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Target: Investing In Grocery And E-Commerce Pays Dividends

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Target (TGT) was founded in 1902 and after a failed bid to expand into Canada, has operations solely in the U.S. market. Its business consists of about 1,850 big box stores, which offer general merchandise and food. Target has a market capitalization of $43.8 billion and should produce about $78 billion in total revenue this year.

The company has been able to withstand the ongoing price war in the grocery sector. The acquisition of Whole Foods by Amazon caused shockwaves for traditional grocers, but the dire forecasts on pricing and market share have not materialized. Moreover, Target has moved in the right direction to address its challenges. It has invested heavily in the remodeling of its stores and has expanded the same-day delivery option to about 65% of U.S. households.

Source

TGT is one of five grocery stocks that is weathering the competition within the sector well and look attractively priced today with the ability to deliver strong total annual returns over the next five years.

Recent Results

Target reported very strong Q1 results, sending the stock up 8% on the day as investors cheered the report:

  • Total revenue was up 5% year-over-year
  • Comparable sales growth of 4.8%
  • Digital sales soared 42%
  • Operating income rose 9%
  • Operating margin improved by 20 basis points
  • SG&A costs were down 30 basis points, reflecting the savings in technology and lower market expenses

Target continues to expect low to mid-single digit gains in comparable sales for this year and an earnings-per-share range of $5.75 to $6.05. Separately, Target returned $608 million to shareholders in Q1, including dividends of $330 million and share repurchases of $278 million in repurchases. The company has $1 billion left on its current buyback authorization.

Growth Outlook

Target has grown its earnings-per-share at an average annual rate of 6.5% during the last decade in part fueled by its aggressive share buyback program, which has reduced total shares outstanding by 4% per year in the last half decade and is likely to remain a tailwind for the foreseeable future. Combining a 3%-4% annual tailwind from the buyback program with low single-digit same-store sales growth and slight margin expansion, it is reasonable to expect about 6% annualized earnings per share growth over the next half decade.

Management has been able to keep the company competitive in the face of growing competition from online retailers such as Amazon as well as continued pressure from industry giant Walmart by innovating extensively. These include new stores with smaller formats, investments into its employees, and the expansion of services such as online shopping, shipping, and home deliveries. Online shopping has proven to be particularly effective, with sales growing by 42% year-over-year in its latest quarter. Another innovation that was initiated by fellow retailer Best Buy was to partner with suppliers in effectively marketing popular products. Perhaps its most effective example of late is its partnership with Vineyard Vines, which has earned rave reviews from Target executives.

Dividend Analysis

Target is a Dividend Aristocrat that has grown its dividend for 49 consecutive years, very nearly making it a Dividend King. Both of these elite groups of dividend growers are full of companies with very resilient business models that enable them to consistently fund and grow dividend payouts for so long. For our complete list of Dividend Aristocrats, click here and for our complete list of Dividend Kings, click here. However, as it has grown its dividend much more quickly than its earnings, the company has markedly increased its payout ratio, from 20% in 2009 to 43% this year. Moreover, the company is heavily investing in its business in order to navigate through the changing landscape in the retail sector. Therefore, Target is likely to raise its dividend at a slower pace in the upcoming years.

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Despite the elevated payout ratio and the slower dividend growth outlook, we believe that the company’s dividend still remains safe given that 43% is still a very low payout ratio and the company’s earnings only fell by 14% during the last recession. This still leaves it plenty of room to sustain and even grow its dividend from current levels should such a scenario happen again.

Valuation

Despite a recent surge in price, shares still remain fairly attractive in our view. Trading at around 15 times earnings, shares are hovering right around their 10-year average price to earnings multiple, which is also our fair value estimate. The dividend yields around 3% and should continue to grow steadily and combine with earnings per share growth as previously discussed to generate close to 10% annualized total returns for the foreseeable future.

Risks

As with all bricks-and-mortar retailers, Target’s number one challenge is the rapid gains being made by e-commerce. Not only does this increased competition take market share away from Target and reduce its revenue growth outlook, but it also forces Target to enter the online retailing business, which, when combined with quick home delivery and dealing with expensive clothing item returns, is a much lower margin business.

On top of that, Target’s better-financed and much larger rival Walmart continues to pressure Target from a pricing and selection standpoint. The company will need to continue to appeal to its niche of loyal followers while also drawing enough general consumer interest by creatively partnering with suppliers, growing its loyalty program, and emphasizing the superior convenience and quality of its shopping experience.

Ultimately, the company will need to continue to build out and optimize its omnichannel business model and supply chain network in order to keep costs to a minimum while also satisfying customers in an ever-intensifying competitive environment.

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Final Thoughts

While Target is no longer the bargain it was just a few months ago, it still remains an attractively priced dividend growth stock that is nearing the prestigious status of Dividend King. Given the low payout ratio, solid growth prospects, and the company’s relative recession resiliency, we have little doubt that it will soon join the ranks of that elite group and will reward investors with solid total returns for the foreseeable future.

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