Target's Dividend Remains Strong Despite Souring Retail Environment

Target's stock price dropped a staggering 25% after reporting earnings this week, marking the company's largest single-day loss since the infamous Black Monday in 1987. Almost one-third of the company's market value has been wiped out this week.

Adjusted earnings contracted a staggering 40% last quarter despite sales growing a modest 3%, reflecting unexpectedly high costs that pressured the company's profit margins.

Other retailers have similarly reported sudden margin declines, leading to the worst week for retailers since the early days of the pandemic.

Several factors have converged to compress retailers' profitability, including a swift inflation-inspired pullback in consumer spending on discretionary items, a spike in transportation and freight costs, and supply chain issues that have created a supply and demand imbalance.

Consumers have reduced their purchases of "bulky" discretionary items like TVs, patio furniture, and kitchen appliances as sales prices have reached levels customers aren't willing to pay as the rising costs of necessities like food and gas have squeezed wallets. 

Customers' pushback on prices is a bigger concern when considering Target's transportation costs were "hundreds of millions of dollars higher" than already elevated expectations last quarter. And for the year, Target now expects about $1 billion in incremental freight expenses.

For perspective, the expected increased transportation costs amount to almost 15% of last year's earnings.

The rapid change in shopper spending habits suggests many consumers won't accept higher prices for discretionary items. And with soaring transportation costs not expected to abate any time soon, Target and other notable retailers will likely need to endure at least several more quarters of reduced profitability.

Further complicating the outlook for profits is the significant buildup in inventories. Many retailers like Target have aggressively built higher inventory levels to avoid the empty shelves of 2020 that led customers to search elsewhere for products. 

Increased inventories and stocked shelves helped induce higher foot traffic in stores, but the sudden drop in spending has left Target with an inventory over 40% higher than last year. These goods may need to be sold at discounted prices to clear up storage space for next season's products.

As the economy potentially teeters on the brink of a recession, it's hard to see these challenges quickly overcome. Inflation, the economy's most ominous threat, will likely take some time to work through.

While there will likely be at least a few rough quarters ahead for retailers, Target's lower forecasts that reflect these challenges imply profit margins will only drop to pre-pandemic levels.

Target's drastic sell-off this week seems to be much less reflective of a dire long-term outlook for the company, and more likely just the market revaluing the company for a period of slower growth following two years of abnormal pandemic-boosted demand.

As you can see, Target's dividend yield and forward P/E ratio soared to relatively extreme levels in 2020-21 but have now reverted back towards their 5-year averages, making the stock look much more reasonably valued going forward.

Economic factors aside, Target is a well-run company with an A rated balance sheet, strong brand equity, and a stable customer base.

Furthermore, even as consumers reduce spending on discretionary items, the company sells an array of staples from groceries and diapers to medicines, which will keep customers shopping online and in stores.

Although Target's stock price may take several years to recover from recent losses, the firm's dividend should remain well-covered by profits.

Even after analysts slashed their earnings estimates in response to Target's latest results, the retailer's projected payout ratio stands near 30%, providing a healthy margin of safety and sitting well below Target's historical norm near 50%.

As a result, we expect Target to declare its 51st consecutive annual dividend increase in June. The firm's payout ratio could allow for another double-digit dividend raise, but management might opt for a more conservative increase given the various headwinds impacting the business. 

Overall, Target is well-positioned to ride out a period of economic instability with an uninterrupted dividend. As such, we are reaffirming Target's Very Safe Dividend Safety Score.

As the economic backdrop remains unstable, we will continue to monitor the situation and provide updates if any development shakes our long-term outlook for the company.