Target Corporation (NYSE:TGT), a Minnesota-based mass merchant retailer, occupies a prominent position in the portfolios of many investors, including those whose investment strategy is focused on dividend growth. Indeed, these investors have been rewarded over the years by this Dividend Aristocrat's consistent and generous increases in their annual dividend checks. Since 2006, the annual dividend has nearly quadrupled, from 42 cents in 2006 to $1.58 per share in 2013, a compound annual growth rate ("CAGR") of 20.84%. The dividend represents 2.8% of the $61 current share price, not a bad yield if it can be counted on to continue to grow.

The rising dividends may give some current investors and potential investors the impression that the company itself is robustly growing its sales and profits. Ironically, however, while Target continues to be profitable and generates respectable amounts of cash from operations, company net earnings have been essentially flat for the past seven years.

In addition to the ever bigger dividend checks, the company has spent $13.3 billion since 2006 to buy back its own shares. That is a practice that normally results in higher share prices, thereby enhancing the total returns of long-term shareholders. Yet Target's share price today is basically the same as it was seven years ago. In my opinion, the buyback program has failed to return value to shareholders and a greater emphasis on dividends would have better rewarded investors.

Key Point: Target's profits are barely growing at all. Even if we momentarily ignore fiscal 2013 the record shows that earnings for the six years through fiscal 2012 grew at a CAGR of only 0.89%, while revenue grew at a CAGR of just 2.46%. Including 2013 would paint a picture even more drab. This is hardly a record of robust growth and there seems to be inconsistency between numbers like those and dividends that have grown at a 20% CAGR.

The following table illustrates Target's annual revenue and earnings, beginning with their 2007 fiscal year through fiscal 2012:

($millions)

Fiscal Year

2007

2008

2009

2010

2011

2012

2013*

Net Sales

61,471

62,884

63,435

65,786

68,466

71,960

72,596

Net Earnings

2,849

2,214

2,488

2,920

2,929

2,999

1,971

Net Margin

4.63%

3.52%

3.92%

4.43%

4.27%

4.16%

2.71%

*preliminary and unaudited

Note that earnings for fiscal 2010 were only 2.49% higher than those of 2007 and that the net margin was even less. Do you think 2010 was an outstanding year based on those numbers? We'll get back to the subject in a moment.

Key Point: Repurchasing $13 Billion worth of shares can paint a very different --and misleading -picture.

Because of the massive share repurchases, earnings per share grew at a more respectable CAGR of 5.42% through 2012, while the average number of shares were reduced at a compound annual rate of 4.59%.

(shares in millions)

Fiscal Year

2007

2008

2009

2010

2011

2012

2013*

Earnings/Share

3.33

2.86

3.30

4.00

4.28

4.57

3.10

Av. # of Shares

850.8

773.6

754.8

729.4

683.9

663.3

641.8

Notice again the earnings stats for 2007 and 2010. In contrast to the small increase in total earnings, 2010 earnings per share stand out for being up 20% over 2007, thanks in large part to a 14% reduction in outstanding shares between periods. Even Target management seemed to be impressed with the arithmetic, judging from the comments on page 22 (in the executive summary introducing the "Executive Compensation" section, no less) of Target's proxy statement of April 28, 2011:

" Overall, our 2010 performance is the result of an unwavering adherence to our strategic priorities, and a thoughtful approach to planning and execution. We achieved very strong financial results in 2010 that were above management's and the financial community's expectations for performance when the year began. Our fully diluted earnings per share ("EPS") for 2010 was $4.00, the highest EPS performance in our history, eclipsing our previous record annual EPS by 20 percent. Comparing our EPS result of $4.00 for 2010, or $3.86 per share excluding net favorable discrete tax items, to the FirstCall median EPS estimate of $3.62 at the start of the year, highlights the strength of our execution in the last fiscal year."

Key point: Free cash flow production has been inconsistent; still it has amply covered the dividend payments. But, in four out of the seven years and for the period in the aggregate, the combination of both its dividend payments and its stock repurchases have exceeded Target's free cash flow. That's true even if we now generously include the extraordinary cash flow of 2013 that was achieved by selling the accounts receivable. {Convention defines free cash flow as the remainder after deducting capital expenditures from operating cash flow.}

The following table tracks free cash flow and how much of it was used to pay dividends, how much to buy back company shares and how much was retained in the business.

($millions)

Fiscal Year

2007

2008

2009

2010

2011

2012

2013*

Total

Cash from Ops

4,125

4,430

5,881

5,271

5,434

5,325

6,520

36,986

-Capex

4,369

3,547

1,729

2,159

4,368

3,277

3,453

22,902

=FCF

(244)

883

4,152

3,112

1,066

2,048

3,067

14,084

-Dividends

442

465

496

609

750

869

1,006

4,637

-Buybacks

2,477

2,815

423

2,452

1,842

1,875

1,461

13,345

=Retained

(3,163)

(2,397)

3,233

51

(1,526)

( 696)

600

(3,898 )

*Preliminary and Unaudited. (Since the receivable sale described earlier was a one-time event, normalized free cash flow for 2013 without the $2.703 billion of sale proceeds would amount to just $364 million, $2.121 billion less than the amount spent on dividends and buybacks.)

As the table reveals, for every $1.00 the company spent paying dividends it spent $2.87 ($13,345/$4,637) buying back shares in the open market. So, instead of splitting $4.637 billion of dividends, stockholders could have been splitting $17.982 billion. Instead of the shareholder who has owned 100 shares that he bought in March 2007 receiving $662 of dividends since then he could have received about $1900.

As far as the financial strength of the company is concerned, it really doesn't matter if the money went out in the form of dividends or in the form of buybacks. No matter how it left the company, it's gone. As pleased as a dividend investor might be with the amount of dividends he's received over the past seven years, it must give him pause to realize that he could have received almost four times the amount if management had emphasized dividends instead of buybacks. If I were that dividend growth investor, I'd be upset, big time, when I realized that not only could my dividend income have been much higher, but that I also not seen the capital appreciation that the buybacks intended to create.

A question worth asking is: if income shareholders haven't benefitted from $13 billion of the cash that left Target's treasury, if long-term total return shareholders haven't seen any capital appreciation and if the corporation hasn't benefitted, who has benefitted? The only groups that I can think of who may have been beneficiaries: total return investors, traders and senior executives.

It's logical to assume that Target's share price may have been higher from time to time over the past seven years because of the rise in earnings per share, modest as they were. That likelihood, coupled with adroit timing, could have benefitted some short term traders. Certain activist shareholders may have benefitted from a higher rise of the stock price from its lows of 2009.

Key Point: Without ascribing any inappropriate motives to management or to the board of directors, a company's senior executives have much to gain from the intended results of massive share buyback programs. Target's executive compensation plan is not so much different from many such plans: a major portion of it is based on the performance of the price of the stock. As we have shown, regular buybacks result in fewer shares outstanding and rising earnings per share -- even when total earnings don't rise -- and earnings per share represent the most influential factor in the stock price.

The following paragraphs are taken from page 20 of Target's proxy statement dated April 9, 2007 available here (I have added bold highlights):

Variable Long-Term Equity-Based Compensation Measures (Option Awards and Stock Awards) · Stock Price Growth- We believe that consistent execution of our strategy over multi-year periods will lead to an increase in our stock price. Stock options are one way in which we provide our executive officers with a stake in this potential reward of their efforts. The stock option award values reported in the Summary Compensation Table use the same option pricing model assumptions as are utilized for financial reporting purposes, except the assumptions used to estimate potential forfeitures for service-based vesting are disregarded. These values are unlikely to reflect the actual compensation realized from the options because the amount realized is entirely dependent on increases in our stock price after the option grant dates and on each executive officer's decision of when to exercise. We also offer performance share units and restricted stock units to our executive officers, the value of which are also dependent on our stock price over time. · Revenue Growth-We base one-half of our performance share unit awards on generating sustained revenue growth over a three-year performance measurement period. Our principal sources of this growth are contributions from new store expansion and increases in comparable store sales. Our objective is to consistently grow revenue at a sufficient pace to facilitate continued market share gains and drive sustainable earnings growth. · EPS Growth-We base the other half of our performance share unit awards on three-year EPS growth. We believe our focus on achieving sufficiently high growth in EPS over a sustained period will generate substantial value for our shareholders over the long term.

Please note the emphasis on stock price and per share earnings growth, not total profitability of the company's operations.

It wouldn't be a stretch to contemplate the possibility, again without casting aspersions, that, like a group of teachers who might with good intentions "teach to the test", senior executives of a corporation with a compensation plan like Target's might well "manage to the market". There's always the potential for that kind of teaching to underserve the students and for that kind of management focus to underserve the investor. One thing is clear: Target had a range of options available to it for investing its free cash flow that wasn't distributed as dividend. Whatever those options were, Target's board decided to spend $13 billion of it buying back its own shares. The results have been questionable.

Conclusion: Looking at the last seven years, there is some good news for Target stockholders: even though company earnings were flat, dividends increased at a remarkable rate and they were well covered by free cash flow. Because of the coverage, it is reasonable to feel confident that Target's dividends can continue to grow at essentially the same rate if management is willing to emphasize dividends at the expense of buybacks. The not-so-good news is that the company frittered away $13 billion in an effort to boost the stock price. That strategy hasn't worked and I'm not impressed with the judgment that went into the decisions to implement it in the first place. For me, Target's experience is an argument for a strategy focused primarily on dividends as the surest way to return value to shareholders, with buybacks taking a back seat.

Disclaimer: I am not a certified analyst, but simply a duly diligent individual investor with opinions, which I have expressed here. Each investor is advised to incorporate his or her own due diligence in making their personal investment decisions.

Source: Target's Buyback Strategy Shortchanged Dividend Growth Investors