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Why Target Is A Buy After 18% Price Decline

Published January 25th, 2017 by The Financial Canadian

Recently, retail stocks have been hammered in response to the growing trend towards e-commerce.

Major players like Amazon (AMZN) are changing the way that consumers view the shopping experience.

One company whose investors have felt this firsthand is Target (TGT). The company’s stock has declined 18% from its recent highs during November 2016.

Target Stock Price

Source Yahoo! Finance

However, this might not be a bad thing for Target’s investors.

“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”
Warren Buffett

Target has many of the characteristics of a great company. They operate in the recession-resistant discount retail industry, and have tremendous brand equity. Forbes estimates the Target brand to be worth $7.2 billion.

Target also has an admirable dividend history. In 2016, the company announced their 45th consecutive dividend increase. This makes Target a Dividend Aristocrat, a group of elite companies with 25+ consecutive years of dividend increases.

You can see the full list of Dividend Aristocrats here.

This article discusses why Target’s recent price decline represents a buying opportunity, not a reason to sell.

Business Overview

Target’s origins can be traced back to a single store in Roseville, Minnesota that was opened in 1962. Throughout the company’s operating history, they have stood by their core mantra – expect more, pay less.

This belief has driven Target’s impressive growth. The company has a current market capitalization of $36 billion, 2015 sales of ~$74 billion, and net earnings of $3.3 billion.

For reporting purposes, Target’s business is divided into five core segments:

Target benefits from considerable diversification across each of their operating segments. Out of the company’s five segments, the smallest and largest contributions to 2015 sales were 17% and 26%, respectively.

Unlike some other retailers, Target’s operations are geographically focused within the United States (recent Canadian expansion efforts aside).

With the recent strength of the U.S. dollar, this has benefitted Target as a number of their competitors have seen currency effects present a headwind to financial performance.

Growth Prospects

Historically, Target has done a phenomenal job of growing their bottom line. The company has compounded their earnings per share from $1.38 in 2000 to $4.69 in 2015, which equates to a cumulative annualized growth rate (CAGR) of 8.5%.

Target Earnings Growth

Source: Value Line

The sharp decline in earnings during the 2013 fiscal year is caused by expenses related to Target’s hacking scandal, a one-time event that has seen Target take additional measures with regard to privacy and information security.

Looking ahead, there are two primary drivers of expected growth for Target. These are the continued growth in their e-commerce platform and the company’s transition to small stores.

Target’s e-commerce platform has grown rapidly in recent times, with fiscal 2015 showing 30% sales growth for this segment. December, the ever-important holiday season, saw impressive 40% growth in Target’s e-commerce sales.

While the brick-and-mortar versus on-line retail debate has been argued exhaustively, Target is in an enviable position because they have a presence in both. The continued growth in their online platform will be a strong contributor to growth moving forward, while their brick-and-mortar locations will continued to appeal to consumers who prefer them.

Target is also revolutionizing their store offering with the implementation of smaller stores in urbanized areas – what management has been calling ‘flex-format’ stores. The company is aiming to open 20 more of these stores in fiscal 2017.

Target views flex-format stores as beneficial because it allows them to penetrate geographic markets that would otherwise fall outside the company’s operating scope. Downtown real estate is in high demand, which results in prices that are simply too high to merit a full-size Target location.

Small stores fill this gap and make Target accessible to a different group of consumers.

Competitive Advantage & Recession Performance

Discount retailers operate recession-resilient business models. Since they sell products to consumers at a discount to most other sources, demand remains strong during economic downturns.

However, Target’s smaller size versus competitors like Wal-Mart (WMT) means that Target does not necessarily have the lowest prices.

The company instead differentiates themselves with the quality of their stores. With competitors like Wal-Mart recently being criticized for disorganization and thin staffing, consumers look to Target as the alternative. This has resulted in Target being seen as the ‘premium’ discount retailer.

For investors, Target’s real estate situation provides an additional competitive advantage. Unlike most other retailers, Target owns the bulk of their locations, benefiting the company in two ways.

First, the company doesn’t have lease obligations to an external party. Secondly, if the company were to ever liquidate (very unlikely), investors would benefit due to the inherent value of these properties.

Interestingly, Buckingham Research has recently estimated that Target’s real estate is currently worth more than the book value of the company, making Target an attractive value play if the firm’s estimates are correct.

Given these factors, it’s no surprise that Target has historically performed well during periods of economic recession. Consider their earnings per share during the last great recession:

After a single year, Target’s earnings per share had recovered to within three cents of their pre-crisis levels. Based on these results, I would expect Target to perform very well during future recessions.

Valuation & Expected Returns

Future returns for Target shareholders will be composed of the current dividend yield of 3.7%, earnings growth, and valuation expansions.

On February 28, Target is will be announcing earnings for fiscal 2016. Management has publicly communicated that they expect earnings above $5.00 on a per share basis, while analysts expect $5.20.

Using this $5.20 estimate and January 24th’s closing price of $64.41, the company is currently trading at 12.4 times 2016’s expected earnings. This is very cheap compared to historical levels, would compare even more favorably if 2015’s earnings were used instead.

The following diagram illustrates how this valuation multiple relates to the company’s historical valuation.

Target Valuation Analysis

Source: Value Line

Target is also attractively valued when considering another metric: dividend yield. The last time investors were able to purchase target shares at a 3.7% dividend yield was in the late 1980s.

Target Dividend Yield

Source: Sure Dividend Newsletter

With these factors in mind, I expect future total returns for Target shareholders to be composed of:

Giving a base case of 9.7%-11.7% total returns. That being said, it is highly probably that valuation expansion will be a major contributor to returns, at least in the short term.

Final Thoughts

Target is an attractive stock at today’s levels. The company is a high-quality business, and this has not gone unnoticed in the investing community – the stock is one of the 10 most popular dividend growth stocks among dividend growth bloggers.

With its high dividend yield, low valuation, and tremendous record of both earnings and dividend growth, Target ranks very favorably using The 8 Rules of Dividend Investing. Investors seeking retail exposure should consider adding this high-quality company to their portfolio.

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