The Dividend Investors' Guide: Part XX - My Favorite General Retailers

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 |  Includes: JWN, KSS, TGT, WMT
by: Mark Bern, CFA

Back to Part XIX - Retail Building Supply Industry

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

As the economy struggles, the likelihood that some retail store types will struggle more than others is a pretty sure bet. This raises some flags about investing in retail stocks. It becomes even more important than usual to be selective. I generally try to stay away from the next hot thing in retail, preferring instead to stick with the companies that are most likely to weather the storms and gain market share through superior cost control and customer service.

There are, I believe, a few companies that fare better than the rest even when the economy is weak. Each of these companies has a different strength and is a leader in its group in terms of serving a distinct group of customers. I tend to look at the retail customer universe as being made up of different types (groups) of customers who favor different types of retail environments. There are those who want the lowest cost possible (discount), those that are looking for a good value, but are not willing to go cheap (mid-range), and then there are those who only shop at the "best name" stores (status conscious). Of these groups, the status conscious stores are the most likely to be hurt by the next recession, in my opinion. Of the other groups, the leaders are in a better position to expand market share by relieving weaker competitors of a migrating customer base. My list contains one company from the discount group and two from the mid-range group. My reason for including two from the mid-range group is that the competition there appears to be the weakest and least able to retain customer loyalties. It appears to me that both Sears (NASDAQ:SHLD) and J.C. Penney (NYSE:JCP) are faltering and likely to lose market share, recession or not. Thus, I believe that there is ample room for growth by the leaders in this group.

I will lead off with my two favorites from the mid-range group. My first selection and favorite overall in this article is Kohl's Corporation (NYSE:KSS). The company operates in 49 states in the U.S. selling brand-name and private-label merchandise while emphasizing value to its customers. It derives 50 percent of sales from private-label and exclusive brands. The company has performed below expectations for the last two quarters, but has relatively easy comparisons coming for the second half of 2012 versus 2011. The stock is trading at a ridiculous P/E relative to its potential growth.

Management has slowed the growth in new stores and is now concentrating more on same store sales growth, which is what it needs to do at this juncture. The company is in the middle of a $1 billion share repurchase program for 2012. Let's take a look at how KSS does against the metrics.

Metric

KSS

Industry Average

Grade

Dividend Yield

2.5%

1.6%

Pass

Debt-to-Capital Ratio

39.0%

32.7%

Neutral

Payout Ratio

23.0%

25.0%

Pass

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$5.21

N/A

Pass

Net Profit Margin

6.2%

3.0%

Pass

5-Yr Average Annual Growth in EPS

5.4%

3.3%

Pass

Return on Total Capital

11.6%

11.5%

Pass

5-Yr Average Annual Growth in Revenue

9.5%

2.9%

Pass

S&P Credit Rating

BBB+

N/A

Pass

Click to enlarge

Eight passes and two neutral rankings is an excellent showing for a retailer in a climate of high unemployment. One neutral ranking for not having paid a dividend long enough to analyze and the other is for a payout ratio that is a few percentage points above the industry average. With a slowdown in the pace of adding new stores, there is a good chance that margins will increase as expenses related to store openings becomes a smaller percentage of operating expenditures. While I don't expect margins to increase in the current year, I do expect that in five years, the net profit margin will increase to seven percent or more. Rising margins should result in EPS rising faster than sales. My five-year price target for KSS is $92, which works out to an average annual total return of about 18 percent. For another author's perspective of KSS valuation please consider this article or for a contrasting viewpoint consider reading this one.

Target Corporation (NYSE:TGT), my second mid-range selection, is that company that caters to those who want to stretch their budgets, but just don't consider themselves Wal-Mart shoppers. It is what I term an up-scale discounter that rather successfully distances itself from the discount image that WMT espouses. The number of customers in this category has expanded over the last few years, and may continue to do so, as long as the economic recovery continues to limp along at its myopic pace. TGT shares took a beating in 2008-09, but have rebounded. EPS fell in 2008, but jumped right back in 2009 and have continued to grow nicely since. It helps that the company has increased its dividend for more than 40 consecutive years. I do not like the debt level, but I'll discuss that more in the discussion following the metrics table.

Metric

TGT

Industry Average

Grade

Dividend Yield

2.3%

1.6%

Pass

Debt-to-Capital Ratio

52.0%

32.7%

Fail

Payout Ratio

26.0%

25.0%

Neutral

5-Yr Average Annual Dividend Increase

21.3%

N/A

Pass

Free Cash Flow

$3.34

N/A

Pass

Net Profit Margin

4.2%

3.0%

Pass

5-Yr Average Annual Growth in EPS

5.9%

3.3%

Pass

Return on Total Capital

11.4%

11.5%

Pass

5-Yr Average Annual Growth in Revenue

8.6%

2.9%

Pass

S&P Credit Rating

A+

N/A

Pass

Click to enlarge

One fail, eight passes and one neutral ranking is a great showing for TGT. The company missed in two categories by 0.1 percent; both could have been ranked either neutral or pass so I split the difference because it was so close. The one fail, debt-to-capital doesn't concern me as much as it would if the free cash flow were not so strong. Looking at the pattern in the company's debt levels, I expect that management will use some of that excess cash flow to pay down debt whenever it is not needed for expansion. My five-year price target for TGT is $93 which results in an average annual total return of about 12 percent. Another author provides some additional perspective about TGT in this article.

Wal-Mart Stores (NYSE:WMT) is the world's largest retailer and one of the world's largest businesses in terms of revenues. This is my discount retailer with a dividend pick. The company continues to add venues and pilot new floor plans for different demographics until it finds what works. Then, the company has the wherewithal to make whatever changes, investments or expansion necessary to leverage the new knowledge. We all know about the company's focus on its supply chain costs, but the focus on costs does not stop there. This is one of those companies that keeps on looking for improvements in every aspect of its operations every day of every year. WMT management does not rest on its laurels from past achievement. When a company gets to this size, something new that will produce increased sales or reduce costs at most locations gets rolled out quickly and seamlessly. Every small, incremental improvement results in increased profits and cash flow on an enormous scale. When the economy is humming, WMT expands its offerings to take advantage by increasing sales to each existing customer. When the economy is hurting, WMT gains new customers who, out of necessity, must find new ways to spend less on the everyday items. Let's look at the metrics for WMT.

Metric

WMT

Industry Average

Grade

Dividend Yield

2.1%

1.6%

Pass

Debt-to-Capital Ratio

40.0%

32.7%

Fail

Payout Ratio

33.0%

25.0%

Neutral

5-Yr Average Annual Dividend Increase

19.8%

N/A

Pass

Free Cash Flow

$3.47

N/A

Pass

Net Profit Margin

3.5%

3.0%

Pass

5-Yr Average Annual Growth in EPS

8.8%

3.3%

Pass

Return on Total Capital

14.0%

11.5%

Pass

5-Yr Average Annual Growth in Revenue

9.1%

2.9%

Pass

S&P Credit Rating

AA

N/A

Pass

Click to enlarge

One fail, one neutral and eight pass rankings when either of the two categories ranked fail and neutral were borderline calls; either could have been ranked a neutral or a fail. Once again, I split the difference on this behemoth, because I just can't see debt becoming an issue for a company that is ranked only one step below the U.S. government for credit. The free cash flow is extremely strong, as the company has enough excess cash, above and beyond paying dividends, to meet operational needs and capital expenditure plans, that it could conceivably pay all of the $20 billion in debt that comes due over the next five years out of cash flow. I believe that management has purposefully raised the payout ratio to the current level to support the stock. The earnings growth by itself was apparently not enough, even though EPS grew every year right on through the Great Recession. My five-year price target for WMT is $103, which would result in an average annual total return of 9.8 percent. The stock has gotten a little pricey recently, and I would advise waiting for a pullback of at least five percent. For another author's perspective on WMT please consider this article or this one.

Nordstrom (NYSE:JWN) almost made the list. There are two factors that kept the company from making the cut. The first is how the company's shares reacted during the Great Recession, falling 89 percent from a 2007 high of $59.70 to a 2009 low of $6.60. I love the customer loyalty and the great personalized service provided by this retailer. How many retailers keep track of your wardrobe and sends you a note when your brown and grey suits are starting to age and in need of replacing? The music creates a pleasant atmosphere, too. For those who like to be pampered, JWN has a great model, and those are usually the customers who can afford to shop. But I think the debt level, which I'll get into a little more after the metrics table, is a primary factor undermining the stock price stability. Let's look at the metrics.

Metric

JWN

Industry Average

Grade

Dividend Yield

2.0%

1.6%

Pass

Debt-to-Capital Ratio

62.0%

32.7%

Fail

Payout Ratio

29.0%

25.0%

Neutral

5-Yr Average Annual Dividend Increase

17.0%

N/A

Pass

Free Cash Flow

$2.05

N/A

Pass

Net Profit Margin

6.5%

3.0%

Pass

5-Yr Average Annual Growth in EPS

4.2%

3.3%

Pass

Return on Total Capital

15.0%

11.5%

Pass

5-Yr Average Annual Growth in Revenue

8.7%

2.9%

Pass

S&P Credit Rating

A-

N/A

Pass

Click to enlarge

One Fail, eight passes and one neutral ranking is slightly better than the average master list company. My biggest concern for JWN is the debt level. Free cash flow is strong, but the debt has been climbing for several years, and I want to wait until this trend reverses and management is able to bring the ratio back down at least below 50 percent. I like the company in many ways, but will keep it on watch for now. I believe that a meaningful reduction in the debt level will provide greater price stability and enable the company to weather difficult times better in the future. But I'll pass for now.

Of the remaining companies in the industry, there are a few that stand out and would make the list, but I feel like I need to limit the number of companies and draw the line somewhere. Family Dollar (NYSE:FDO), Costco (NASDAQ:COST) and Macy's (NYSE:M) are all strong candidates. The dividend yield and my projected total return were primary reasons to cut COST and FDO. Both are also over-valued at this time, in my opinion. As regular readers of this series know, I don't like companies that cut dividends. That rules out Macy's, even though the dividend is now above the pre-cut level. I do not advise against holding any of these three companies, although I do not recommend starting new positions. Dillard's (NYSE:DDS) is doing well relative to its peers, but tends to keep the dividend flat, as do Aaron's (NYSE:AAN) and JC Penney. Rent-A-Center (NASDAQ:RCII) does not pass the credit rating requirement.

Disclosure: I am long (KSS).