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Summary

  • Target will generate an additional $3.5 billion in sales from its expansion into Canada.
  • Dilution to earnings from the Canadian expansion will turn around in 2016.
  • Target pays an attractive 3% dividend yield.

Target Corporation (NYSE:TGT) is an upscale discount retailer that provides high-quality, on-trend merchandise. The company was founded in 1902 and is headquartered in Minneapolis, Minnesota. Target Corp. provides services to customers at 1,921 stores - 1,797 in the United States and 124 in Canada, and at Target.com. The company also distributes its merchandise through 40 of their distribution centers, as well as third parties and direct shipping from vendors. My positive investment thesis for Target Corp. is based upon nine key criteria, which include:

Key Selection Criteria

  1. Large market capitalization.
  2. A leadership position within a growing industry.
  3. A dominant, or large, market share within its product mix.
  4. A strong and/or growing position internationally.
  5. A strong balance sheet and high credit rating.
  6. A high free cash flow number.
  7. A low historical relative valuation as measured by price/sales and/or price/earnings ratios.
  8. A strong dividend growth rate.
  9. A catalyst of new revenue opportunities.

Capitalization

Target Corp. is a large-cap general merchandise retail firm with a current market capitalization of $37.4B.

Leadership

Target Corp. has maintained a leadership position in the retail store industry. Today, Target is currently the second largest general merchandise retailer in America, with Target.com currently ranked as the 58th most visited website.

International

Target is actively looking to diversify its operations geographically. It opened 124 stores in Canada in 2013. It is also looking to expand in Mexico and Latin America.

Balance Sheet/FCF

The balance sheet of Target Corp. is in excellent condition. Target maintains a credit rating of A+ from Standard & Poor's Ratings Services. This rating was affirmed this past November. The firm generates substantial free cash flow. This allows Target to continue with its expansion into Canada, provide investors with strong dividend increases, and buyback stock on a continual basis.

FCF

2013

3.0B

2012

3.2B

2011

4.1B

2010

883M

Source: Target Corp. Annual Report

Relative Valuation

As for relative valuation, I have a preference for price/sales ratio when examining the merits of a company in the consumer discretionary sector. Target is trading toward the bottom of its range in history in terms of price/sales at 0.50 TTM. Target has traded at a price/sales ratio range of 0.42 to 1.1 in the last decade. The average price/sales ratio since inception has been 0.75.

Date

Price/Sales Ratio Avg.

2017 SPS Projected

Price/Sales 2016

= 136

Target Price 2017

= $88.40

Sales Per Share

2013

0.6

115.80

2012

0.6

113.59

2011

0.5

104.39

2010

0.7

95.72

Source: Target Corp Annual Report

I expect with the Canadian expansion delivering enhanced sales of $3.5 billion by 2017, sales per share can easily advance by 5.5% in the next three years. I assume a mere 1% growth in sales in the U.S. markets. Buybacks will improve SPS results by approximately 1% per year. I feel this is probable as Target has spent over $10 billion in stock buybacks from 2008 to 2012. In 2013, Target purchased an additional $1.5 billion of company stock. The Canadian expansion will no doubt account for most of my SPS expansion projections, resulting in SPS advancing to 136 (total revenue/number of share outstanding) by 2017. As the Canadian expansion begins to produce better free cash flow results and the credit card crisis fades over time, I expect Target can trade at a modest price/sales ratio of .65. This expected price/sales ratio is well below the historical average and dramatically below the 1.1x price/sales ratio reached in 2007.

Dividends & Cumulative Return Projection

Dividends have grown on a consistent basis for Target over the preceding five years. Dividends have escalated from $0.66 cents to $1.58 a share, a compound growth rate of nearly 20%. The current dividend yield stands at an attractive 3.0%. In June of last year, Target upped its dividend to 0.43 a quarter versus 0.36, a 19% year-over-year increase. Although I expect Target to not match its rapid pace of dividend hikes in the past five years, I believe the firm can deliver an 8% dividend growth rate to 2017. With an 8% growth rate, Target will pay an investor $1.70 in 2014, $1.84 in 2015, and $2.00 in 2016. Add the total dividends collected ($5.54) to my target price based upon SPS analysis (136*.65 = $88.40), an investor would potentially earn a cumulative return on investment of 62% ($88.40 + $5.54) - ($58 current price)/($58 current price). This return does also not account for the reinvestment of dividends over time.

Target Corp. Dividend Payout History - 5 Years

2009

2010

2011

2012

2013

Dividends Per Share

0.66

0.84

1.10

1.32

1.58

Source: Target Corp. Annual Report

Catalysts

In a stock market rampant with companies trading at high historical valuations, Target is one firm that trades below intrinsic value. A primary reason is the negative headlines that have followed Target since its credit security breach at the end of 2013. Its CEO just got fired and the Canadian expansion has been described continually as a disaster. But negative news flow often offers opportunity. I think for a long-term investor, Target offers a very solid investment opportunity with limited downside risk.

Target is now trading near a historic low price/sales ratio of 0.50, less than half of what it traded for in 2007. Target also has "yield support", with a strong above-average dividend yield of 3%. Target's recent firing of its CEO is no doubt a sign that management has executed poorly. Not only had management handled the credit card fiasco in a imprudent manner, but the Canadian expansion has not gone as planned. The company will have to repair its reputation over the next few years. The cost of improving the credit card security program will be high. Target will have to replace 40 million credit cards with the new security feature. This could cost between $300 to $400 million. In addition, all the point of sale terminals in Target stores will be updated to Mastercard's chip-in-pin technology for a few hundred million. Free cash flow in 2014 will most likely be modest, as the costs of the security measures plus the additional Canadian expansion charges are felt.

The entry into Canada has cost the firm a $1 billion operating loss to date. But a primary benefit for Target going forward for its Canadian operation is the dilution effect will dissipate over the next few years. Target generated $623 million in revenue from its Canadian stores in Q4 of 2013, or $48.50m a sq ft. In Q3, Target only generated $36.8m. The dilution to earnings was $1.07 in 2013 for the Canadian operations. Target expects this to fall to only -$0.75 for calendar year 2014. As mentioned above, sales from the Canadian operations should reach $3.5 billion by 2017. At that point, I expect Target to have 150 stores across the country. Dilution to earnings should be eliminated by 2016, and the Canadian operations should generate $0.50 a share in earnings for 2017. Net free cash flow should also gain momentum as 2016 approaches. Free cash flow can easily grow to $5 billion in 2016 from $3 billion today. This will be helped by capital expenditures, which should drop by $1 billion over the next two years. Along with the Canadian operations revenue increase, this should allow for Target to finally see positive results from its Canadian operations. This additional free cash flow could be utilized to increase its sizeable buyback program starting in 2016, or raise its dividend markedly. Target has other growth ambitions. Its recent foray into online subscription services is starting well. It announced last month that it is increasing its items offered to 1500. Target customers receive items on a specified basis delivered free to their door. It already accounts for 15% of online sales, above expectations. The service was launched only in September. "Made to Matter" is another new Target initiative to break into the organic market. 120 new products have been added with a rollout to all Target stores by year end. The organic market is growing at a double-digit rate. The rollout should help Target maintain sales per share growth in the U.S. markets over the next couple of years.

Analysts are quite bearish on the stock. Only 25% of stock analysts have a "buy" or "strong buy" rating on the company. Most of the analysts that are bearish are not buying into Target's ambitious financial projections. Many analysts are projecting continued dilution into 2017 for the Canadian operations and capital expenditures of $3 billion through 2017. The argument is that Target will need to ramp up spending for a replacement of a significant portion of their entire IT system to improve customer security. However, even with these dour projections, Target would generate $2.75 billion in free cash flow. This amount can easily cover the current dividend, plus modest raises. It would reduce the potential for further stock buybacks. But even if the Canadian operations only generate a street low estimate of $2.5 billion in sales for 2017 and capital expenditures remain at $3 billion, I calculate SPS would still grow to 123 (total revenue/number of shares outstanding). The lowest price/sales ratio that Target has traded for in the past decade is .42 during the abyss of 2008. That would leave a potential 2016 year-end low price of $51.66. However, an investor would collect dividends of $5.54 over the three year period. Thus, an investor in Target can be confident in the fact that the "margin of safety" in purchasing Target shares at $58 a share is very high. But if capital expenditures are more in line with average analyst estimates and the Canadian operations at least break even by 2017, the potential for significant capital gains is high. A new outside CEO hire should help drive a sentiment change in 2014 as well. Overall, Target only needs to demonstrate a slight improvement in company results over the next three years to make a cash outlay in TGT stock a solid contrarian investment.

Disclosure: I am long TGT. 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.