Shares of Target (TGT 2.25%) tumbled 11% on Nov. 20 after the retailer's third-quarter numbers missed estimates on both the top and bottom lines. Its revenue rose 6% annually to $16.9 billion, but failed to hit expectations by $110 million. Though its comparable-store sales jumped 5.1%, it didn't achieve the consensus forecast for 5.5% growth.
Target's adjusted earnings per share rose 20% to $1.09, but fell short of expectations by $0.02. Its gross margin contracted 90 basis points annually to 28.7%, and its operating margin fell 40 basis points to 4.6%. Buybacks and a much lower effective income tax rate (13.6% versus 22.2% a year ago) partly offset those margin declines.
Image source: Target.
Target expects its comps to go up 5% during the fourth quarter. For the full year, it expects its adjusted earnings to spike 13% to 17%, matching Wall Street's expectations. Based on that forecast, Target trades at just 13 times this year's earnings while paying a decent forward dividend yield of 3.2%. Is Target a cheap income play after its latest decline?
Target's strengths and weaknesses
Target struggled to compete against Amazon.com (AMZN +0.37%) and Walmart (WMT 3.53%) in the past, but it mounted a comeback by expanding its digital ecosystem, adding more delivery options (including its Restock next-day essentials delivery service), offering more Drive-Up pickups, remodeling stores, and launching small-format stores for urban areas.
As for Amazon's brick-and-mortar advance, Target is leveraging its long-term leases to prevent its lockers or Whole Foods stores from being opened in the same shopping complexes. Target also increased its total store count by 18 annually to 1,846 -- which is a rare sign of strength as other retailers shutter weaker stores.
Those efforts all boosted Target's comps and revenue growth over the past year. More importantly, its digital sales growth surged 49% and outpaced Walmart's 43% e-commerce sales growth in the U.S. last quarter.
| Metric | Q4 2017* | Q1 2018 | Q2 2018 | Q3 2018 |
|---|---|---|---|---|
|
Total comps |
3.6% |
3% |
6.5% |
5.1% |
|
Digital comps |
29% |
28% |
41% |
49% |
|
Revenue |
10% |
3.4% |
6.9% |
5.6% |
Year-over-year growth. Data source: Target quarterly reports. *Includes an extra week.
The problem is that Target's second-quarter comps growth -- its best in 13 years -- caused many investors and analysts to set the bar too high for the third quarter. Its digital comps growth is also a double-edged sword -- it boosts its revenue growth but applies pressure on its margins.
That's why cost of sales rose 7% annually during the quarter, as sales, marketing, and administrative expenses jumped 5.5% and its operating profit fell 3%. Therefore, without a lower tax rate and $526 million in buybacks (at a poorly timed $84 per share) during the quarter, Target's EPS would have likely dropped. However, Target still has $1.8 billion left in its current buyback program, so this trend should continue for the foreseeable future.
Image source: Target.
But what about the dividend?
Target has raised its dividend annually for five decades, making it an elite Dividend Aristocrat of the S&P 500. Walmart, which pays a forward yield of 2.1%, is also a member of that club, with over four decades of annual dividend hikes.
In June, Target boosted its dividend 3% to $0.64 per share. Therefore, the midpoint of its projected earnings, at $5.40 per share, can easily cover its annual dividend payments of $2.56 per share with a payout ratio of less than 50%.
However, its yield of 3.2% also might not be high enough to attract income investors for two reasons. First, the 10-year U.S. Treasury yield is currently above 3%, which makes the government bond a much safer income investment than Target. Second, plenty of other stocks trade at lower multiples than Target while paying higher dividends.
The verdict: Wait for a lower price
Target's top-line growth is encouraging, but its contracting margins, dependence on buybacks and lower tax rates, and inflated earnings indicate that it's still spending a lot of money to keep pace with Amazon and Walmart.
Upcoming headwinds, like higher wages and tariffs, could make it even tougher for Target to grow its earnings without those crutches. I still have faith in its long-term plans, but I think investors should wait for a steeper drop to reduce its valuation and boost its yield.
