Is Target a good value stock or a value trap?

Having recently bought V.F. Corp stock (I talked about it here: Why I am adding VF Corporation to my portfolio, my eyes are now on Target (ticker: TGT). Target is another dividend aristocrat in the depressed retail sector which has recently pulled back by about 15% from its 2016 highs.

At a current dividend of 3.4% and a P/E of 13.6, TGT is starting to look attractive. Currently, I have a very small position (<1% of total portfolio value) in Target. I bought these shares in August of 2016 with a YOC of 3.4%. You can see my entire portfolio here: My Stock Portfolio

It looks like TGT is about at the same yield level as when I bought it five months ago, this is shown in the F.A.S.T Graphs TGT price chart below. The green dot shows the date and price when I bought my TGT shares.

TGT Historical Price Graph
Copyright 2017, F.A.S.T Graphs - All Rights Reserved

As you can see, my TGT stock's return is almost flat (without dividends). In other words, in the last five months, my TGT investment didn't grow at all. Though, I am receiving 3.4% dividend on my shares, but I am still concerned regarding capital growth as it is my secondary goal after dividends.

So, is Target stock a value trap? Let's take a look at long-term fundamentals and earning projections and see what we can find out.

TGT Historical Price and Earnings Graph
Copyright 2017, F.A.S.T Graphs - All Rights Reserved
The chart above shows 18-years of Target's stock price (black line) and earnings (green area) as well as forward earning estimates.

The first thing to notice is how nicely the stock price has kept above its fair value (the orange line) throughout the first half (till end of 2007) and just before the 2008 recession.

After the 2008 recession, the stock price and earnings have recovered nicely. However, the stock price has kept under pressure and has traded mostly below its fair value (the orange line) mainly due to the pressures from the online retailer Amazon and its other big competitor Walmart.

Also, the earnings dropped by 32% during 2013. That's a huge drop in one year.  The two main reasons for this drop were:
  1. Customer credit card data breach and its fallout. 
  2. The performance of Target in Canada was under-whelming as costs ran up higher than anticipated while sales lagged estimates.
Since then target has recovered from both issues and earning growth has also recovered almost to the levels prior to the drop. The earnings have grown double digit since recovery from 2013 drop and is projected to report  ~11% growth for the full-year 2016.

This is where the double digit earning growth seems to stop. The 2017 and 2018 full-year earning projections are significantly lower at 5% and 6%, respectively.

We have to wait for the Q4 earnings report on 2/22/2017 to get a better handle on company outlook for 2017 and its earnings guidance, especially after the disappointing 2016 holiday sales as reported by several other retailers.

Current Valuation

The 5-year F.A.S.T Graphs chart below shows us current (P/E) valuation compared to Normal P/E (blue line), Fair-Value P/E (orange line), and Current P/E (pink line).

Per the F.A.S.T Graphs chart, the stock is currently trading at below fair value (orange line) at a discount of 9.1% to its fair value.

TGT Normal vs. Fair vs. Current Valuation
Copyright 2017, F.A.S.T Graphs - All Rights Reserved
Assuming the stock has a potential to go back up to its normal 5-year historical valuation P/E 16.7. For the full-year 2017, that's an upside potential of 30% (not counting dividends).

A 30% potential upside in one year is quite tempting; however, what if the stock stays stuck at or below its fair value (orange line)? That's how it has been since I bought my first shares of TGT last year and it is starting to look like a value trap.

Before we can decide whether it is a value trap or not, let's shift gears and look at Free-Cash-Flow (FCF), dividends, and debt levels.

Free Cash Flow, Dividends, and Debt Levels

TGT FCF and Dividend History
Copyright 2017, F.A.S.T Graphs - All Rights Reserved
For the year 2016, FCF is estimated to decline by 13% followed by further declines of 4% and 2% in 2017 and 2018, respectively.

FCF-to- Dividend Payout Ratios: 

2015: 30.8%
2016 (est): 38.3%
2017 (est): 42.9%
2018 (est): 46%

Dividend is well covered by FCF as the FCF-to-Payout ratio is still below 50%; however, the payout ratio has been rising gradually which is a result of declining FCF. Declining cash flow can be a result of weakening profits (i.e. operating cash flow) as well as higher cost of running the business.

Dividend Growth:
As a dividend aristocrat, Target has rewarded its shareholders with generous dividend increases for the past four decades. The current 3.4% yield is the highest yield ever for the stock with the 5-year DGR (CAGR) of 23.5%.

TGT Historical Dividend Yield Graph
Copyright 2017, F.A.S.T Graphs - All Rights Reserved
Debt Levels:

Target currently has a 50% debt/capital ratio which is still quite good with a S&P credit rating of  'A'.

EBIT (Q3' 2016): $1057 million dollars
Net Interest Expense (Q3' 2016): $142 million dollars
Interest Coverage Ratio: 7.44

Per interest coverage ratio, the debt interest expense is well covered at 7.44 times the Q3 earnings.

Target's fundamentals still look good and are inline with a dividend aristocrat status. However, I do have concerns regarding future earnings growth, continued pressure on sales, and decreasing FCF. All these factors could keep stock price depressed for the next few years while slowing dividend growth.

At the current price, the TGT stock looks like a value trap with a potential to stay under valued for the next year. The current dividend yield of 3.4% is good, but not good enough to make up for the earnings slowdown and being a potential value trap.

To hedge against the risks, I would want no less than a 4% dividend yield. That should give me a total return of at least 9% - 10% annually (counting the 5% - 6% earnings growth) for the next two years. The company is also expected to keep growing dividends at the rate of 6% - 7%.

I believe the higher yield along with the lower cost basis would give me a good margin of safety to weather the short-term headwind in the stock price while collecting a juicy dividend.

Therefore, I would wait for the stock price to come down to about $60/sh (~14% drop from current price with a 4% yield) before buying any more shares. That's my plan!

Update (1/18/17): A day after I posted my article on TGT, the company announced lower guidance for Q4 and full year EPS. As of pre-market, stock is down about 4% to $67.48. I may not have to wait for too long to get to my target price of $60.

What's your plan? Are you buying, holding, or selling?

Disclaimer: I own shares of Target. 
Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Full disclaimer can be read here: Full Disclaimer


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