Sometimes when a name goes against you, it presents the mother of all opportunities to double down and capitalize on a high conviction idea and research process. Other times you have to man-up, admit things have changed, and that you are simply wrong. That’s the hardest and most humbling thing to do in this business. Most of all you have to keep it intellectually honest and look forward instead of clinging to a view that Mr. Market is (sometimes violently) saying is wrong. That’s the case today with Target. We had (now past tense) this name as a Best Idea Short side as our view is that the company is losing out to Amazon and WalMart in the battle for same/next day delivery, and that margin and cost pressures required a 4% comp or better this year to hit numbers. Over a TAIL duration, for reasons we outlined in our recent Black Book (Link: CLICK HERE), I still think that is the case. But there was a game changer this quarter, and that is the gross margin that the company was able to put up with an otherwise ‘slightly better’ comp. It was beyond impressive and changes the trajectory over a TREND duration. Now it faces two easy GM compares when its ‘merchandising strategies’ (which we suspect is at least in part extracting value from vendors) still have momentum. In the end, we can get to the company beating the guidance it set with today’s release for the balance of the year. Given the secular pressure we see inherent to Target’s business model, we might be staring at what in hindsight could be the stock’s all time capitulation-driven high. But that’s no reason to stick with a thesis that will likely prove wrong for another two quarters of results. Licking our wounds here and moving to the top of our Short Bench. Likely to revisit the well after we de-risk the next two quarters of earnings beats.
What’s Changed
Gross Margin - Big Surprise
- Given the performance this Q, our gross margin outlook for 2H has significantly changed.
- From a high level, the performance for TGT of +30bps vs retailers like KSS (down 70bps) and WMT (down 22bps) clearly stands out, as well as the trend vs last Q. GM% this Q beat our expectation by about 50bps. But if we break it down, with ecommerce pressure being ~30bps and mix help being ~20bps, the variance was almost entirely made up of the implied ~40bps of “merchandising strategies”. Given we were lapping the first material contribution of this new disclosure this Q, we expected minimal or at least moderated help, which was not the case. Additionally, as we can measure and analyze ecommerce and mix margin impacts with some visibility, the opacity on these merchandising margin levers is too great to get clarity on the trend. We’re not even confident what the levers being pulled here are. Is it new limited collections like Vineyard Vines? Vendor pricing pushback? Private label initiatives? Pricing actions? Whatever it is we think it’s more concrete than the team simply being ‘the best in retail’. Still we can't defend a short positioning with no visibility on the duration or magnitude of this margin lever over a trend time frame.
- So as the trend outlook on gross margin has taken a near 180 degree turn, the 2H numbers look very doable. Looking out beyond 2019, the ecommerce pressure will persist, mix help should moderate, and we suspect merchandising strategies will run out of steam. At the same time tariffs will matter (assuming they are in place) in 2020, management didn’t appear to want to talk about or quantify risks on the call. Maybe that’s the next catalyst for a short on fundamentals, but we’re over 6 months away from the annual investor day where the company would probably have to guide that impact.
Comps/SG&A/Credit – Slight Changes
- The comp beat was not overly surprising. The US consumer has not weakened yet (we’ve seen 2 year improvements on retail sales), and we saw WMT put up a 2 year comp acceleration as well. The company continues its remodels, targeting 300 this year, which buoy comps, and ecommerce growth remains strong as we hit somewhat easier compares vs 2Q. We could see 2H comps being a bit better or worse than guided, at the moment we’re just slightly below, an upward revision from prior estimates.
- SG&A came in lower than we expected this quarter, though the variance was just about entirely the ~40mm shift from marketing and other expense timing noted on the call. Our math on wage pressure was only 75-100bps in 1H, but ramping to 150-200bps in 2H with the recent dollar increase in TGT’s min wage. We’re taking our SG&A up for 2H (mostly in 3Q) given the timing shift and our small upward comp revision.
- Other revenue (credit) inflected to 7% growth from roughly flat. Though not a large driver of EBIT growth in the Q, if credit can maintain this growth rate it is definitely bullish on the margin given this revenue is very high margin.
