TGT | Losing at Defense

08/17/16 04:13PM EDT

The obvious place to start the conversation on TGT would be on the numbers, and the company gave us plenty of ammo to poke holes in the print this morning. But we think the far greater concern for the long-term health of this company is the lack of definable plan or any clear insight by the management team as to what actually caused the worst quarterly comp number since the data breach and subsequent guide down for 2H16. We heard a lot of excuses, everything from Apple products losing their cache, to deflation, e-commerce pressure, and soft Rx traffic. Which all may be legitimate in their own right – but we have a NEWSFLASH for Cornell and team...

This is something we like to call RETAIL. The environment/consumer isn’t going to throw anyone a bone, especially at the tail end of a seven year economic expansion. In this sport, only losers point fingers. Stocks that make investors money on the long side find a way to win. Target is doing the opposite.

All in, we think this is all very characteristic of a management team playing defense instead of offense. Need further evidence? How about 2 consecutive quarters of earnings beats generated by cost cuts and share buy-backs with the stock at or near all-time highs. We’d argue that the team in Minneapolis would be better served missing expectations and taking down numbers by 2x the rate we saw today in order to build a superior platform from which to grow.

That may sound harsh, but after running through the numbers and sitting through the 60-minute conference call, we were still left asking what actually happened? In the absence of a clearly articulated answer from the TGT C-Suite, here’s what we think is playing out…

1) Competitive dynamics evolving: TGT has one of the least enviable competitive sets in all of retail stuck, right smack dab in the middle of four unique competitors – 1) WalMart, 2) Department Stores, 3) Dollar Stores, and 4) Supermarkets. As a bonus, it has Amazon.com hovering over its head plucking away every last sales dollar it can. The bookends of that are the real callouts, with WMT investing its way to flat earnings growth over the next 4yrs and AMZN taking 25% of the incremental sales dollars spent by the consumer. Both have huge implications for TGT, who clearly isn’t winning or investing.

2) TGT underinvesting: That’s on a relative and absolute basis. SG&A per square foot was down 0.7% in the quarter, and that’s in the face of WMT taking SG&A/sq. ft. up 9% as it spends on e-comm/stores/labor in order to propagate positive store traffic. TGT is content with managing expenses to free up $2bn in cost savings in order to invest at a measured pace. Without a considerable step up in the investment line, we have a hard time seeing how TGT wins as the competitive dynamics continue to evolve in favor of the other guys.

3) Market share loser: Retail has been a bit fickle over the past 6 months to say the least. But we think that given the prior two points, TGT is facing the brunt of that tough environment to a greater degree than its most immediate peer group. And that’s because there isn’t a clearly articulated strategic or capital investment plan in place in order to win in any environment. We saw the company lose share for the first time since the data breach hangover, and we expect that to continue as the two points cited above compound to make TGT a net loser.

 

So what does that mean in dollars and cents? We get to $4.60 in 2018 vs. the street at $6.25. The components of that number are a 1% comp (20% e-commerce growth and flattish store comps) and margin contraction to the tune of 20-30bps per year driven by both GM deleverage and an uptick in SG&A. On that, we’d argue a generous low double digit earnings multiple for a zero square footage growth retailer positioned as a market share loser. That’s a stock in the low-50’s, good for 25%-30% downside from current levels.

Additional Details On The Quarter:

A Lot Promised, But No $ Allotted

We heard about a dozen or so initiatives the company is working on internally as part of the long-term plan, and the projects run the gamut from investing in people, self-checkout lanes, digital assets, to back end infrastructure. Those all fall under the overarching theme which is boiled down into the phrase, ‘initiatives to drive future growth’, that TGT management throws out when it communicates with the Street. The only problem is that there is a considerable mismatch between the number of projects the company speaks to on any given conference call and the actual dollars allocated to those projects.

For TGT, the numbers speak for themselves, with SG&A/Sq. Ft. still in negative town down 0.7% in the quarter on TTM basis. The company can tout its $2bn cost savings plan all it wants (we thought it was particularly strange to see that as the number two bullet point in this morning’s earnings release) but the fact of the matter is that a cost savings plan isn’t going to support top-line acceleration. Not when WMT is investing a boat load to eat TGT’s lunch supported by SG&A/sq. ft. up 9% in 1Q (a number we expect to stay elevated when we see numbers out of the company tomorrow). At the same time, AMZN steps up its marketing and fulfillment spend in order to continue to take share. For AMZN, the numbers work out to an incremental $5bn in marketing/fulfillment expense over the past 12 months to support an incremental $20.5bn in revenue, with the expense rate up 90bps.

Bottom line, TGT is not getting it done.

TGT | Losing at Defense - TGT SGA

Traffic Slowing, Why?

That’s a fair question, and one that we don’t think was answered during the duration of the 60 minute conference call today. We heard a lot about a tough consumer environment, weekly/regional volatility, and apples of multiple varieties (tech and food), but very little concrete detail on what the company actually has in the works to stop the bleeding. This is an important point on the TGT story from here. The benefit from the data breach is now in the rearview, much of the improvement in the ‘signature categories’ has been recognized over the past two years, 20% of its revenue base is broken and that’s food, and we think most importantly, the company is being bombarded from all sides from the competitive set which includes, WMT, AMZN, dollar stores, grocery stores, and department stores.

From here (outside of price, which has its own margin implications) we can’t point to any material initiatives the company has in the pipeline to offset a decelerating comp trend. There are a few private brands (Cat & Jack, Pillowfort), continued investment in out-of-stocks, duct-tape work on the grocery division, regionalization, and digital spend. But none of the efforts are being allocated the capital needed or the marketing dollars behind them in order for the company to play offense and take market share.

TGT | Losing at Defense - 8 17 2016 growth slowing

Losing Share Like Never Before

Pre-data breach, TGT was good for 2-3% points of the incremental consumer outlays in retail category per quarter. It took an obvious step back in wake of the data breach, and recognized a snap back in demand as the company restored consumer confidence and recognized part of the Cornell plan. Fast forward to where we are today and TGT in this quarter just posted its biggest market share decline we’ve seen over the past 6yrs. Some of that is due to the sale of the $4.2bn Rx business, which we don’t adjust for in the chart below. The biggest callout from where sit is the bifurcation between a relatively healthy retail sales figures (ex Auto/Food Service/Gas) which has been in the 3.5% on a TTM basis and TGT’s decelerating comp store sales into negative territory for the first time since 1Q14. We think that’s due in large part to the following…

1) AMZN: If you run the same math on AMZN as we did with TGT, you’ll see the guy’s in Seattle carving out a bigger and bigger part of the incremental retail dollars. 2x the rate from a year ago and good for 25% of the incremental retail dollars. Compare that to TGT at -1.8%. That pressure isn’t going away unless TGT implements a material capital investment plan to beef up its e-commerce operation.

2) Stores: TGT no longer has the benefit of sq. ft. growth. Not that it had a big tailwind back in 2011-12, but it’s now in sq. ft. consolidation mode with smaller format store growth offsetting some of the big box closings. That means that traffic needs to be earned organically or online. Which brings us to point 3...

3) Digital: TGT owns one of the most underfunded and underdeveloped e-commerce operations in retail. The company took the operation in house from AMZN in 2011 and since that time, sales have grown to ~4% of total. Sales in the channel grew just 16% in the quarter, 40% the rate the company promised two years ago when it spoke to a 40% e-commerce growth CAGR (the company has since talked down expectations). There is a clear divide between the e-commerce winners and TGT. Unfortunately for them, the ante chip to play the game just went up with WMT’s $3.3bn acquisition of Jet.com.

TGT | Losing at Defense - 8 17 2016 TGT   of US retail

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