'Hope' Isn't The Only Reason To Hold On To Your Target Shares

| About: Target Corporation (TGT)
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Summary

Some dividend growth investors are questioning the future viability of Target. At least one is holding on only in the "hope" that he can recover his cost and sell.

While sales and earnings haven't been growing, neither have they fallen off a cliff. Cash flow amply supports the dividend. Seven years of operating performance are presented.

There are several reasons to believe Target is reasonably positioned to succeed in this environment over time.

Background

Just over 3 years ago (March 10, 2014) I published an article for Seeking Alpha readers that covered 7 years of Target's (NYSE:TGT) operating results. In those 7 years (2007 through 2013) Target's dividend per share had grown at a compound annual growth rate of 20.84%, from 42 cents in 2006 to $1.58 in 2013. At the time that my article was published, TGT's share price was ~$61, virtually unchanged from what it was at the same point in 2007.

In the article I made the following key points:

  • Target's profits had barely grown at all.
  • Repurchasing $13 billion worth of shares had painted a very different -and misleading - picture of Target's earnings trend.
  • Free cash flow production had been inconsistent; still it had amply covered the dividend payments. But in four out of those seven years and for the period in the aggregate, the combination of its dividend payments and its stock repurchases exceeded Target's free cash flow.

My main thesis was that the dollars spent on share buybacks, while they may have served the interests of senior management, had a) done nothing to increase the share price and b) would have served shareholders' interests better if they had gone directly to them in the form of dividends.

After criticizing Target for its buyback strategy, I concluded my article as follows:

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.

Finally, I disclosed that I had no positions in TGT at that time.

Current Update

I decided to update my work on TGT at this time because of the recent drop in Target's share price, coming on the heels of a poor 4th quarter and pessimism about what the future holds for Target. Some people are convinced that Target and most retailing in the U.S. is in the tight grip of what some say is the slow, painful, inevitable death of bricks and mortar retailing. (One commenter to Mike Nadel's recent article on TGT doesn't think the death will be slow, confidently stating with mathematical certainty that "I still believe that in 8 years (or less) there will no brick and mortar retailing.")

Okay, I get that hyperbole rules our culture nowadays, but most of us recognize it for what it is. Even so, some committed dividend growth investors who currently hold the stock question whether they want to continue to do so. At least one now justifies holding onto his TGT shares because he "hopes" that the share price will levitate to a point where he can recover his initial investment, before (I suppose) all of America's mega malls, strip malls and free standing stores are, in the end, transformed into Amazon drone hangars.

I'm not much of a fan of either hyperbole as a communication style or of "hope" as an investing strategy, despite the seeming popularity of both. When it comes to my investments and to Target, I am guided mostly by numbers - supplemented by occasional channel checks, though I haven't made photographic records of them. I like to look at multi-year metrics. Updating Target's numbers from 3 years ago leads me to conclude the following:

  • Target's profits are still not growing (same for sales) but they are not falling off a cliff, either;
  • Target has continued to buy back its shares (and I don't like that any better than I did before);
  • Free cash flow still amply covers the dividend.

Sound familiar? Not much about Target has changed.

Key Point: Target may be skating but Target isn't falling over a cliff.

The following 7-year table covers Target's annual revenue and earnings, from fiscal 2010 through fiscal 2016. Note: all numbers contained in this article are from 10K reports filed by TGT with the SEC. They can be found at sec.gov.

(in $millions)

Fiscal Year

2010

2011

2012

2013

2014

2015

2016

Net Sales

65,786

68,466

71,960

72,596

72,618

73,785

69,495

Net Earnings

2,920

2,929

2,999

1,971

(1,636)

3,363

2,737

Net Margin

4.43%

4.27%

4.16%

2.71%

-2.58%

5.35%

4.74%

Averages for the 7 years are as follows:

  • Net Sales: $70,672
  • Net Earnings: 2,183
  • Net Margin: 3.3%

Target's most recent fiscal sales, earnings and net margin were not out of line with those of recent history, which includes the following noteworthy, non-recurring items (net of tax, in millions):

  • 2012 Canadian losses were $369.
  • 2013 Canadian losses were $723.
  • Loss on extinguishment of debt was $270.
  • Gain on sale of credit card receivables was $247.
  • Net non-recurring items for the year were $746.
  • 2014 Write-off of Canadian operation was $4,000 -- normalized earnings were $2,364.
  • 2015 Pharmacy operations, representing ~5% of Target's sales, were sold for earnings gain of $487.

Those events are history. Target is now facing market share issues in the U.S. as direct-to-consumer, online retailing threatens traditional, big-store shopping format's retail dominance.

Key Point: Target continued to buy back shares with no apparent benefit to shareholders.

It's the same old story: Billions of dollars were spent to reduce shares and thus help boost earnings per share, but, alas, the share price is the same as it was 10 years ago. In the past 6 years (fiscal 2011-2016) Target has spent $12.4 billion to repurchase shares, $7 billion of that just in the past two years. The following table shows the share repurchase expenditures over the past 6 years (millions):

Fiscal Year

2010

2011

2012

2013

2014

2015

2016

Purchases ($)

1,842

1,875

1,461

26

3,483

3,706

Y/E Shares O/S

704

669

645

632

640

602

556

Despite the 21% reduction in the share count (net of options and awards) TGT's price at the end of March 2011 was the same (~$55) as at March 31, 2017. That reflects a 21% drop in the market capitalization of the company. Another way of expressing it: Even though a shareholder owning 100 shares of stock in TGT for the entire period saw his percentage of ownership in Target grow by 26%, the value of his now bigger piece of the pie is no more than that of his then smaller slice.

It's not supposed to work that way.

Fortunately, the shareholder received $1,038 of dividends during the 7 year period. But imagine his glee if, instead, he had received another $1,761, his portion of the money that the board could have directed to him instead of buying the shares of other shareholders who wanted to get rid of them.

Key Point: Target has continued to generate ample cash to pay and grow its dividends.

The following table tracks Target's free cash flow (FCF) and how much of it was used to pay dividends and buy back stocks and how much was retained in the business: ($ millions)

Fiscal Year

2010

2011

2012

2013

2014

2015

2016

Total

Cash from Ops

5,271

5,434

5,325

6,520

4,465

5,254

5,329

37,598

-Capex

2,159

4,368

3,277

3,453

1,786

1,438

1,547

18,028

=FCF

3,112

1,066

2,048

3,067

2,679

3,816

3,782

19,570

-Dividends

609

750

869

1,006

1,205

1,362

1,348

7,149

-Buybacks

2,452

1,842

1,875

1,461

26

3,483

3,706

14,845

=Retained

51

(1,526)

( 696)

600

1,448

(1,029)

(1,272)

(2,424)

Over the period, free cash flow was insufficient (by $2.4 billion) to cover both the dividends and buybacks. However, the deficiency was more than made up for by the cash proceeds from the sale of receivables generated by third parties in fiscal 2013 and from the sale of the pharmacy business in fiscal 2015, transactions not included in the calculation of cash from operations. Those transactions were a major factor in the board's approval of the buyback amounts. As a result, Target has been able to avoid a net increase in long-term debt over the period covered while consistently raising the dividends per share.

Key Point: The dividend per share has continued to grow at a robust rate, amply covered by free cash flow.

Although I am of the opinion that the money spent on stock buybacks has been wasted, nonetheless free cash flow has been and continues to amply cover the dividend. That is important, because it is clear that the board is committed to a growing dividend. As fiscal 2014 (and also 2009) demonstrated, the board seems to have been more than willing to curtail stock buybacks in order to preserve the quality of the balance sheet and credit rating, while continuing to grow the dividend. In fact, in 2009, the dividend was raised by 10% and in 2014 by 20%. During the recent conference call, management suggested that buybacks in 2017, if any at all, will be much less than in 2016.

The following table tracks free cash flow per share and the per share dividend amount, as well as the year-to-year growth of the dividend:

Fiscal Year

2010

2011

2012

2013

2014

2015

2016

FCF/Share

4.27

1.56

3.09

4.81

4.19

6.09

6.49

Dividend

0.85

1.10

1.32

1.58

1.90

2.16

2.32

Coverage Ratio

5.11

1.42

2.36

3.05

2.20

2.80

2.81

% Div. Growth

28.8

29.4

20.0

19.7

20.3

13.7

7.4

Target's annual dividend increases occur in the 3d fiscal quarter. The amount of the 2017 increase has not been announced.

Key point: While the dividend is extremely well-covered by free cash flow, Target must adapt to sector headwinds. The investor must judge a) if that is possible, b) how long will it take and c) what its operating performance is likely to be in meantime.

The risk in holding TGT, as I see it, isn't that the dividend won't continue to grow at a mid-single digit rate, but that the share price may continue to erode if certain of the soothsayers forecasting the collapse of traditional brick-and-mortar retailing turn out to be correct. I don't suppose I see the future any more clearly than anyone else, but I think I form my opinions deliberately and logically. Here are some of the reasons (in no particular order of importance) why I have confidence that Target is reasonably positioned to successfully confront the challenges it and its competitors face:

  • Target already has real estate within 10 miles of 75% of Americans. Most of its more than 1700 stores are not mall-based. Some might argue that all that brick and mortar is a liability. It is, unless it is well-located and can be used to serve customers the way they want to be served. Target's stores are well-located, large and can serve not only customers who want in-store shopping, but also customers who order online and pick up at stores. They can be used as distribution points for quickly filling and delivering online orders. The company reports having filled 68% of online orders directly from their stores in 2016. Something to remember: Target hasn't been one of the retailers announcing massive store closings.
  • In addition to excellent cash flow, Target has a strong balance sheet and an investment grade credit rating. Financial strength provides Target the time and flexibility to redirect its investment dollars to those areas that will facilitate customer expectations. Not all of Target's traditional competitors can say the same thing. Granted, Target's earnings will be impacted as it increases investments, because some of those investments will be at the expense of gross margins. That could put further pressure on the share price, at least over the next eight quarters or so.
  • Target isn't starting from zero. The company may have been slow to respond to the challenge of online retailing, but it has been developing, refining and improving its digital capability over several years. Digital sales have been growing and last year represented 14% of Target's $69 billion total sales (almost $10 billion), and merchandise was shipped to customers from 1000 of its stores. Typically, the more experience one gets at performing something, the better one becomes. There is a learning curve, one that Amazon (NASDAQ:AMZN), for example, has already scaled and one that Target is still climbing -- with some sense of urgency, it seems.
  • Target has new management, not tied to Target's past performance. Since I wrote my first Target article, the top senior executives have been replaced. Notably, Brian Cornell (Wikipedia bio here) replaced Gregg Steinhafel as CEO in August of 2014. Since then, Target has replaced its CFO and has a new Chief Information and Digital Officer as well as a new Chief Marketing Officer. (Cornell was, apparently, the chief mover behind the company's decision to extricate itself from the bungled incursion into Canada.) In addition, the company recently beefed up its grocery operations with the recent hire of the president of the Fred Meyer division of Kroger.
  • The competition may be fierce, but the competitors aren't invincible. The main disrupter of the retail industry is Amazon, a take-no-prisoners competitor that is executing nearly flawlessly and, as a result, is annually capturing a growing share of the retail market. Amazon's growth reminds me of Walmart's growth in the 1980's, a time when pundits were mathematically (though not seriously) calculating the date upon which Walmart, if its growth continued apace, would account for 100% of retail sales in the U.S. But success invites competition, and Amazon is now as much the hunted as the hunter. Because Amazon is a bit stingy with information about the breakdown of its retail sales, it is unclear to me how much of Amazon's business involves products that Target deals in and how rapidly those sales are growing. It may already be less robust in those areas than many believe. But it's clear that in order to continue its current retail growth rate, Amazon needs to add even more domestic customers and reach deeper into the pockets of its existing customers by penetrating deeper into product categories it does not currently dominate. It may forfeit margins in an attempt to do so, but growing at its current rate will become increasingly difficult. Wal-Mart (NYSE:WMT) may be an even greater threat to Target's market share than Amazon, since Wal-Mart is also well along the e-commerce learning curve and has an efficient distribution network. On the other hand, weaker, particularly mall-based, retailers may fold their tents over time, surrendering a major portion of their market to traditional retailers like Target.
  • Key Point: Mr. Market has repriced TGT shares to reflect his reduced expectations about Target's financial performance. When Target management revealed its plans and what they will cost, the share price dropped precipitously to reflect a change in investors' assumptions about the company's near term operating performance. That is to be expected. Mr. Market doesn't like surprises. The question for investors is whether the adjusted price is one that offers a reasonable reward for taking the risk that Target's outlook is worse than it appears. How Target's sales and earnings play out in the medium term will determine where the share price settles.

Conclusion

As before, the good news is that Target shares offer a well-covered, premium dividend that has the capacity to grow. Despite the hyperbole about the death of bricks and mortar retailing, Target is not on the verge of collapse and furthermore the company has a reasonable prospect of stabilizing its market share and continuing to generate respectable free cash flow. On the other hand, the company is challenged to profitably maintain its market share while investing for long term growth.

What current and prospective stockholders are challenged with is evaluating what the investment case for Target is. The way I see it the current share price, at about 11 times trailing earnings, is roughly where it reflects value, mostly because the dividend yield is well above what is available from other retailers with similar investment grade ratings. Because I think earnings per share will be under pressure for the next eight quarters, I don't think a price closer to 10 times trailing earnings is out of the question. That would put the share price at around $48, about 7% less than the current price. Most investors, including dividend growth investors, may find that scenario unsatisfactory relative to other opportunities with similar yields and clearer outlooks. But long-term value investors might find the opportunity offers a sufficient combination of dividend income and ultimate capital appreciation to include TGT as a non-core holding. I fit into that latter camp and am long TGT at this price level.

(But it sure would be helpful if the company still had the $20 billion it spent in buybacks over the last 10 years!)

Disclosure: I am/we are long TGT, WMT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please beware: I am just some guy who has been handling his own investments for over 20 years. I am not licensed to do anything except drive and fish. I am not a certified financial planner or financial advisor. I have no letters whatsoever before or after my given name. I don't ask Seeking Alpha for any compensation for the articles I write.