Wednesday, June 25, 2014

Is Target's Yield At 3.6% Worth The Risk?

One of the nice things about dividends is they provide a cushion for annual returns; if a stock is yielding 3.6% then we only need to see a 5% gain in a security to a decent annual gain.  And, when the company paying the dividend is one of the largest US retailers, taking a deeper look makes sense.

The retail environment has been extremely difficult for US retailers since the end of the recession.  Let's start by looking at a chart of real personal consumption expenditures:

Above is a chart of the year over year percentage change in real PCEs.  In most of the previous expansions, we see the number fluctuating a bit below the 5% line.  However, since the end of the last recession, we've seen that number halved to about 2.5%.  This lower level of demand has impacted the results of all retailers, making them attractive shorts:

Among the 62 retail stocks within his team's coverage, 14 stocks had short interest of 15% or greater, which is the highest number of companies above the 15% threshold in the post-recession period. Of the 14 stocks with high short interest, those that have been shorted the longest have seen the largest stock price declines.

Target is the third largest discount retailer by market cap, coming in behind Walmart and Costco.  When looking at a retailer, the first statement I look at is the cash flow statement to see two things: are they generating cash and is it sufficient to cover annual investments?  The average of Target's investment activities for the last three years is $2.9 billion while the median number is $3.2 billion.  The lowest amount of cash flow from operations we've seen over the last five years is $5.2 billion, so they've generating more than enough cash from operations.  In fact, the lowest margin they've had of operating minus investing funds over the last 5 years is $1.2 billion.  This margin gives them a greater degree of flexibility with their funding structure, allowing them to use multiple financing options depending on cost and availability. 

The growth in their income statement margins is less than impressive:

We see a slow pace of overall revenue growth for fiscal years 2011-2013.  According to Reuter's, Target's pace of growth is far below that of its industry (which has a 10.8% growth rate over the last five years).  Given Target's size (I don't expect one of the largest retailers to grow at that pace) , I don't think slow growth rate is fatal, but more an indication of its position as one of the biggest retailers in the country.

Also note that operating and net margins are under pressure.  Retailing is by definition a low margin business, with the industry's average net margin coming in at 4.44%.  However, we would expect a large retailer to have a bit more control over its margin, given its ability to pressure venders etc.. 

The obvious culprit of the disastrous results last year is the data breach which occurred in the 4Q.   The company's latest 10-K offers the following on that issue:

As previously disclosed, we experienced a data breach in which an intruder stole certain payment card and other guest information from our network (the Data Breach). Based on our investigation to date, we believe that the intruder accessed and stole payment card data from approximately 40 million credit and debit card accounts of guests who shopped at our U.S. stores between November 27 and December 15, 2013, through malware installed on our point-of-sale system in our U.S. stores. On December 15, we removed the malware from virtually all registers in our U.S. stores. Payment card data used in transactions made by 56 additional guests in the period between December 16 and December 17 was stolen prior to our disabling malware on one additional register that was disconnected from our system when we completed the initial malware removal on December 15. In addition, the intruder stole certain guest information, including names, mailing addresses, phone numbers or email addresses, for up to 70 million individuals. Our investigation of the matter is ongoing, and we are supporting law enforcement efforts to identify the responsible parties.

Expenses Incurred and Amounts Accrued 

In the fourth quarter of 2013, we recorded $61 million of pretax Data Breach-related expenses, and expected insurance proceeds of $44 million, for net expenses of $17 million ($11 million after tax), or $0.02 per diluted share. These expenses were included in our Consolidated Statements of Operations as Selling, General and Administrative Expenses (SG&A), but were not part of our segment results. Expenses include costs to investigate the Data Breach, provide credit-monitoring services to our guests, increase staffing in our call centers, and procure legal and other professional services.

In addition to the costs, there is the potential for protracted litigation related to the breach.

But Target's issues run deeper.  A Recent story on the ouster of their CEO offers a good, in-depth report of the problems, highlighting a big change in corporate culture under the new CEO that de-fanged the company's internal drive for innovation.  And their attempt to expand into Canada has not gone as well as it should have, creating more headaches and problems.

However, despite the rather negative view of their income statement margins in the above chart, Target generated $72.2 billion in revenue in 2013, which was a little more than 1% below their 2012 gross number.  And as they're a big box retailer, they're not going away anytime soon.  Yes, annual sales totals may drop further, but they're not going to go crashing through the floor.  And, the lowest EDITA they're printed in the last 5 years is $6.4 billion with the largest annual interest expense being $1.2 trillion.  This means the dividend payment (which was a little over $1 billion in their most recent year) is safe.


The weekly chart shows a security that has declined about 17% from its high of 71.4.  By most valuation measures (price to sales, price to book etc..) the company is undervalued.  At this level, with a dividend far above that of its industry, this look like a decent level for a dividend play.  But, assume you'll hear more bad news about internal management and the cyber-issue going forward.  In other words, treat this like an income play with a turnaround component.