It’s not too often that you find a dividend aristocrat with a 3% dividend yield and 20% annual dividend growth over the past decade.

Target (TGT) just so happens to be one of these stocks. The company has been in business for more than 100 years and will likely be around for the next 100 as well.

Despite the company’s durability, it has faced a number of challenges in recent years – the 2013 data breach, an unsuccessful expansion into Canada, and rising pressure from e-commerce competitors.

Let’s take a closer look at the business and see if these challenges make TGT a worthwhile investment for our Top 20 Dividend Stocks portfolio today.

Business Overview

TGT was incorporated in 1902, but its first discount Target store opened in 1962. The company now has nearly 1,800 locations across the United States. TGT’s stores focus on convenient one-stop shopping and competitive discount prices, offering a broad range of product categories including personal care, beauty, electronics, apparel, food, furniture, appliances, baby care, movies, and much more.

The company is the second largest general merchandise retailer in America, second to only Walmart. Compared to Walmart, TGT is much smaller ($73 billion in sales last year vs $486 billion at Walmart), has less grocery business (21% of sales vs 56% at Walmart) and targets a relatively wealthier demographic. TGT’s typical customer is 40 years old and has a median household income of $64,000. Approximately one-third of TGT’s sales are related to its owned and exclusive brands. The rest of its products are mostly national brand merchandise.

Business Analysis

Like most companies with over 100 years of operating history, TGT has not been without its challenges. Many consumers remember TGT’s data breach that exposed about 40 million credit and debit cards to fraud in December 2013.

According to the Wall Street Journal, trade groups representing community banks and credit unions estimate that they spent more than $350 million to reissue credit and debit cards and deal with other issues tied to TGT’s breach and the subsequent Home Depot hack.

TGT settled with Visa for $67 million earlier this year and is expected to strike a similar agreement with MasterCard. The costs of the settlement were already reflected in its 2013 and 2014 results, but the data breach certainly gave TGT a black eye with consumers.

While the data breach was going on, TGT’s former CEO was focused on expanding the company into Canada to drive growth. The company’s strategy was overly aggressive from the beginning as TGT bought 124 locations in 2013 by purchasing all of the outlets from Zellers, a failed discounter with presumably subpar locations. Perhaps things would have turned out differently if the company launched new stores slowly and in locations that had been researched better.

Regardless, store location wasn’t the only problem. TGT faced numerous supply chain challenges that resulted in empty shelves and prices that Canadian shoppers found to be too high. After racking up $2 billion in losses since its creation in 2011, TGT’s former CEO Gregg Steinhafel, who had spent 35 years at the chain, was replaced by Brian Cornell, a hands-on retail guru who helped improve operations at Safeway, Michael’s Sam’s Club, and Pepsi.

After an internal analysis showed that it would take at least six years for TGT’s Canadian division to turn a profit, Cornell quickly decided to discontinue the company’s Canadian operations. TGT closed the last of its Canadian stores in April 2015, ending a $7 billion experiment that also caused TGT to lose some focus with its U.S. business.

However, these challenges are in the past and leave the company better focused on improving its U.S. business.

TGT’s economies of scale create high barriers of entry because it can negotiate more favorable supply contracts with buyers. New entrants would be able to match TGT’s pricing and merchandise quality. Consumers are very price-conscious and have few reasons to shop at pricier retailers offering similar merchandise.

Managing its distribution network and supply chain is another major challenge new operators would need to overcome to compete with TGT. The company has long-lasting relationships with suppliers that often span decades and has invested heavily in logistics to keep its shelves stocked.

Simply put, TGT is not going away anytime soon. Its stores are in good condition, it sells needed merchandise across nearly every product category imaginable, and the company is investing to stay relevant in e-commerce.

TGT is also taking out $2 billion in costs over the next two years which, combined with moderating new store capital expenditures, should make the company a cash cow for years to come.

Key Risks

We have no doubts that TGT’s U.S. stores will continue generating loads of cash to fund the dividend and selective reinvestment back into the business. Our bigger question is growth.

TGT became a giant by filling the suburbs of America with 130,000 square-foot boxes. This industry looks more mature by the day as giants like Walmart struggle to drive incremental growth.

We can see TGT is facing similar reinvestment challenges because its new store growth has all but come to a screeching halt over the last few years:

TGT Dividend New Store GrowthSource: Target Annual Reports, Simply Safe Dividends

These are signs of a saturated market, and with Canadian expansion off the table, TGT will need to find a way to drive growth from its U.S. business. We believe the company will increasingly pursue smaller store formats better fit for urban expansion, invest more in e-commerce to protect same-store sales growth, and pursue additional productivity initiatives to free up more cash.

Altogether, TGT seems likely to continue transitioning to more of a mature cash cow that increasingly returns cash to shareholders. Profitable growth in the mass merchandise industry is hard to come by given the market’s saturation, rising labor costs, and increased pressure from e-commerce competitors that benefit from lower operating costs.

The business will continue generating nice profits for years to come, but investors expecting 5-10% annual earnings growth could end up disappointed.

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. TGT’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

TGT recorded a very strong dividend Safety Score of 86, suggesting its current dividend payment is safer than 86% of all other dividend-paying stocks. The company’s moderate payout ratios, consistent cash flow generation, and durable store base support the rating.

Over the last 12 months, TGT’s dividend has consumed just 30% of the company’s free cash flow, providing plenty of support for the dividend and opportunities for future dividend growth. Its forward earnings payout ratio is higher but still less than 50%.

For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. TGT’s sales grew each year during the recession, reflecting the value of TGT’s lower priced merchandise and the essential nature of many of its products (e.g. food = 20%+ of sales).

TGT Dividend Sales GrowthSource: Simply Safe Dividends

High quality companies are able to generate free cash flow year in and year out. Rising cash flow is important because it supports continued dividend growth without expanding the payout ratio. As seen below, TGT has generated positive free cash flow in nine of the last 10 years. We expect free cash flow generation to improve as the company cuts costs (targets $2 billion over the next two years) and new store capex moderates.

TGT Dividend FCFSource: Simply Safe Dividends

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.

Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.

TGT’s balance sheet appears to be in reasonably good shape. As seen below, the company’s net debt / EBIT ratio is a modest 2.2x. This means that TGT could cover its entire net debt balance with about two years of operating profits. Standard & Poor’s has also assigned TGT an “A” credit rating with a stable outlook.

TGT Dividend Credit MetricsSource: Simply Safe Dividends

TGT’s 3.1% dividend yield is very safe, making it a reasonable candidate for investors living off dividends in retirement to consider.

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

TGT’s Growth Score is 73, meaning its dividend’s growth potential ranks higher than 73% of all other dividend-paying stocks in our database. The company has increased its dividend for 48 consecutive years, making it one of the strongest stocks on the dividend aristocrats list.

As seen below, TGT’s dividend growth has been fantastic over the last decade. The company’s dividend increased at a 20% annualized rate during the past 10 years and most recently grew 20% last year. With sub-50% payout ratios, consistent cash flow generation, and ongoing productivity initiatives, we think TGT can continue growing its dividend by 8-12% per year for the next few years.

TGT Dividend GrowthSource: Simply Safe Dividends

Valuation

TGT trades at 15.5x forward earnings and has a dividend yield of 3.1%. We believe the stock is about fairly priced given the uncertainty surrounding future earnings growth – with fewer opportunities to open new stores, rising labor costs, and competitive e-commerce investments, which levers can TGT pull for sustainable earnings growth?

Even with low single-digit same-store sales growth, the company wouldn’t be growing much faster than inflation. Regardless, if we give TGT credit for 2-4% same-store sales growth, earnings could grow 6-8% per year. When paired with the stock’s 3.1% dividend yield, TGT would appear to offer investors a 9-11% annual return.

We are less certain that TGT can achieve this level of earnings growth given our earlier concerns about the market’s saturation, rising labor costs, and increased e-commerce pressure. Our preference is to purchase reasonably priced dividend aristocrats with a wider funnel of growth opportunities to take advantage of over coming decades.

Conclusion

TGT is a high quality business, and its 48-year dividend growth streak should continue marching higher for years to come. The company has been through several trials in recent years (e.g. data breach, Canadian expansion), but its biggest challenge will be finding sustainable earnings growth in a very saturated retail market.

We think the company’s valuation is fair today given our questions about future growth. For conservative retirees, TGT’s dividend looks extremely safe with above-average growth prospects over the next several years. However, we prefer other blue chip dividend stocks at this time.

The post Target (TGT): A Dividend Aristocrat Yielding 3% With 20% Dividend Growth appeared first on Simply Safe Dividends.