Why Target Is A Better Dividend Play Than Wal-Mart

| About: Target Corporation (TGT)

The warm weather in the first quarter and an early Easter helped boost discount retailers' same-store sales on a year-over-year basis. Target (NYSE:TGT) saw a robust 5.3% annual growth in U.S. sales, while Wal-Mart's (NYSE:WMT) domestic sales increased 2.6%.

While the buoyant momentum likely moderated in the second quarter as the economy slowed, employment growth decelerated and consumer confidence weakened, the outlook for both discount retailers still looks better than over the past several years. In recent weeks, stocks of both companies have rallied to their new 52-week highs, with Wal-Mart's surging 45% and Target's gaining 28% over the past year. Now, both retailers are dividend aristocrats that pay competitive dividends, albeit Target's yield is slightly higher at 2.3% than Wal-Mart's at 2.1%. Given these characteristics, which company is a better dividend play for the next five years?

Historically, Wal-Mart has produced higher total returns to investors over the very long term. However, over the five- and ten-year investment horizons, Wal-Mart's performance relative to Target's is mixed. Over a five-year period, Wal-Mart outperformed Target by a very large margin of 10.5 percentage points. Yet, over a ten-year period, Target was a better performer, generating excess total returns of 2.2 percentage points relative to Wal-Mart.

A decade ago, Wal-Mart had a dividend yield of 0.6%, while Target had a dividend yield of 0.8%. While Wal-Mart had higher dividend growth over a ten-year period, averaging 18.2% per year over the past decade versus Target's 17.5% per year, Target beat Wal-Mart in terms of total returns over the same investment horizon. The opposite took place when total returns were observed over a five-year period. Target hiked its dividends at a higher average rate than Wal-Mart (18.2% per year for the former versus 12.6% per year for the latter). However, despite Target's higher dividend growth, the rally in Wal-Mart's shares over the past five years drove its total return to the relative outperformance.

Wal-Mart's outperformance relative to Target over the past five years was partly propelled by Wal-Mart's stronger EPS growth. Wal-Mart's EPS growth over the past half decade averaged 9.2% per year, compared to Target's EPS growth rate of about 6.0% per year. Over the past five years, both stocks were also attractive based on their valuations, as they traded at large discounts to their historical average P/Es. Wal-Mart has carried a premium relative to Target given the former's higher return on invested capital.

Now, what about the future? Target currently yields slightly more than Wal-Mart. Looking at dividends alone, Target would have a higher yield on cost in five years if both companies maintained their dividend growth from the past five years. Under that scenario, assuming no change in stock prices, in five years, Target would have a yield on cost of 4.7% compared to Wal-Mart's yield on cost of 4.0%. Now, if the two companies continued to apply their latest annual dividend hikes in the future - Wal-Mart growing dividends by 8.9% per year and Target by 20% annually - in five years' time, Target would have a yield on cost of 5.2%, while Wal-Mart's yield on cost would be a lower 3.3%. Target has expressed an intention to raise its dividend to $3.0 per share by 2017, which implies that the average dividend growth rate for the next five years will be consistent with the average dividend growth rate over the past five years. Both Target and Wal-Mart have low dividend payout ratios of about 33% of earnings.

Still, capital growth matters and Target may stand a better chance than Wal-Mart of producing comparably higher stock price gains in the future. Target's EPS is forecast to expand at an average annual rate of nearly 12% per year over the next five years, compared with Wal-Mart's forecast EPS growth of 8.6% per year. Target's planned expansion into Canada in 2013 is responsible for the company's expected higher growth in the future. (Wal-Mart is also increasing its foothold in various international markets, which will likely account for an increasing share of sales growth in the future.) Also noteworthy is Target's retail coalition with the high-end retailer Neiman Marcus. The two companies plan to sell jointly a limited edition of exclusive clothing, home goods, and even electronics, which could boost the value of sales at Target. On the other hand, as for valuations, on a forward P/E basis, Target is trading at a 19% discount to its five-year average P/E, while Wal-Mart's discount on the same basis is 9%. (Wal-Mart's shares will probably continue to trade at a premium to Target's shares due to the former's higher return on invested capital).

Both retailers are popular with major fund managers. Billionaires Steven Cohen and Ken Griffin are very bullish about Target. Each had more than $100 million invested in the company at the end of the first quarter. On the other hand, legendary investor Warren Buffett is one of the biggest fans of Wal-Mart. He owned nearly $3 billion worth of Wal-Mart stock at the end of the first quarter. Also bullish about the stock are Ken Fisher and Jean-Marie Eveillard (First Eagle Investment Management - check out its top holdings). We think Target is a better bet for dividend investors because of its higher dividend yield, cheap valuation, and higher expected growth rates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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