Takeaway: Great companies don’t talk of a ‘tough retail climate’. Retail’s always tough. Great companies invest and make it tough for everyone else.

We said last week that out of all of our shorts, if there was just one we’d have clients focus on this earnings season, it’d be Target.

Target Is A 'Killer Name On The Short Side'

The fact that it missed expectations so badly and the stock subsequently sold off near 8% (big for TGT – only 7 times in 10 years it traded down that much, and all were in the Great Recession) does not mean that our cautious view is realized. Quite the opposite…the numbers that we saw if nothing else validate the issues that we think will plague this company for years to come.

Think of it like this…

Retailing is a full-contact sport. Sometimes the best retailers miss, and the worst retailers beat. Neither success nor failure are linear – ever. But this event is not simply an otherwise great company (which, in all fairness, TGT probably is) catching a bad break. It is the poster child for a ‘retailer behaving badly’, that we think will result in share loss in coming years. Here’s what we’re thinking…

  1. ‘Behaving Badly’. Let me define ‘behaving badly’ before I catch flack on it from the TGT bulls (which will happen anyway). I’m referring to investing in the business to gain share on a consistent basis and take financial returns meaningfully higher. I love when I hear CEOs say ‘It’s really a tough retail climate’. It’s ALWAYS a tough retail climate. That’s what retail has been in the 2+ decades I’ve covered it. That’s why our internal idea sourcing tools are overwhelmingly levered to changes in SG&A, capex and working capital. These tools and processes back-test better than anything else. Target fails on every one of them.
  2. This Really Wasn’t A Beat. Target beat this quarter for one reason and one reason only – it had a -7.8% decline in SG&A on a +1.2% comp. Yes, much of the SG&A decline was associated with the CVS Rx deal. But even excluding that we saw 50bps of cost leverage on such a menial comp. That’s not normal.
  3. Capex Continues to Be Light. Too light. Last year the company said it would come in between $2-$2.5bn in capex. When all is said and done in came in at $1.4bn. This quarter, we’re looking at $285mm in capex, which is down 18% from last year. Bulls might like this. We don’t. Keep reading…I’ll get to the point.
  4. Deteriorating Working Capital. Working capital trends look worse for Target than we’ve seen since the Steinhafel years. Seriously…look at TGT’s SIGMA. It made a swift move to Quad2. That, by a country mile, is the most dangerous place to be. It’s when inventory is building relative to sales but management is complacent because margins are positive. Over 90% of the time, the move from this position in the SIGMA is bad – both financially, relative to expectations, and for the stock.
  5. Buy The Peaks. Instead of investing in its infrastructure – both capex and SG&A – keeping in mind that about 70% of all SG&A dollars are associated with a head -- TGT bought $900mm in stock near its all-time high. Well isn’t that special. So let me get this straight, it’s investing less in the infrastructure, but buying more of the public equity?
  6. If TGT is investing in the wrong places, everyone else must me as well, right? Nope. Ever hear of a company called Wal-Mart?  Yeah…last year the company said that earnings would be largely flat over four years while it invested in e-commerce, labor costs, stores, vendors, and talent at Corporate. TGT is foolish to ignore any competitor, and by its actions...it is. But it absolutely cannot be backing off investment spending while its top competitor is going full-throttle, and AMZN is making an incremental push into consumables and pretty much everything else TGT sells. 

TGT | Brian Behaving Badly - 5 18 2016 TGT SIGMA

Additional Details on the Quarter…

“Need to learn more, check back in later”. We are paraphrasing the closing comments made by CFO, Cathy Smith, in her portion of the prepared remarks as it left a bad taste in our mouth. Especially in light of the fact that management held guidance for the year – despite a sales miss in the 1st quarter, extremely bearish commentary on the promotional posture of the peer group and resulting pressure to margins, as well as flat to negative same store sales guidance for the 2nd quarter. There seems to be a whole lot of hope baked into those forecasts. Which seems to be the trend across retail in this earnings season. Of the big four mid-tier players in the general merch/dept store space who have reported to date, only Macy’s ripped the band-aid taking full year guidance down 15%, everyone else (JCP, KSS, and TGT) kept earnings guidance in check for the year.

If this is truly just a one quarter weather induced blip that drastically affected consumer spending across the entire category in the months of April and first two weeks in May, then we might be eating crow. But, we and our firm wide Macro view strongly disagree. Keep in mind that TGT called out weather as a negative in the Northeast last year in 1Q as snow blanketed much of the region, now mild weather has somehow compounded the problem.

 

Where’s The Investment: We haven’t seen it under Cornell’s year and a half tenure at the company. Some of the cuts he made were obvious – Canada and corporate employee overhead. Others opportune – CVS pharma deal. But, now the low hanging fruit on the tree is picked. And, its competitive set is spending up big. WMT earnings expectations for FY17 (calendar ’16) have come down by $2.07 over the past 24 months due to strategic investments in vendors, price, employees, and e-comm. Plus AMZN, who everyone and their brother has pegged as the biggest enemy to brick and mortar retail, doesn’t have much of an operating margin to protect. Over that same time period, what has TGT done? a) Underinvested by as much as $700mm on the capex line in 2015 vs. the stated plan, and b) posted negative organic SG&A growth of -3.3% and -1.6% in the past two quarters, respectively.

Keep in mind that the plan for TGT to keep EBITDA Margins steady over the long term at a Pharma adjusted rate of 10.5%, the company needs to produce 3% comps. But retail 101 says that a company cannot manufacture unprecedented comp rates (it’s been over 8yrs since TGT posted consecutive years of +3% comp rates) without a significant investment on the SG&A or CapEx lines…preferably both. So, TGT can continue to financially engineer earnings growth through share buybacks and underinvestment in SG&A at the risk of long term market share.

Driving Comp Through GM: Over the past two quarters, each of which we would characterize as low quality prints, TGT has propped up the top line with increased promotional activity. Though this quarter, the promotional activity was masked by the pharma sale, core GM was down 20bps -- a slight increase from the -50bps seen in 4Q15, but we also saw a 110bps sequential deceleration in the 2yr comp. That pressure will continue to persist for TGT, as inventory isn’t just way out of whack in the industry (as management noted a number of times on the call), but is on the balance sheet for TGT. Long-term guidance calls for flat Gross Margins at a pharma adjusted rate of 30%, but this race to the bottom on price and quarterly volatility go a long way in proving that the targets Target laid out two months ago are incredibly optimistic. Not to mention the gross margin drag from e-commerce growth. That will more than offset any supply chain benefits Mulligan’s 7 minutes of real estate on the call would otherwise suggest.

Cat & Jack: To be clear, let’s call this brand what it is. A private label kids apparel line that is not entirely incremental (it will take floor space away from existing product), that has no brand recognition yet. Assuming that the brand started off out of the blocks in the 2nd half of 2Q16 at a $1bn run rate and was entirely incremental the best it could add would be 70bps of comp. We, however, know that it won’t either a) start off at a $1bn run rate, or b) be entirely incremental. To talk to the comp lift potential of a private label brand with a $1bn target for a company with a revenue base of $70bn seems entirely off topic for a management team that doesn’t have a firm grasp on the reasons for the slowdown in consumer demand in the first place.