Why Target is a Superior Dividend Stock
Different approaches to dividend payments:
Target prioritizes the use of free cash flow (FCF) to fuel its dividend growth. During challenging periods when FCF alone may be insufficient, the company can rely on cash reserves or its strong balance sheet to ensure the fulfillment of dividend obligations and maintain investor confidence. In comparison, Costco, like Target, pays ordinary dividends but primarily reserves special dividends for times when its cash position reaches a notable excess.
The significance of special dividends:
On the surface, Costco’s strategy of distributing special dividends appears logical, as it directly rewards shareholders and generates excitement. Special dividends possess a certain “plop factor” that ordinary dividends cannot replicate. However, the true value of a quality dividend-paying company lies in its ability to provide consistent and growing quarterly payouts, regardless of economic conditions or internal challenges. Target, as a Dividend King, exemplifies this attribute, consistently increasing its dividends even during tough times.
While Costco has posted strong financial performance and experienced stock market success, distributing $6.7 billion through a special dividend does not appear to be a prudent capital allocation decision.
Valuation and Investment Considerations
Costco’s stock price versus earnings and revenue growth:
Examining the past three years, Costco’s stock has surged by 80%, while Target has experienced a decline of nearly 20%. Given its superior business performance, Costco’s stock price growth is justified. Currently, Costco’s price-to-earnings ratio stands at 45.1, considerably higher than Target’s ratio of 17.5.
The case for Target:
In recent years, Target faced challenges due to mismanagement of consumer demand, inadequate inventory forecasting, and supply chain issues. Over-ordering and subsequent product markdowns resulted in compressed margins. However, Target has taken corrective measures, adopting a leaner inventory management approach, even during the holiday season. The company continues to grow with initiatives like the Target Circle rewards program, expanded online ordering, curbside pickup, and enhanced app engagement.
When evaluating Target as an investment option, its reliable dividend, coupled with upside potential and attractive valuation, makes it a compelling long-term stock choice.
The Drawbacks of Special Dividends
Special dividends as capital gains:
While a special dividend may seem like a boost to the stock price, it essentially represents what can occur any day in the market. Unlike capital gains resulting from market recognition of a company’s improvements, special dividends function as forced capital gains. To maximize long-term value, Costco shareholders may prefer a higher ordinary dividend alongside the elimination of special dividends or alternatively, reinvesting these funds back into the business rather than distributing them as a one-time payment.
In conclusion, the attention-grabbing nature of special dividends offered by Costco is overshadowed by the consistent dividend growth and solid overall performance of Target. Target’s combination of a reliable dividend, potential for growth, and attractive valuation positions it as an appealing choice for investors.