My Crosshairs Are On Target

Published by Nick Mackintosh on

  • The company published its Q1 report on May 23rd and declined 5.3% after missing analyst estimates
  • Margin compression has caused fears over future performance
  • Were the results really that bad, or are investors focusing too much on wall street predictions
  • Target has increased dividends for 50 years in a row with a dividend yield of 3.50%

Business Overview

Target Corporation (NYSE: TGT) started in 1902 under the name Dayton Dry Goods Company by its founder, George Draper Dayton. Since then the company has grown to become the second largest discount retailer in the United States behind Walmart (NYSE: WMT).

The company is diversified equally among 5 business segments, Beauty & Household Essentials, Food & Beverage, Apparel & Accessories, Home Furnishings & Decor, and Hardlines.

Strategy

The company is currently modernizing key aspects of its business, digital marketing and e-commerce have been a big focus since Amazon (NYSE: AMZN) started disrupting the sector with its huge growth on virtually no profit. Redesigning over 1,800 stores as showrooms and neighborhood fulfillment centers will make it easier for Target’s e-commerce by outsourcing warehousing and shipping. This will help boost the profit margins in future as they can close down brick and mortar stores that have the lowest profitability.

Within the last 12 months, Target has rolled out new technology that includes a mobile wallet, they’ve simplified their flagship app and also created a strong relationship between the user experience when using digital channels and when physically browsing the stores.

Over 110 stores have been remodeled, and close to 30 new small format stores were opened in key urban markets, a next-generation prototype store was launched just outside of Houston, Texas.

As I’ve previously mentioned, Target’s focus on investing in its e-commerce has meant that services like Order Pick Up, Drive Up and its next-day delivery service have improved significantly. The company also acquired 2 technology platforms, Grand Junction and Shipt, to unlock same-day deliveries and make it more cost-effective.

Annual Figures

After compiling the annual results the figures are definitely not as gloomy as what wall street would have you believe. There are 3 metrics I go by when determining a company’s valuation, these are as follows, CapFlow, CROIC and FCF Yield.

The first is a ratio of the capital expenditures of the business compared to the operating cash flow, as it will show how much the ratio that is free cash flow, and this can be used on dividends, share buybacks, reducing debt, acquisitions or reinvestment to keep growing.

The second is a ratio that uses the free cash flow and divides it by the invested capital, this will show how much cash a company can generate. For example, a company with a CROIC of 20% means it generates $0.20 for each $1 invested.

The third is basically the inverse of the price to free cash flow ratio and turns it into a percentage, historically anything under a ratio of 15 or 6.66% represents fair value and the lower it is the better. For a margin of safety, I usually don’t recommend a company unless we’re getting a 10% yield return on our money.

2013 2014 2015 2016 2017
Total Revenue (M) $ 71,279 $ 72,618 $ 73,785 $ 69,495 $ 71,879
Operating Income $ 4,121 $ 3,653 $ 4,923 $ 3,965 $ 3,646
Operating Margin 5.78% 5.03% 6.67% 5.71% 5.07%
Net Income $ 1,971 $ (1,636) $ 3,363 $ 2,737 $ 2,934
Net Income Margin 2.77% -2.25% 4.56% 3.94% 4.08%
Free Cash Flow Per Share $ 4.78 $ 4.15 $ 6.96 $ 6.67 $ 7.98
Dividend Per Share $ 1.65 $ 1.99 $ 2.20 $ 2.36 $ 2.46
Free Cash Flow Payout Ratio 34.52% 47.95% 31.61% 35.38% 30.83%

As we can see from the table above, total revenue has remained flat over the past 5 years and the operating margin has decreased by roughly 70 basis points compared to 2013. There has also been an improvement in the companies net income.

What is clearly evident is that the dividend is extremely safe as the company generates a huge amount of cash compared to what it pays out to shareholders. Recently the company has only raised dividends by roughly 3.50% the past few years, and this is something that definitely needs to be addressed, as the company can go up to a 50-60% payout ratio and still be perfectly safe. Investors expect a larger raise when the dividend is only 3.50%, anywhere from 6-8% would be reasonable. We’ll be able to find out what the next raise will be when the company reports its Q2 figures in June.

Year Cap / Flow CROIC FCF PS
2013 52.96% 10.89% $ 4.78
2014 40.23% 10.83% $ 4.15
2015 24.61% 21.13% $ 6.96
2016 28.46% 19.97% $ 6.67
2017 36.59% 21.54% $ 7.98

You can see that capital expenditures have decreased recently and this has created the vast amount of free cash flow the company now enjoys. For example, the company generated $4.4 billion in free cash flow in its 2017 annual report, while dividends paid out only cost $1.34 billion. This leaves the company with a vast amount of money for the things I mentioned earlier.

The return on invested capital is also the highest its ever been, which is why I believe investors are overreacting to recent results and are not looking at the bigger picture. The free cash flow per share has increased by a massive 67% within that 5 year period. One of the reasons is that the company has started to repurchase its own shares.

Q1 Report

The main negative over the Q1 figures reported on May 23rd was that the operating margin fell by 90 basis points from 7.1% to 6.2% when compared to the same quarter last year. The strongest traffic growth in 10 years and improving its digital sales, which should help cut costs and keep margins steady.

The company has boosted guidance for Q2 and reaffirms full-year expectations, there is nothing for investors to worry about!

  • In the second quarter, Target expects an acceleration in its comparable sales into the low to mid single-digit range.

  • For full-year 2018, Target continues to expect a low-single digit increase in comparable sales, and both GAAP EPS from continuing operations and Adjusted EPS of $5.15 to $5.45.

Conclusion

There are only a few companies that can say they have increased dividends for over 50 years in a row and Target is one of them. Its average dividend yield has been 3.20% so you’re getting it at a discount with the yield at 3.50%. The company’s share price suffered last year and it fell dramatically to $48 after a boycott of its stores over its transgender bathroom policy.

Warren Buffett’s “be greedy when others are fearful” quote gave value investors an amazing 40% return to today’s current share price of $71.21. The crazy thing is, with free cash flow of $7.98 per share the company is still ridiculously cheap at a ratio of only 8.92! This gives you a free cash flow yield of 11.21% on your money! I’m recommending you buy roughly 50% of your normal position size and if you’re reading this article late you can buy up to a price of $79.80.

The second half of your position will be reserved for $50 as I’m not a fool and understand where the shares have been recently and could be again, after a 10-year bull market its best to stay conservative and not commit all of your cash to a position.

 

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Nick Mackintosh

My name is Nicholas Mackintosh and I’m the Creator and Founder of HelpingTheLittleGuy.com I created this website to help anyone looking for a way to save and earn more with their money. Knowledge is given freely in order to give you a fair shake in a system that is determined to keep you poor, preventing you from having the lifestyle you deserve.

2 Comments

Jim · June 12, 2018 at 5:25 pm

You are right that the company looks good on its current numbers, but from 2013 to the present time the US economy has grown as the economy has recovered. Despite this Target has been unable to grow its revenue. The company faces competitors such as amazon and soon Aldi /Lidl who have much higher sales per m2 and therefore can sell at lower prices. Target has a portfolio of large stores and will struggle to compete since it cannot reduce the size of its stores to get its sales per m2 up. It therefore has to carry too much inventory and slow selling lines of stock.

Online retailers such as Amazon enjoys a virtuous cycle of greaters sales and lower costs which drives growth. I agree with all of you other analysis on other stocks but I wouldn’t touch retail because their is a secular shift into discounters and online. I dont think big store operators will be able to compete going forward.

Regards,

Jim

    Nick Mackintosh · June 12, 2018 at 7:29 pm

    Hey Jim, thanks for taking the time to comment!

    Retailing is extremely hard to value due to increased competition and margins being squeezed, this is why I stay far away from the likes of Tesco, Sainsbury and Marks & Spencer in the UK. I agree with you that Target has a tough time ahead, Amazon has been a disruptor in the sector for many years now and Walmart is taking on its own initiatives such as the acquisition of Flipkart, India’s E-Commerce giant to be in direct competition with Amazon. Walmart’s potential acquisition of Pill Pack (not sure if that has gone through or not yet) could also increase their margins rather handsomely.

    The recent announcement of the Toys R Us bankruptcy could definitely help Target’s toy division, and I have mentioned they were on-target to double their e-commerce while remodeling stores that should improve sales. I admit this isn’t a WOW factor, but the CROIC and FCF growth are enough to convince me that its worth the investment at this price. Though obviously not a full position as I mentioned the risks towards the end of the article of where the price has been.

    These are interesting times ahead, Aldi & Lidl are very dominant in the U.K. but I’m not sure of Aldi’s impact in the USA. The sector is packed with heavy hitters such as Costco, Ross Stores, Walmart, Target, Dollar General and Dollar Tree just to name a few… I do wonder how much market share is left for discounters & Amazon to take? It’s not exactly a free lunch and we’ve seen that the companies are adapting, albeit slowly compared to Amazon which always seems to be ahead of the curve.

    Thought-provoking indeed.

    Nick

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