(Published by Bob Ciura on April 13)
Target (TGT, Financial) is struggling to find its place in the retail landscape.
It is a discount retailer yet it has trouble competing with Walmart (WMT, Financial), particularly when it comes to groceries.
It wants to be a leader in e-commerce yet it lags far behind Amazon.com (AMZN, Financial).
What is happening to Target may ring a bell.
Some investors may conclude that Target is following the same path as Sears Holdings (SHLD, Financial) took to irrelevance.
Potential investors interested in Target are likely enticed by the company’s high dividend yield, currently at 4.5%.
Target is a Dividend Aristocrat, a group of companies in the Standard & Poor's 500 that have raised dividends for 25-plus years.
You can see the entire list of Dividend Aristocrats here.
But dividends are reliant on the health of the underlying business. Sears was once a dividend payer, too.
Fortunately, Target and Sears are much more different than they are alike.
A willingness to adapt
Sears is in a death spiral. It lost $2.2 billion last year, roughly double the loss from 2015.
With escalating losses, there are legitimate concerns about Sears’ ability to remain an ongoing concern.
The company ended last year with $3.57 billion in long-term debt and another $1.75 billion in pension liabilities, compared with just $286 million in cash.
In response, the company is cutting costs and selling off assets wherever it can. It recently announced a new $1 billion cost-reduction program including the closure of 150 stores.
In January Sears sold its crown jewel brand, Craftsman, to Stanley Black & Decker (SWK, Financial) for $900 million.
These are the key components of Sears’ turnaround efforts.
Source: 4Q 2016 Earnings Presentation, page 4
But with sales crumbling – comparable-store sales declined 10.3% during the holiday period –Â selling off assets and cutting costs is akin to tossing furniture overboard while a ship is sinking.
Sears finds itself in this position largely because it effectively ignored the trends sweeping through the retail business over the past several years.
Specifically, Sears completely missed the push toward modernized stores, low prices and greater digital capabilities.
All the while, Sears has become notorious for messy shelves, scattered product assortments and understaffed stores.
Improving this required capital investment, which Sears CEO Eddie Lampert was notoriously reluctant to do.
In the chairman’s letter to shareholders dated March 1, 2007 (the first year after the merger of Sears and Kmart), Lampert makes it clear:
“Unless we believe we will receive an adequate return on investment, we will not spend money on capital expenditures to build new stores or upgrade our existing base simply because our competitors do.”
In 2006, Sears spent $816 million for share repurchases, 72% more than the $474 million used for capital reinvestment in the business.
Over the past decade, Sears woefully underinvested in its business. It has been in decline ever since.
While share repurchases help boost earnings per share, they are not very helpful if comparable sales are declining at a double-digit rate.
Meanwhile, Target stock crashed when it drastically reduced its own earnings guidance for fiscal 2017.
Target expects adjusted earnings per share to decline 16% to 24% for the fiscal year.
But the major difference with Target is that the reason for the earnings decline is mostly due to the internal investment it is making.
It will be much more active on price to better compete with Walmart.
In addition, Target is accelerating investment in its e-commerce platform. It is making notable progress there. Target’s digital channel sales doubled in the past three years.
Lastly, Target is renovating its stores to make them more appealing as a consumer experience.
It is also building small-format stores under the CityTarget and TargetExpress banners to gain entry in urban areas and college campuses.
Source: 4Q Earnings Presentation, page 77
Target plans to more than triple its small-store count by 2019.
While this investment carries a significant negative impact to fiscal 2017 earnings, these are necessary strategic moves to make Target more competitive.
They are the exact kinds of moves that Sears refused to make.
Target is run by retail people
While Target CEO Brian Cornell has only been at the helm since 2014, he has an extensive background in retail.
Cornell’s recent job titles include acting as CEO of Sam’s Club from 2009-2012 and CEO of PepsiCo (PEP, Financial) Americas Foods from 2012-2014.
It is at least reassuring to know that the CEO has spent many years in the consumer products and retail industries.
By contrast, Sears Holdings is a company led by a hedge fund manager and is run like one.
In principle, there is nothing wrong with a hedge fund manager running a retail business, provided that individual has an intimate knowledge of the industry.
But the Wall Street mentality often succumbs to short-term thinking. Hedge funds too often place heavy focus on quarter-to-quarter performance.
The retailers that have succeeded in the past have done so by listening to what the consumer wants, knowing the retail business model inside and out and investing when necessary to respond to changes in consumer behavior.
Lampert exhibited little of this in his tenure as Sears CEO.
For the most part, his focus was on the stock price while the rise of e-commerce and the erosion of the shopping mall were completely glossed over.
It should not be surprising to see that Lampert put so much focus on the share price. He owns just shy of 32 million shares of Sears, which makes him the company’s largest shareholder.
However, the share price is a function of earnings. Focusing on the share price above all else while neglecting to invest in the business is letting the tail wag the dog.
At some point, the long term becomes the short term. Sears’ inability to listen to what consumers wanted has caused it to lose billions of dollars of shareholder wealth.
Dividend track record
Sears does not pay a dividend, which given its operating losses and fundamental deterioration should come as no surprise.
Meanwhile, Target has increased its dividend for 45 years in a row.
Not only is Target a Dividend Aristocrat, with five more annual dividend hikes, it will become a Dividend King.
Dividend Kings are stocks with 50-plus consecutive years of dividend increases. There are just 19 Dividend Kings.
You can see the entire list of Dividend Kings here.
Of course, a dividend track record is only as good as the business model supporting it. Dividends alone won’t stop Target from becoming the next Sears.
But even when Sears was doing relatively well, its dividend track record was spotty at best.
For example, while Sears had been paying regular quarterly dividends since 1993, it cut its dividend by 43% in 1995.
Then, Sears suspended its dividend payout in 2005 after the merger with Kmart and the creation of Sears Holdings.
At the time, Sears stated in an SEC filing related to the merger that it did not expect to pay dividends “in the foreseeable future.”
This was a less-than-reassuring sign.
While there is nothing inherently wrong about a company not paying a dividend, from a financial perspective, a dividend does help keep a company’s management team honest.
Paying a dividend compels management to be more disciplined when it comes to allocating capital.
A dividend at least serves as an added protection against a company using excess cash flow on ill-fated acquisitions or spending an excessive amount of money on share buybacks.
Sears is guilty of this on both counts.
Final thoughts
At first glance, there seem to be similarities between Sears’ dramatic decline and the troubles currently facing Target.
However, there are many key differences between the two in terms of corporate culture and capital allocation.
While Target is investing in re-imaging its stores and competing in digital, Sears is conducting a fire sale and cutting costs to buy itself more time.
However, it increasingly appears as though Sears is simply delaying the inevitable.
There is no guarantee that Target’s turnaround efforts will work, but it has demonstrated a willingness to adapt to a changing retail environment in ways that Sears never did.
For these reasons, Target is not the next Sears.
To see how Target stock matches up against its closest competitor, Walmart, click here.
Disclosure: I am long Target and Walmart.
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