The market appears to imply that Walmart (WMT) and Target (TGT) are very much the same company, or similar asset return investments. After all they both have been open and seeing strong sales, heck they both comped right around 10% in 1Q.
TGT actually comped slightly better at 10.8%, WMT comped 10.3%. Yet TGT saw gross profit down 5% while WMT saw gross profit up 6% (companywide), and TGT had EBIT down 60% while WMT grew operating income 4% in the US. The two biggest aspects driving this divergence are category mix and the level of prior eCommerce investment.
If we break down the TGT margin, gross margin was down 450bps. (Commentary from WMT for comparison is down below) These are the factors TGT noted:
- Factor 1 “millions of dollars of incremental costs, including inventory impairments resulting from the severe slowdown in Apparel sales” That appears to be in the area of 150-200bps.
- Factor 2 “category sales mix accounted for more than 150 basis points of this quarter's gross margin decline.” Category details below.
- Factor 3 “The third major factor was digital fulfillment and supply chain costs as digital penetration more than doubled compared with last year” That’s probably in the area of another 100-150bps.
The third factor is perhaps the one we find the most interesting, as we think TGT has under-invested in e-commerce vs the competition (see chart below). Management has downplayed the nature of the channel shift dilution in the past saying that leveraging stores is a cost saver. But our take is it's strategy is less efficient and that the costs would show as eCommerce scaled, and this Q eCommerce clearly scaled rapidly and there appeared to be some real margin impact.
Management noted “a portion of our investment in the team shows up in (gross) margin because supply chain labor shows up in margin”.
That makes sense, though all fulfillment costs of eCommerce orders supposedly to go to COGS, and with all of the comp dollars basically coming from digital, and stores fulfilling nearly 80 percent of Target's first-quarter digital sales, there must be a lot of SG&A that should be digital allocated. We’d be curious as to the specifics of that allocation methodology.
Management even admitted “We've been investing in planning and the capability to support this volume. We just thought it'd be 3 years from now. And so we've seen an acceleration for what we would expect it to take 3 years that's now happened in a matter of weeks.” That almost sounds like they are 3 years away from being at the point they need to be today. The question becomes are the prepared for the new normal relative to key competitors? and how much more do they need to invest in digital infrastructure?
When addressing this channel margin issue in Q/A, this is the answer the CFO provided:
“But I think it's worth pausing for a moment on that mix shift to digital and the rate pressure that comes with that because I want to spend a second on how I think about digital economics because I think there's real risk in over-rotating on the profit rate headwind that shows up there for a couple of reasons. The first is for the vast majority of those digital transactions and especially the ones where the guests taking advantage of our same-day services, the sales dollars, the market share dollars and the variable profit dollars from those sales are definitely a good thing. And second, and this is most important, the economics of a digital transaction, as I've said before, are so much bigger than just the single transaction. When we see guests engage with more of our fulfillment choices, they become stronger customers of Target and we build relevance with them in total. And that's where the economics of digital get most powerful.”
So is the dilutive nature of digital a marketing expense for brick and mortar? We get what management is trying to say, but why doesn’t the margin just go higher with higher eCommerce penetration then?
Or could there be structural reasons why, like an extra shipment trip, and/or having to do picking/handling with employees rather than customers “self-picking” goods from the shelf in a store.
TGT is trading at 23x EPS, WMT at 24x. From a profit perspective Target is ~30% an apparel retailer, WMT is more like 10%. We think they should be valued as such, with apparel getting big discount in this market.
Then we continue to believe that TGT is not as well invested in eCommerce as key competitors which will be a share or margin and ROIC risk over the long term as eCommerce has just clearly and rapidly changed the cadence of penetration into global retail.
Both of these companies have long term opportunities in terms of retail share given the disruption we see today, but quite simply we think WMT’s is greater and it is better positioned to capture that opportunity profitably... we think the multiples should reflect that.
TGT remains on our short bias list.
- “strongest performance in Hardlines, which grew comparable sales by well over 20%. Growth was particularly strong in electronics where comps grew more than 45%, reflecting high demand for video games and home office items.”
- “Essentials and Beauty saw high-teen comp growth, “
- “while comps in Food and Beverage grew by more than 20% as guests trust the Target for both their stock-up trips and their everyday needs.”
- “In home, we saw high single-digit growth led by kitchen, which saw comp growth in excess of 25%.”
- “And in apparel, first quarter comparable sales declined about 20%, reflecting soft sales in late March into early April, followed by a resumption of growth in the last 2 weeks of April.”
In margin commentary “Our 3 lowest-margin categories, Hardlines, Essentials and Food and Beverage, each saw first quarter comp increases in the high teens or higher. In contrast, our 2 highest-margin categories, Home and Apparel, saw slower trends, with Home in the high single digits and the Apparel decline of more than 20%.”
WMT US Gross Margin Commentary: “Despite strong sales, the carryover of last year's price investments and the unfavorable shift in category channel mix pressured the gross margin rate by over 100 basis points. Category mix shifts included increased sales of lower-margin food and consumable categories and softer sales in higher-margin categories like apparel, which declined about 14% in the quarter. Seasonal markdowns and the temporary closure of our auto care centers and vision centers also pressured the margin”