We expect the first quarter to be relatively in-line – not like the upside we saw from Wal-Mart -- we’re modeling a penny beat on slightly weaker comps than the street. It’s the rest of the year that’s the problem for TGT as cost increases are locked, comp expectations are high, and we see both WMT and AMZN go to all-out war to secure the incremental sale via next-day delivery. TGT gets left in the cold in that scenario. It has to meaningfully step up its investment levels if it doesn’t want to be left in the dust. In other words, TGT is losing share of wallet at a 6% EBIT margin – and it will likely cost 2-3 points if it wants to grow in line with peers over a TAIL duration. There’s no way that risk is embedded in TGT’s current $71 share price. Best Idea Short.
1Q19
1Q has a very easy compare so numbers look doable to us, even if the sentiment around retail is that 1Q was “meh” because of weather and an Easter shift. Outgoing CFO Cathy Smith was willing to bless the first quarter guidance at the recent analyst meeting, while she appeared much more resistant to do that for CEO Brian Cornell’s full year guide (for details, see our last note TGT | Be Careful Who You Believe). So the 1Q guidance assumptions are likely more reasonable and done with some visibility to trends. Comps should slow vs an easier compare, and margins are pressured by mix impact as TGT continues to see a mix impact of stocking more toys/baby post the Toys R Us shutdown. Note that we have seen some “beats” so far out of retailers, though keep in mind the stock reactions of those beats… M, RL, PLCE all closed down this week on decent to large headline beats. Even WMT traded up only modestly on a big EPS headline. Sentiment around retail appears to be shifting negatively, TGT is unlikely to be an exception. With a roughly in-line print we expect the company to stick to its full year guidance, which we do not think is achievable. TGT will cross its fingers and hope for improvement in underlying consumer demand/sales trends, but it won't materialize.
2019 Set-up
Expectations are as high for TGT as they have been in years. Believe it or not, at this time last year the expected comp for the year was just 1.9%, the year before it was -2.1%. Both of those years ended up much better than planned (+5% in 2018, and +1.3% in 2017), but that presents the risk this year. In 2019 we have difficult growth comparisons, with consumer confidence looking peaked, and expectations now for TGT to comp 3.1% on street numbers, while WMT and AMZN aggressively steal its traffic via next day delivery.
Guidance for the year, as we see it, is all about the comp, and the company is guiding “low to mid-single digits”. Gross margin has to be down 20-50bps in 2019 we don’t see a way around that for TGT given its investments and its inventory position (TGT screams GM% bearish on our SIGMA chart below). Given the other cost pressures, the SG&A leverage needed to grow EBIT will only happen if the company can comp 4-5%. Given the comparison set-up, our macro view of slowing US GDP and the slowing consumer, and the fact that the company just made it clear that Toys and Baby growth was a big help in 2H 2018 (our math was about 100bps of help, but company comments implying potentially more, which is not repeatable), we think 4-5% is not achievable with margin expansion in 2019.
The Shipping Battle
This week WMT announced Nextday delivery on 220k items, with no membership fee. Per the earnings release “we’ve been mirroring our eCommerce inventory in the U.S. to enable free next-day delivery from Walmart.com. Earlier this week, we launched this service in the southwest and will ultimately cover about 75 percent of the country by the end of the year.” That comes about 3 weeks after the Amazon announcement to work towards Prime Free 1-Day shipping. Just as it looked like TGT might have its highest investment years behind it, its top competitors raise the bar. As this mass merchandiser shipping battle continues we see TGT as the biggest loser. Bigger, stronger, and heavier budgeted competitors are still investing heavily to take share. TGT had signaled this year to be the start of leveraging investments, but if it wants to keep up it might have to step up investment again. Free shipping recently became the industry standard, we’re now rapidly heading towards 1 day free shipping as the market standard. That equals industry margins grinding lower at an increasing rate.
Other Cost Pressures
-Wages continue to march higher. TGT has baked in ~$0.45 in EPS pressure for this year and next from taking its min wage up to $15 by 2020. Market rates are marching higher as well as retail non-supervisory wages were up 5% in Feb and March, meaning at the end of this ramp, TGT’s relative wage rate won’t be as far ahead of the others as it might have expected.
-Tariffs are a risk. TGT has exposure to the goods increasing to 25% tariff rates, and believe it or not, tariffs and China were not topics of conversation during the annual investor meeting in March. TGT hasn’t said much on tariff risk except to seemingly send a message to the administration on the 2Q call saying they would “increase prices on everyday products for American families. In addition, a prolonged deterioration in global trade relationships could damage economic growth and vitality in the United States”. Macy’s comments Wednesday implied adding tariffs on the final tranche of Chinese imports would be materially negative, whereas the impact of the the move from 10% to 25% can potentially be mitigated.
-Freight is an area that was starting to look like a margin tailwind, as the Cass Freight Index was down YY in 1Q. But recent escalations in the tariff battle might mean accelerated shipment demand and a reversion back to price increases, as was the case last year on tariff concerns.
-TGT has credit exposure with its branded credit card partnership with TD Bank. 16% of EBIT is profit sharing from this agreement. We think consumer credit quality is past peak as we see delinquencies getting worse for retail store card lenders like SYF and COF. That means the profit share could contract materially if industry delinquencies keep heading the wrong way.
