Target's Dividend Safety Score Upgraded to "Very Safe" on Financial Strength, Store Performance

In 2017, Target's dividend yield approached 5% as investors worried about the long-term fate of big-box retailers in the age of Amazon.

The company's same-store sales had started declining as more shopping migrated online, and Target's margins dipped as management invested in a digital-focused turnaround plan.

Despite these bumps in the road, Target always maintained a Safe Dividend Safety Score, reflecting the company's reasonable payout ratio, consistent cash flow generation, and healthy balance sheet.

Today we are upgrading Target's Dividend Safety Score to Very Safe as the firm has materially improved its key fundamental metrics and demonstrated further traction with its turnaround plan.

Target reported earnings on August 19 and delivered the company's strongest ever comparable sales growth of 24%, fueled by the pandemic.

Target's results provided more evidence that its store-based fulfillment model can not only keep the retailer relevant but also deliver profitable growth.

Despite a nearly 200% increase in digital sales, which historically hurt Target's margins due to their higher fulfillment costs (shipping to homes is expensive), Target's operating margin increased from 7.2% to 10% year-over-year.

The retailer's stores played a critical role in reducing Target's average unit costs for digital fulfillment by about 30% compared to a year ago.

The pandemic has spurred more customers to use same-day shopping options such as in-store pickup and drive up, which are much less costly compared with shipping goods to homes.

The majority of digital orders consist of items already available in Target's stores as well, so the company can efficiently rely on its locations to fulfill demand.

Ultimately, Target believes its stores drove more than 90% of the firm's second-quarter growth by enabling more than 75% of its digital sales.

As same-day order volumes grow, Target gains additional efficiencies by picking multiple orders together and increasingly delivering multiple orders at a time, reducing the cost per order of delivery trips to the parking lot.

It's too soon to say how the pandemic has permanently altered shopping habits, but we believe the popularity of same-day options will only continue growing given its convenience and value.

With smaller and less sophisticated brick-and-mortar retailers unable to match Target's offerings and scale advantages, this bodes well for the company's market share.

Management estimates Target's market share already increased $5 billion through the first half of the year. For context, Target's sales last year totaled $78 billion.

From a financial perspective, Target's return to earnings growth and conservative dividend increases in recent years have lowered its payout ratio from more than 50% in fiscal 2018 to its lowest level since 2013.

Source: Simply Safe Dividends
We believe Target's payout ratio provides the company with plenty of flexibility to continue paying a safe, moderately growing dividend (increased by 3% in June) while continuing to invest in digital initiatives.

Target's leverage ratio has ticked down as well, reaching its lowest level in at least a decade. With an A credit rating from Standard & Poor's, Target's financial health remains strong and supportive of its dividend and investment plans.

Source: Simply Safe Dividends

Going forward, Target will rely on improving the performance of its existing stores to drive profitable growth. 

Target became a giant by filling the suburbs of America with 130,000 square-foot boxes, but the days of material new store expansion are over.

In fact, Target's total retail square feet ticked up just 0.3% over the last four years. 

Instead, Target will look to build on its omnichannel retailing momentum, combining physical and online commerce to achieve long-term profitable growth. 

While shopping habits continue evolving, Target's status as a reliable dividend payer should remain steady. 

The retailer has paid uninterrupted dividends every year since it went public in 1967, a trend we expect will continue for the foreseeable future.