Coming out of the Great Recession, Target (NYSE:TGT) saw an opportunity, and seized it. Wal-Mart (NYSE:WMT) already had a corner on the ultra-low-priced warehouse model. Target's management believed there was room for a slightly more upscale version of what Wal-Mart had, and that it could actively exploit that demand.
And exploit it the company did. Between January 2009 and January 2013, sales at Target increased 13% while earnings per share jumped a whopping 60%. More importantly for investors, shares of Target stock returned 150% versus Wal-Mart stock's 58% between the market bottom and 2013.
Over the last year, however, things haven't been so great for Target. A breach of the company's security has been a drag for management, customers, and shareholders alike. And financial results haven't been so great, either. So where does that leave Target stock and its dividend for investors today?
The most important metric for dividend investors
As things currently stand, Target offers a sizable 3.4% dividend yield. That's pretty great when you throw in there the fact that the company has increased its payout for 42 consecutive years. Will the company be able to keep that pace up?
When it comes to dividends, nothing is more important than free cash flow. It is from free cash flow that dividends are paid, and it is the direction of a company's free cash flow that will determine the dividend's fate in the years to come.
For those unfamiliar, free cash flow represents the amount of money a company was able to put in its pockets over the past year, minus the money spent on capital expenditures.
Here's what Target's free cash flow and dividend situation look like since 2009.
There are a few important caveats to this chart. First, in 2011, the company spent lots of money on new locations and redesigns. Therefore, its capital expenditures were much higher than normal -- $4.4 billion as compared to $3.3 billion in 2012 -- and free cash flow was much lower.
Second, in the first half of 2013, the company benefited by getting $2.7 billion from a sale of its credit card portfolio. That sale isn't included in the trailing twelve months, and paints a somewhat bleak picture for the company's current dividend situation.
Over the past year, a whopping 95% of all free cash flow has been used to pay the company's dividend. Of course, the company could choose to slow down capital expenditures and bring that ratio down in the coming months. But as it is, this high payout ratio means that Target is perilously close to having an unsustainable dividend moving forward.
How did things get this way?
To understand how a company that's increased its dividend for 42 consecutive years -- and just a few years ago used a measly 12% of free cash flow on its dividend -- has found itself in this position, it's worth investigating the business over the past two years.
One of the key metrics of any retailer is same store sales. This measures how popular a store's concept is with its customers, and whether or not it is able to increase sales at a rate exceeding inflation.
As you can see, the last year-and-a-half have not been kind to the company. Management has made it clear that the breach of the company's credit card information has been the main culprit behind the slowing sales.
The final word on Target stock and its dividend
Ever since the company's data breach, things at Target have been somewhat of a mess. The company's former CEO Gregg Steinhafel left back in May, and it will take time for new CEO Brian Cornell to get a strategy in place to reignite same store sales.
For the time being, Target's dividend is definitely on the more risky side. At the same time, the company has consistently raised its dividend and offers a nice yield today. There are several ways the company can raise free cash flow -- particularly by cutting back on capital expenditures -- to ensure the safety of its dividend.
The big question you have to ask yourself is whether or not you think Target can salvage its brand over the next three years or not. The answer to that question should go a long way in determining whether or not you should invest in the stock.
Brian Stoffel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.