Undervalued Dividend Growth Stock of the Week: Target Corporation (TGT)

March 19, 2017
By

I’m the kind of person who doesn’t really live with regret.

I don’t ever think back on mistakes I made, wishing I would have done things differently.

Instead, I simply try to learn from my mistakes. I then use those experiences to my advantage, becoming a better and smarter version of myself.

But I can say for sure one of the biggest mistakes I ever made in my life was waiting until I was in my late 20s before I started aggressively saving and investing.

If I had started back when I was, say, 20 years old, I probably would have been financially independent before I turned 30.

However, the effects of compounding are so powerful that they overcame my prior mistakes.

Indeed, even though I didn’t start investing until I was almost 28 years old, I was still able to retire in my early 30s.

But that’s what can happen when you live well below your means and invest in high-quality dividend growth stocks like those featured on David Fish’s Dividend Champions, Contenders, and Challengers list.

I stick to high-quality dividend growth stocks because it involves investing in wonderful businesses that have lengthy track records of paying increasing dividends to shareholders.

Growing dividends over a long period of time is a great initial litmus test of a company’s quality.

That’s because a business has to be regularly growing profit and running a solid operation in order to write ever-larger checks to shareholders for years – or decades – on end.

Most of the passive income that renders me financially independent at such a young age comes from the real-money, real-life portfolio of high-quality dividend growth stocks I’ve collected over the last seven years of my life.

But I didn’t just buy these stocks at random.

I performed a full quantitative and qualitative analysis on each business before actually going through the process of valuing its stock.

This is absolutely crucial if you want to successfully and intelligently invest over the long haul.

The quantitative analysis involves actually going through financial statements to look at objective business results (like revenue and profit growth, debt, margins, etc.).

The qualitative analysis involves looking at what a company does, what competitive advantages it might have, and its growth opportunities looking forward.

And valuing a stock involves putting all these pieces together into a coherent equation that gives an investor a reasonable estimate of what the stock is worth.

That last part is so important.

The price of a stock is simply what it costs. Price actually tells you very little.

The value of a stock is what it’s worth. Value tells you almost everything.

Value gives context to price. Value tells you whether or not the price is appropriate. And how much you pay relative to value has a major impact on your investment over the long term.

This is why I always aim to buy a high-quality dividend growth stock (determined after the aforementioned quantitative and qualitative analysis) when it’s undervalued.

Undervaluation is present when the price is below fair value.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk over the long run.

That’s all relative to what the same stock would offer if it were otherwise fairly valued or overvalued.

It’s easy to see how these benefits are conferred with undervaluation.

For example, price and yield are inversely correlated.

That means, all else equal, a lower price will result in a higher yield.

That higher yield then positively impacts total return over the long run, as yield is one of two components of total return.

And the other component, capital gain, is also positively influenced by virtue of the upside that exists between the lower price paid and the higher worth of the stock.

That gap is upside. And if the gap fills, it results in capital gain.

The good news is that while price may wildly differ from value over the short run (due to media coverage, human emotions, etc.), price and value tend to converge over the long run.

All of this also reduces the investor’s risk, too.

After all, paying less per share is going result in risking less absolute capital if one is buying a fixed number of shares.

Even if the investor decides instead to get more shares for the same amount of money, a margin of safety is introduced when one pays less than what a stock is worth.

That margin of safety is a buffer against any number of negative events that can (and do) happen when investing in companies.

Management incompetence, malfeasance, eroding competitive advantages, and negative regulatory changes are just a few examples of that which can have a negative impact on the value of a company.

As such, one doesn’t want to pay fair value or more, because that leaves no room for these possibilities.

So buying a high-quality dividend growth stock when it’s undervalued is appealing.

But how does one know when undervaluation is present?

Well, that’s where fellow contributor Dave Van Knapp’s dividend growth stock valuation lesson comes into play.

This lesson is part of an overarching series of lessons on dividend growth investing, and it’s a great tool to use when it comes time to value a dividend growth stock.

But it doesn’t end there, folks.

Nope.

I’m actually going to discuss a high-quality dividend growth stock that right now appears to be modestly undervalued…

Target Corporation (TGT) is a North American retailer that operates approximately 1,800 stores across the US.

Target needs no introduction. The odds are pretty strong that most of you reading this article have stopped in a Target store at some point in the last 30 days.

With ~1,800 stores and a corporate history that dates back more than 100 years ago, Target is one of the largest and most enduring retailers that has ever existed.

However, the face of retail is changing quickly.

Recent results from the company disappointed, growth is increasingly hard to come by, and e-commerce is making the prospect of running a fleet of large-footprint stores daunting and not as economically intelligent as it used to be.

In response, Target is going to invest $7 billion into its stores, digital platform, and lower prices over the next three years in order to stoke growth and reclaim lost market share.

So there’s a lot to consider here.

However, one thing that isn’t up for consideration is Target’s amazing dividend growth pedigree: the company has increased its dividend for 49 consecutive years, which is one of the longest such streaks for any company in any industry, let alone retail.

Over the last decade, the dividend has grown at a compound annual rate of 18.1%, which is mighty impressive.

CaptureHowever, the most recent dividend increase was just a little over 7%.

And with the $7 billion in investments over the next three years, that leaves even less money for dividend increases.

As such, I would expect low-single-digit growth moving forward.

But the payout ratio is just 51%.

That’s almost what I would call a “perfect” payout ratio – a ratio that perfectly balances profit returned to shareholders, and reinvestment back into the business.

So even without any profit growth, Target could actually grow its dividend at a modest rate moving forward.

The only issue here being that FY 2017 guidance is calling for a ~15% drop at the midpoint, due in large part to the ongoing investments they’re going to be making into the brand.

With that in mind, again, I think mid-single-digit dividend growth is what investors should be expecting insofar as dividend growth is concerned, and even that could be argued as an aggressive expectation.

But – and there’s always a but – the stock does yield a monstrous 4.42% here.

So while investors might not be getting the dividend growth they’ve long come to expect from Target, the current yield is making up for at least some of that.

That yield is right up there with a lot of utilities – and it actually surpasses many utilities.

That’s because the stock is down more than 30% over the last year.

While Target is probably worth less than it was a year ago, 30% is a pretty strong move to the downside. If the downside move is too strong, it creates upside by way of undervaluation.

By the way, Target’s stock has averaged a yield of 2.7% over the last five years. So the stock now offers a yield that’s about 170 basis points higher than its five-year average.

Lower growth, but definitely a much higher yield.

However, in order to really get an idea of what kind of dividend growth to expect moving forward, we must first look at what kind of underlying growth the company is generating.

We’ll look at what the last 10 years looks like in terms of top-line and bottom-line growth, and we’ll then compare that to a near-term forecast for profit growth.

This will help us not only gauge dividend growth, it’ll also help us when it comes time to value the stock.

Target’s revenue has increased from $63.367 billion to $69.495 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 1.03%.

Not much top-line growth here at all, which is disappointing.

Meanwhile, the company’s bottom line fared a little bitter, thanks to significant share buybacks. The outstanding share count is down by more than 30% over this 10-year stretch. Of course, the price of the stock was above its current price for much of this period, so the buyback probably wasn’t a great use of shareholders’ capital.

Nonetheless, Target’s earnings per share grew from $3.33 to $4.70 over the last decade, which is a CAGR of 3.90%.

Again, disappointing.

If you would have looked at these numbers a year ago, they would have looked a lot better. The most recent FY wasn’t great, which changes the whole equation.

Looking forward, S&P Capital IQ believes that Target will compound its EPS at an annual rate of 10% over the next three years, citing online sales growth and improving economic conditions.

I’m not that optimistic. Recent guidance is calling for a pretty big drop in GAAP EPS, and the massive spending plan takes place over the next three years (the same time frame as S&P Capital IQ’s projection). However, even eventual growth at half that 10% forecast would be solid.

The rest of the company’s fundamentals are acceptable, as we’ll now see.

First, the balance sheet.

The long-term debt/equity ratio is roughly 1, while the interest coverage ratio is approximately 5.

Both numbers are competitive for the industry, but I think there’s definitely room for improvement. The good news is that Target’s balance sheet hasn’t measurably deteriorated over the last decade, unlike a lot of large companies across most industries.

Profitability is naturally limited due to the retail industry; however, Target is doing better than a lot of other large general retailers.

Over the last five years, the company has averaged net margin of 3.88% and return on equity of 17.66%.

All in all, this is a company that’s fallen on hard times.

Competition has never been more fierce, and they haven’t yet solved the e-commerce conundrum.

However, they’re not taking the challenge sitting still. They’re aggressively investing back into the business. And they’re rapidly growing their digital sales – up by 34% for the most recent quarter (though the digital channel is still a small overall portion of their sales).

Target is one of the most enduring retailers of all. Almost 50 years of dividend increases proves that out. As such, it doesn’t take a ton of faith to believe they’ll continue to change with the times again.

But it does appear that others have lost the faith, as the stock is down about 25% in 2017 alone.

This could be leading to an opportunity, however…

The P/E ratio for the stock is sitting at 11.82, which compares extremely favorably to the broader market. In fact, that’s less than half the P/E ratio for the S&P 500. And the yield, as noted earlier, is substantially higher than its recent historical average.

So the stock does look cheap here, but we have to factor in the slowing growth. What might the stock be worth right now?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate to account for the high yield.

And I assumed just a 5% long-term dividend growth rate, which is conservative on purpose.

The dividend growth is likely to slow considerably from its long-term average, as slowing profit growth and reinvestment back into the business limits dividend growth potential.

The DDM analysis gives me a fair value of $63.00.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even with a pretty conservative valuation analysis, the stock still looks fairly cheap. But let’s compare my perspective to that of professional analysts that have taken the time to analyze and value the stock, as my viewpoint is but one of many.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates TGT as a 3-star stock, with a fair value estimate of $54.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates TGT as a 3-star “HOLD”, with a 12-month target price of $58.00.

I came in the most aggressive, which means these other analyses must be even more conservative than what I figured on. Nonetheless, the average of the three figures comes out to $58.33, which would indicate the stock is potentially 7% undervalued right now. Not a huge discount to fair value, but the yield and dividend growth track record are both pretty phenomenal.

TGT_chartBottom line: Target Corporation (TGT) is a high-quality retailer that has increased its dividend for almost 50 consecutive years, proving time and again that it has the ability to change with the times. New investment initiatives are necessary in order to change once more; however, near-term dividend growth may be muted as a result. Still, investors are looking at a utility-like yield and the possibility of 7% upside on top of what’s almost a sure bet for more dividend increases for years to come.

– Jason Fieber

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