This was a stellar absolute quarter for TGT. 24% comps, 26% gross profit growth, 75% EBIT growth and 86% EPS growth, it’s fair to say TGT may never see results this good again. Management is pumping the strong fundamentals and TGT is clearly gaining share with positive transactions (to WMT’s down 14%) and bigger revenue growth than competitors. But even with the strong sales momentum, as we dive in on the details of the quarter we see too many risks to both trend and tail EPS growth to get this onto the long side of our ledger relative to the overwhelmingly positive sentiment the stock sees today as it hits new highs.
Digital Margin Appears Significantly Dilutive
This quarter the company noted the digital fulfillment and supply chain costs were a 130bps drag on gross margin. Last quarter it wasn’t explicitly given, but we can deduce somewhere in the 100-150bps range. Back in 2Q of 2019, there was 30bps of headwind. As we do the rough math, the implied margin variance between digital and stores appears to still be in the area of 1250bps (math below, but simple point being 10pts higher digital penetration having 130bps drag). That is improving from ~1700bps a year ago, but with 10pts change in penetration. Big dilution makes sense at 3-5% of sales, but TGT is now approaching 20%. And the dilution this quarter comes alongside the company highlighting “average unit costs for digital fulfillment was approximately 30% lower than a year ago”. So a big margin variance with the gap closing some. That average cost comment syncs reasonably well with the implied change in margin variance, though in our math we assumed ecom margin to be similar Y/Y, if it is improving the implied variance actually needs to be higher to get the disclosed dilutive impacts of the channel mix shift.
Obviously more scale will mean more leverage, but where would this margin variance settle out long term? 800bps lower for digital? 500bps? This is only a 6% operating margin company. What keeps the channel shift from taking that down to 5%, 4%, 3%? For now it’s ‘merchandising initiatives’ are doing that, but we suspect that as the consumer environment normalizes, merchandising strategies will not be as material a lever and markdown risk returns.
Sales Slowing, Costs Rising, Macro Quad3
The company gave the monthly sales cadence, May was up 33%, June 21%, July ‘about’ 20%, August has slowed to low double digits. Without another big round of stimulus the sales rate likely trends lower still. Yet SG&A from a rate of change perspective has full quarter impacts of the min wage move to $15. Covid has its incremental procedural costs, and TGT continues other team/store investments. As macro Quad3 (inflation accelerating as real growth slows) continues and flows to corporate P&Ls, we suspect gross margin pressure will build as elements of COGS inflate at the same time sales and pricing power slow with the consumer.
The Unseen Risk: Credit
Despite 24% comps, TGT's income from its credit sharing agreement with TD Bank was down 6% this quarter. Credit is not massive for TGT like some other retailers (KSS,GPS) but it is $677mm over the last 12 months, and ~15% of EBIT. We think buyers of TGT at these prices aren't thinking there is 10% or more EBIT risk in 2H from a consumer credit cycle rollover, but there is.
5 Years Ago vs Today
Brian Cornell spent some time reflecting back and comparing this quarter to 2Q15 five years ago. We don’t want to take away from what Cornell has done, he made some great early moves to clean up profitability (Canada & Pharmacy) and he and the company have done much better than we would have expected in a challenging retail environment over the last few years. But comparing this Q to the same quarter 5 yrs ago isn’t exactly being genuine. Just a quarter ago making the same comparison would be $0.59 today vs $1.10 in 2015, so we shouldn’t hand pick quarters. But if we take a wider view, after this stellar quarter over the last 12 months TGT delivered just under $5bn in EBIT, slightly below the level seen in fiscal 2015. EPS has gone from $4.70 to ~$6.95, but about $1.00 is from tax reform, and the basically all the rest is share count. So things are definitely better than a couple years ago, rate of change has looked solid over the last 12-18 months, recent cash generation has been strong, but on above the line operating results we’re not much different than 5 years ago. Things are good, but let’s recognize what the real value creators have been and what they haven’t been.
2021 and Beyond
For now the trend outlook (slowing revs, rising cost pressures) keeps this name on the short bias side. If we get a better sense of what 2021 will look like this could either become a higher conviction short, or potentially a long. But so much of 2021 for the retailers that have been performing under Covid19 and gaining share remains uncertain.
- Will sales be down lapping stimulus and wallet shift?
- How much share from competitor closures is up for grabs?
- Will gross margins be worse from a promotional environment and a more price conscious consumer, or better with mix returning to normal and less ecom growth?
- What impact will wage inflation have and what further investments will have to be made to protect/gain share?
- As consumers take more shopping online and consolidate shopping trips, is that bullish or bearish for TGT long term?
There will be a lot to sort out in the coming quarters for the tail view on TGT, for now we see pressure on EPS growth, and are modeling that next year will be a down year.
