One of the best ways to find core holdings for your portfolio is to look at the business behind the stock. In doing so, I present discount retailer Target (NYSE: TGT ) . You may be surprised by the recommendation of a retail stock as a core fit for your portfolio. But Target is on track to be a leader in this space.
Target is a discount retailer that provides essential products to a broad base of customers. Today, Target operates 1,767 stores in 49 states and online at Target.com. In addition, the company plans to open between 100 and 150 stores throughout Canada in 2013 and 2014. The corporation operates a credit card segment that features a branded Target REDcard, which offers users an additional 5% discount on every item purchased. Not only does the REDcard help shoppers save more, but it also drives repeat business for the retailer.
Why it's a core holding
For one thing, Target pays a quarterly dividend of $0.30 per share, and has done so since 1967. Target's dividend yield of 2.4% is pretty impressive compared to that of industry peers. Rival discounter Costco (Nasdaq: COST ) has a current yield of just 1.16% and has paid one since 2004. Markdown retailer J.C. Penney's (NYSE: JCP ) dividend yield of 2% is more in line with Target's. However, Penney's dividend is far less sustainable, as in recent quarters the payout ratio has climbed well above 100%.
Not only does Target give back to shareholders, it also helps local communities. Since 1946, the company has dedicated 5% of its income to giving through community grants. On the fundamental side of things, Target does an incredible job of connecting with customers.
The bull's-eye retailer understands that consumers want to connect with a brand and its story. In 2006, the Target launched an innovative style program that provided affordable fashion created by up-and-coming designers. Today, more than a dozen world-renowned designers have been featured. The program also contributed to the success of Target's strong brand recognition.
The discounter has unique products that you can't get from other big-box retailers such as Wal-Mart (NYSE: WMT ) . Some of the world's most esteemed fashion designers have made limited-edition apparel lines exclusively for Target -- widening the company's competitive moat. Who can forget the hysteria surrounding their Missoni collaboration? Target stores around the country sold out of the merchandise in minutes, and the rush of customers trying to snag Missoni products online managed to crash Target's website.
On top of having a wider selection of exclusive items, Target now beats Wal-Mart in pricing on many of those products. While Wal-Mart continues to back off the deep-discount strategy, to its detriment, Target's new mini-store strategy will further differentiate the two retailers. The company's recent plan to launch five specialty stores within select Target locations should be a big win for the retailer.
In addition to its exclusive fashion lines, Target sells groceries and other essentials. In a push to become a one-stop-shop, the retailer expanded its fresh food offerings behind rival Wal-Mart, whose superstores also feature a range of perishable items.
True, groceries have a lower profit margin, but everyday items like groceries pull more customers through the doors. By offering groceries, Wal-Mart and Target are hoping that once in the store, the customer will make other higher-margin purchases. Price comparisons at the two retailers show that Target offers lower prices than Wal-Mart on some grocery products as well. Once you add in REDcard savings, that discount gap widens.
Investors can expect this momentum to continue as more customers become REDcard members. The percentage of purchases by REDcard users increased to 9.5% of total Target store sales. The company says REDcard users are shopping more often and spending more per visit at Target stores.
Risks to watch
While Target's credit segment helps drive repeat business and build brand loyalty, all those discounts might cut into the company's profits. The REDcard program could hurt future earnings if receivables increase or REDcard holders are unable to make timely payments. However, the company has recently reduced bad-debt expense -- average receivables for Target's fiscal 2011 third quarter decreased 9.9% to $6.2 billion, down from $6.9 billion a year earlier. For now, the benefits of Target's credit division outweigh the risks.
Another potential threat not only to Target but also to big-box retailers like Wal-Mart and Best Buy is the proliferation of comparison-shopping. Customers check out products in the retailer's store, scan an item barcode, and then find cheaper prices elsewhere online.
Smartphone apps like Google's Shopper and Amazon.com's (Nasdaq: AMZN ) Price Check allow consumers to comparison-shop on sites like Amazon. The changing retail landscape makes it hard for chains like Target to compete with Amazon, which doesn't have a physical storefront or a lot of employees to pay for, and therefore can charge less for a product while still making the same margin on the item.
However, unlike Best Buy and other brick-and-mortar stores, Target is reaching out to suppliers for help defending its stores against comparison-shoppers. The retailer is working with vendors to create special products that will be sold exclusively in Target stores. According to The Wall Street Journal, "where special products aren't possible, Target asked the suppliers to help it match rivals' prices."
Target also revamped its online store this year and now offers free shipping on all REDcard orders. All of these efforts help tip the odds in Target's favor.
The bottom line
Target's brand promise -- "Expect more. Pay less." -- is a winning business model that works in tough economic climates. By investing in Target you're not only buying a great stock, you're becoming a part-owner of a quality business. The next 10 years should be bright for Target. I see the company successfully expanding and rewarding investors and communities around the world for years to come.
The best way to build a solid portfolio for the long term is to find companies like Target that offer investors a reliable dividend that will likely continue to grow along with profits. For another stock providing sustainable returns, I encourage you to read our latest free report: "The Motley Fool's Top Stock for 2012." For a limited time you can get this special report for free. Click here to get it now.