Market Overview

Why This Struggling Retailer Could Produce Great Returns


It seems crazy to suggest that a retailer struggling under the weight of a data breach that has eroded its brand with consumers and a poor rollout of its major growth initiative could represent a good buy. But that's exactly what Target (NYSE: TGT) looks like right now, because its challenges are accounted for in its valuation, and then some.

Target is performing poorly, but it still maintains a highly profitable business. Assuming its challenges subside with time, its current valuation presents a compelling long-term opportunity, along with a high dividend yield.

Target shares have performed poorly this year, down almost 5% while the broader market has gained this year. But now, Target holds an attractive valuation, especially when compared to peers in the discount retailing space like Costco (Nasdaq: COST).

A recovery may be right around the corner

By now, everyone knows that Target is having troubles. The massive data breach has taken a toll in the level of trust that customers place in Target, and that's evident by the fact that transactions in the United States declined 1.3% last quarter.

Target's other main operating geography, Canada, is a mess right now too. That's because Target only recently expanded into Canada, having previously been confined to the United States. But Target's growth strategy isn't going very well. While sales in Canada soared 63% last quarter, Target is spending a lot of money to fund its expansion. Its Canadian segment lost $204 million last quarter, which was actually a bigger loss than the $169 million loss in the same quarter last year.

As is often the case with stocks, the best buying opportunity is when things aren't going well. Despite Target's problems, there's reason to think a recovery is around the corner. Sales trends have steadily improved with each passing month, as same-store sales increased 1% in July. And, Target noted even better results in the first week of August, thanks to a robust back-to-school shopping season.

As far as Canada is concerned, soaring costs should wind down as the expansion campaign nears completion. A huge retailer like Target enjoys the benefits of scale, and to that end, its SG&A expense in Canada fell almost 30 percentage points last quarter, year-over-year.

With regard to the data breach, as time passes, consumers will likely forgive and forget. Target is still a brand name that resonates with consumers, and with a slew of additional retailers reporting similar breaches, Target's will fade into the rear-view mirror. This probably explains why sales trends have improved recently.

Target's problems appear priced in

Meanwhile, Target's future recovery presents an opportunity right now. Target expects $3.20 per share in adjusted EPS this year, which reflects the many challenges it's facing. That means shares of Target trade for around 18 times this year's adjusted earnings, a valuation multiple which is about on par with the S&P 500 Index.

But analysts widely expect Target's earnings to steadily recover over time. Shares of Target trade for 15 times fiscal 2015 consensus estimates. Target generated $4.38 per share in adjusted profits just last year. If it can manage to regain that level, it would trade for 13 times earnings. It's not at all unreasonable to suggest Target could get there, as the factors weighing on its earnings are temporary setbacks, rather than a long-term deterioration of its business.

In comparison to Costco, Target is downright cheap. Costco trades for 27 times trailing twelve-month earnings, and 21 times forward EPS. This is a huge premium to Target's valuation. Plus, it's worth noting that Costco offers just a 1.1% dividend yield, compared to Target's 3.5% dividend yield which provides a much better margin of safety. Costco is a great company, but even a fantastic business can be a poor investment if too high a price is paid, and for a retailer, Costco's valuation looks frothy.

Hold your nose and buy Target

Target's operating woes seem severe, but are likely short-term. That's why management has the confidence to aggressively raise the dividend in the face of these challenges. Earlier this year, Target raised its dividend by an impressive 20%. Target has actually grown its dividend at a higher rate than Costco over the past several years, which underscores its true strength.

In the discount retail space, while Costco is performing better on a fundamental basis, investors are paying a high premium for that performance. Target isn't getting much credit from investors, but its valuation and high dividend represent a compelling opportunity for long-term income investors.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.


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