Image Source: Mike Mozart
Another day of earnings — another bad day for retail.
May 18 brought a disappointing first-quarter report from retail bellwether Target (TGT) that sent the prices of it and most of its big box brethren including WalMart (WMT), Best Buy (BBY), and hhgregg (HGG) lower on the session, the latter two lower due to weakness in Target’s electronics vertical during the period. We’re reiterating our $71 per share fair value estimate of Target at the time of this writing.
Except perhaps home improvement retailers Lowe’s (LOW) and Home Depot (HD), which continue to post desirable comparable store sales increases (+7.3% and +6.5% in the first quarter, respectively), and arguably the auto retailers, including AutoZone (AZO) and O’Reilly Automotive (ORLY), the rout in big box retail shows no signs of letting up, “.” Retail, especially the discretionary variety (XLY), has become the proverbial “mine field,” and investors should consider the risks of positions correspondingly. Lowe’s and Home Depot are priced to perfection, meaning that they are trading at lofty valuations.
Many of our members are well-aware of our criticism of Target for some time, probably to the point that they may think we’re not even fans of the company, “Target or WalMart (May 2015).” Of course we like Target, the company, but the May 2015 piece may be as good as any as a reminder of what we’ve been saying about the big box retailer and its brother, WalMart:
…there is one reason that we are vitally concerned with the long-term picture at Target, and we’ll talk about this in depth. Second, there are two reasons why we think Walmart’s long-term picture is bleak, albeit both of the factors at Walmart arguably apply to Target’s business model, too. Now, don’t get us wrong. Let’s be clear. Are Target and Walmart fantastic free cash flow generators? Absolutely. Do Target and Walmart have substantial competitive advantages? Absolutely. Will Target and Walmart continue to pay their dividends for the foreseeable future? Absolutely.
These aren’t the points we are addressing. Every business will have strengths and weaknesses, and in this piece, we’d like to address the ones most prevalent on our minds – both for brevity and relevancy. Target’s and Walmart’s 16-page stock reports and the commentary archives on them can be accessed on their respective landing pages. So, when we speak of concerns, we’re talking about fundamental dynamics, and how they may come back to impede future earnings and cash-flow performance, perhaps not in the next year or two, but in the next 5 to 10 years.
For those that may have missed the event, Target closed the last of its 133 retail stores in Canada April 12, laying off 17,000 employees and taking a $5.1 billion quarterly charge. The justification for leaving Canada boiled down to the following rather unusual short-term oriented statement: “Unfortunately, we were unable to find a realistic scenario that would get Target Canada to profitability until at least 2021.” Six years? Just six years? This is a blink-of-an-eye for most long-term investors. But yet, complete abandonment? We didn’t think the problems in Canada were unfixable. Inventory, pricing, and branding should be core competencies for any retailer. After all, there are successful retailers in Canada, and Target’s one of the best in the US. It should have worked. Right?
Here’s what you need to know – and here’s the real reason why Target abandoned Canada. At the beginning of 2014, the incentive committee at Target added ROIC as a third metric to its performance stock unit plan (measured through 2017). According to the new incentive plan, the Canadian Segment would be “included in ROIC to ensure participants are held accountable for the significant startup investment related to this key growth initiative.” Brian Cornell joined Target as board chairman and the new CEO in August 2014. Did you really think the new head honcho was going to spend his first six years on the job languishing over building a business in Canada, while receiving no incentive pay for such efforts? We think not. Hence, the exit from Canada ensued, for good or bad.
From our perspective, however, by abandoning Canada, Target has effectively capped the size of its company. As perhaps many of our Canadian friends would agree, the US and Canada aren’t too different. In fact, we can’t think of many differences at all. However, Target’s foray into Canada and its rapid abandonment of its efforts in the country reveal something terribly wrong with the transportability of its franchise–and an incentive structure at the top that’s still too near-term focused. We learned about the superiority of ROIC over operating EPS targets in incentive structures with respective to the example with IBM (IBM), but the length of the measurement period of an incentive plan is important as well. It’s very possible that a 10-year incentive program as it relates to Target’s Canadian business would have kept top brass in the game.
In 2021, we think Target investors will look back and say, “We could have had a profitable Canada by now.” It’s very probable, and we can’t wait to find out.
Let’s now move on to Walmart.
First, we won’t belabor this issue, but the well-documented view of encroaching online competition from Amazon (AMZN) and from dollar-store retailers such as Dollar General (DG) and Dollar Tree (DLTR) is only worth a brief mention, and we’ll now move on. ‘Nuff said, as you may say.
Second, Walmart is at the center of political upheaval in America. The company has become the poster child for all of what many believe is unfair pay practices, and this will be difficult to overcome as the ranks of millenials swell. We talked about the frightening path of labor expenses in this piece here, but they won’t abate…at least not anytime soon. We nearly fell out of our desk chairs when we heard the country’s second-largest city Los Angeles was raising its minimum wage to $15 per hour over time, following the lead set by Seattle. It didn’t just pass – the City Council voted 14-to-1 in favor!
With product prices under pressure and labor costs on the rise, something’s got to give. It really doesn’t take a mathematician to understand that Walmart is simply getting squeezed and may be in a lot of trouble over the long haul. As for the minimum wage hikes, we don’t know how workers will fare during the next recession, which is an inevitable part of the cycle, but when revenue falls and labor-costs-per-person have price floors, the only response is layoffs. Both Target and Walmart know it.
During the three months ended April 30, sales at Target dropped 5.4%, while earnings from continued operations before income taxes fell more than 10% in the period. Net earnings from continuing operations fell 5.8%. Yet, the company was quick to note that first-quarter adjusted earnings per share of $1.29 increased 16.5%, above its guidance range of $1.15-$1.25. Incredible how non-GAAP or adjusted measures always seem to make things look better, would you say? The really doozy, however, was Target’s second-quarter guidance of $1.00-$1.20, which came in definitively short of the $1.36 consensus mark, sending shares a-tumbling by a high-single-digit percentage on the trading session May 18. Target blamed “the recent slowdown in consumer trends,” and on the basis of what we’ve been seeing from other retailers, it appears endemic. Comparable store sales in the second quarter are expected to be flat-to-down 2%.
We know US consumers are spending, but they won’t be spending more at Target on a same-unit basis, at least during the second quarter, and management’s pullback from Canada means long-term growth trends may disappoint at the retailing giant as well. We think it makes sense to reiterate our two major concerns about Target’s long-term health: e-commerce proliferation and rising labor costs, “10 Bucks per Hour; What It Really Means (February 2015)” Are the glory days of Target and Walmart over? It appears so – as Amazon appears to be eating both of their lunches. We do not hold either Target or Walmart in the newsletter portfolios.