Buy this Well-Known Retailer Before it Takes Off

So far this year, the market (as measured by the S&P 500 Index) has rallied almost 5%. In stark contrast, this leading big-box retailer is down about 15% to start off 2011 and is trading near its lows of 2010. I can’t find any valid reason for this near-term disconnect.

Quite often, there aren’t good explanations for short-term fluctuations in stock prices. I judge price performance over a longer time frame and believe it follows the underlying fundamentals of a company over the long haul. In my mind, short-term movements are largely random, creating opportunities for smart investors to take advantage.

In Target’s (NYSE: TGT) case, the company is projected to report full-year sales growth of a few percentage points, but earnings growth of nearly 18% per share. One year is still a pretty short period to judge the company by, but expectations for the following year call for a similar level of top-line growth and an earnings improvement of close to 12% as they reach nearly $4.40 a share. Overall, that’s impressive profit growth in the coming couple of years and I think the valuation of the shares (the stock’s P/E is about 13) is telling me this fact is being ignored at current levels.

The market is underestimating Target’s sales potential in the coming years. For starters, sales will continue to recover from the credit crisis and ensuing recession that sent shoppers from the likes of Target and other more fashionable retailers into the hands of Wal-Mart (NYSE: WMT) and Big Lots (NYSE: BIG), as low cost became the primary motivation to help stretch shopping dollars as far as possible in an uncertain economy.

Target’s sales had slipped to growth of only a couple percentage points a year during the downturn, but should perk back up to the high single digits going forward. There is further upside potential as well. Back in January, the company inked a deal to make its first foray into Canada. It plans to open 100 to 150 stores in Canada by 2014 and it has acquired the leasehold interest for a total of 220 store sites. This will allow Target to grow its store base by more than 12%.

Target also has ambitions to expand into Mexico and Latin America within the next five years and has plans to remodel 20% of its U.S. stores in 2010 to drive more efficiency and add more grocery space to its stores. Wal-Mart has already seized on the huge potential to sell fresh food and drive more foot traffic in its stores. As a result, it is now the largest grocer in the country, but Target plans to take a bigger share of this market. Finally, the company plans to add smaller urban locations to reach even more shoppers in the United States.

Given the maturity of the U.S. market, Target will be lucky to grow sales 10% a year on a consistent basis, but it has a solid track record of leveraging single-digit sales growth into double-digit profit gains. In the past decade, it has grown sales less than 7% while growing earnings at about 10.5% annually. Free cash-flow growth has also been impressive, reaching $5.50 a share last year.

Another move to free up capital to boost store expansion into the Americas is Target’s plan to sell off its $6.7 billion credit card receivables program. Unlike most retailers, Target runs its credit card portfolio in house, which means having to extend credit to customers and deal with collecting payments and trying to recoup bad loans. These bad loans went up significantly during the credit crisis and dented profits, but won’t be an issue going forward. Better yet, Target will receive a payment for shifting these operations to an outside party. 
Action to Take —> Since the stock has fallen, Target’s forward earnings multiple has become very reasonable at just over 13. Its dividend yield is a decent 1.9%, but you can certainly depend on it — it’s been paid since 1967. Payouts to shareholders have also increased for 39 years, so you can count on it to grow going forward. The company also consistently buys back its shares to help boost per-share profits each year.

There is little doubt that Target is going to grow going forward. At the current stock price, it doesn’t have to grow much to reward shareholders handsomely. The price-to-earnings (P/E) ratio has exceeded 20 for much of the past decade and though that high of a multiple would be a stretch in today’s environment, it speaks to the comfort level investors had with Target’s growth. That confidence fell slightly during the credit crisis, but it should be regained given the growth drivers mentioned above.

Within the next couple of years, Target could report close to $5 in earnings per share (EPS). A multiple of about 15 off these earnings suggests the stock could rally 50% from current levels (15 X $5 = $75).