Does Target's Surprise Announcement Signal an Imminent Turnaround?

Target's huge dividend increase could be a sign that business is starting to improve.

Jun 21, 2014 at 10:00AM

Target Seattle

Seattle CityTarget

Source: Target website

Discount retailer Target (NYSE:TGT) can't seem to get much right lately. Its major growth initiative in Canada hasn't panned out. Put simply, the expansion into our neighbor to the north has proved to be more costly than management anticipated.

In addition, Target's domestic operations were thrown into chaos when the company revealed a massive hacking breach. It announced that tens of millions of shoppers had their personal data stolen over the holiday shopping season.

These setbacks have impaired Target's brand image and connection with consumers. This is now having a ripple effect on earnings. Target's sales and profits are suffering mightily, which is especially concerning since the operating climate for discount retail is actually quite favorable. This can be seen in strong results from close competitor Costco Wholesale (NASDAQ:COST).

But at the same time, Target management sees a light at the end of the tunnel. It believes its Canadian venture is on the verge of a turnaround and that the effects of the security breach will fade with time.

Target's board of directors just surprised everyone by announcing a whopping 21% dividend increase. Dividends are historically a high percentage of a stock's total return. According to research from BNY Mellon, dividends accounted for more than half of the S&P 500's total return since 1926. Target management struck a tone of confidence during its last quarterly conference call, stating it would have enough future cash flow to continue growing the business and reward shareholders with a significant dividend increase. If Target's huge dividend raise is any indication of the future, the company may have a real turnaround under way.

This retailer misses the target
Target's earnings reports over the past several months have been weak, to put it mildly. The major culprits have been the struggling expansion in Canada and the fallout from the data breach.

Target's Canadian operations generated $1.3 billion in sales last year, but soaring costs resulted in a $941 million loss in terms of earnings before interest and taxes. Target's Canada segment reduced the company's profits by $1.13 per share. Things didn't get much better in the first quarter of this year. Target's loss in Canada increased to $211 million year over year.

Overall, Target was profitable last quarter, but earnings are going in the wrong direction due to lagging sales. Comparable sales, which measure sales at locations open at least one year, declined by 0.3% in the first quarter. Earnings per share dropped nearly 14%. Escalating costs in its Canada segment and the damage incurred from the data breach are clearly taking their toll.

By contrast, Costco has done very well, which is what you'd expect to see given the fact that consumer spending has been buoyant. Excluding the impact of currency effects and gas prices, Costco's total same-store sales increased 5% in the most recent quarter and over the past nine months. That's why Costco is doing relatively well compared to Target, as its EBIT is up 1.4% year to date.

What Target's big dividend increase says
Despite all these headwinds, Target management doesn't seem fazed at all. This is evident because the board of directors just increased the dividend by a massive 21%. Judging by this alone, you wouldn't think the company was at all worried about its current state or its future prospects.

Indeed, there's reason for optimism. Target still has a well-known brand, and with time it's likely the damage from the security breach will fade. Plus, the overall economic environment is one in which consumers continue to closely monitor their spending habits. The unspectacular economic recovery means people are still flocking to discount retailers. That's why Target is still solidly profitable. In addition, Target's CEO John Mulligan stated last quarter that there were early signs of improvement in its Canadian operations.

Foolish Takeaway
The company still expects adjusted profits of $3.75 per share this year, at the midpoint of its 2014 forecast, so there's no reason for panic. In fact, that provides more than enough financial cushion to increase its dividend since Target's payout ratio stood at just 39% of last year's adjusted earnings.

The bottom line is that while Target's turnaround isn't guaranteed, it stands to reason management sees a recovery ahead based on its huge dividend increase. Investors now receive a very attractive 3.6% yield. It appears Target has something to offer both value and income investors alike.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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