Lately, there has been lots of talk amongst dividend growth investors about Target Corporation. Over the past year, TGT has underperformed the S&P 500 by nearly 34%. In a world where it is difficult to find value, TGT’s 12-month performance is enticing. Add on the now 3.4% dividend yield, 46 years of dividend growth, and a household brand name and we’ve got ourselves a very tantalizing offer.
Target’s woes are very widely known and can be traced back to two primary issues:
Target moved towards expanding outside the United States, opening up 127 stores in Canada. So far, it’s been nothing but a complete and total disaster. One Canadian TV broadcaster described it as, “the biggest retail failure Canada has ever seen.” Target’s Canadian adventure has been so badly botched that Target actually created a video specifically apologizing to Canadian customers.
They should also create one apologizing to shareholders. The debacle has been very costly and is now clearly reflected in Target’s stock price. While there are certainly signs that Target is starting to gain a little traction, reputation is an integral part of any business and bad first impressions are difficult to recover from. Only time will tell whether Target can turn it around in Canada, but it was a very large investment that has – so far – not come close to paying off.
(2) Data Breach
40 million credit card numbers and 70 million addresses were leaked to hackers who installed malware on Target’s system. More than 90 lawsuits have been filed against Target, who has already spent $61 million responding to the data breach.
Before investing in Target (or any company for that matter), you really should read through the company’s SEC filings. Not to ruin the suspense, but Target reported some pretty interesting things to the SEC in their latest 10-K filing. Target warned that the legal expenses resulting from lawsuits and government investigations could have a “material impact” on future earnings and/or the company’s reputation. In addition, some expenses related to the breach have not been accounted for on Target’s balance sheet not because they are unlikely to occur, but because they are impossible to accurately estimate. In other words, Target has some significant unplanned expenses on the horizon and they, nor anyone else, has any remote clue how large they will be. Yikes!
Yeah, But Those Are Just One-Time Issues… Right?
As a result of the data breach and Canadian problems, Target’s CEO resigned. In the interim, CFO John Mulligan has stepped into the CEO role. The company has indicated that it will be looking outside the organization to fill the leadership void. Looking outside means they don’t have much confidence in what’s inside, which is not a good sign for current or potential shareholders.
All companies go through a few isolated issues at some point in their lifetimes. If Target were merely experiencing a few road bumps, it might make sense for long-term investors to buy in and ride through the bumpiness. However, Target’s woes extend beyond these isolated issues.
Retail companies are very low net margin businesses, with the industry average at a paltry 4.4%. These businesses are under tremendous pricing pressure as consumers dance around different stores and online retailers to quickly and easily find the best price for the same goods. As CEO John Mulligan said in Target’s 2014 Q1 conference call, “We ramped up the intensity of our deals in the first quarter to get guests back into our stores and this decision was reflected both in better sales traffic and a lower gross margin rate.” Retail is a difficult business to build a wide economic moat, which is why it generally makes for a poor investment.
Despite the difficulties in the retail environment, Wal-Mart’s operating income has grown by 3.5% since 2010. That’s certainly not going to blow the stocks off of anyone, but it is much more impressive than Target, whose operating income has shrunk by 2.7% over the same time period.
Despite the lackluster historical record, analysts seem to be rather optimistic about Target’s turnaround. According to Yahoo! Finance, the consensus 5-year growth rate for Target is 12.9%.
I don’t know who exactly is making those projections, but I sure would like to try what their smoking. Profitability metrics don’t provide much more to get excited about than the lackluster growth history. Target’s Return on Equity (ROE) multiplied by its retention ratio (what it doesn’t pay out in a dividend) is 4.9%. The same calculation using Return on Invested Capital (ROIC) is a slightly more impressive 6.3%. Cash Return on Invested Capital (CROIC), which use’s Warren Buffett’s “owner’s earnings” as a substitute for reported earnings, is a paltry 4.1%. Without some sort of miraculous revenue growth or additional investment, it seems unlikely that Target can grow much faster than 6.3% over the long run.
Despite my hesitations about analyst’s estimates, let’s just assume that Target can actually grow at 12.9% over the next 5 years. Using that growth rate discounted at 11%, Target’s fair value comes out to $63.20 using the median of six different models (dividend discount model, discounted cash flow model, earnings power valuation, Katsenelson’s absolute PE model, Graham model, and EV/EBIT valuation). Substituting the analyst’s 12.9% growth rate for the much more conservative 6.3%, Target’s median valuation falls to $46.95.
Many dividend investors point to Target’s 3.4% yield as one of their primary factors for purchase. In an environment where the 30-year U.S. Treasury bond is yielding less than Target’s dividend yield, that’s a pretty impressive argument for buying TGT. However, it is worth noting that Target’s yield is benefited by a rather high dividend payout ratio of 56%. By comparison, Wal-Mart’s payout ratio is 37%. If Wal-Mart were to increase their payout ratio to match Target’s, they would have a dividend yield of 3.8%.
Perhaps consumers will soon forgive Target of it’s woes and their stores will catch on in Canada. If that happens, Canada will likely be a good buy from its current prices. However, as Ben Graham said, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Betting that Target will return to its former glory (if that even existed in the first place), sounds an awful lot like speculation to me. At current price levels, I would encourage investors to be wary of investing in Target without a much larger margin of safety.