Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Target Corporation – May 2013 IR Presentation

By Callum Turcan

Elevated demand for consumers staples products and rebounding consumer discretionary sales helped Target Corporation (TGT) report record comparable store sales growth in the second quarter of fiscal 2020 (period ended August 1, 2020), which were up 24.3% year-over-year. Digital comparable sales were up a whopping 195% year-over-year as same-day delivery services grew by 273%, with Target citing strength at its curbside pickup, order online/pickup in-store and home delivery options. Please note Target generates virtually all of its revenues in the US.

Market Share Gains and Digital Investments

The uplift in US consumer spending power from the Coronavirus Aid, Relief, and Economic Security Act (‘CARES Act’), particularly the direct cash payments to certain US households and enhanced unemployment benefits, supported Target’s performance during the initial stages of the coronavirus (‘COVID-19’) pandemic. Target also reported that it “saw unusually strong market-share gains across all five of its core merchandise categories” last fiscal quarter. Back in December 2017, Target agreed to acquire the “leading online same-day delivery platform” Shipt in an all-cash deal for $550 million, which has since played a key role in enhancing Target’s ability to be competitive with giants like Walmart Inc (WMT) and Amazon Inc (AMZN).

E-commerce, home delivery, order online/pickup in-store and curbside pickup options have become increasingly popular during the pandemic. Consumers can order online and then pick those products up either in-store or outside in designated areas, operations that Target has been aggressively bulking up and building out in recent years. Home delivery operations have leaned heavily on Target’s Shipt acquisition and going forward, Target is reportedly seeking to acquire additional home delivery technology, this time from Deliv.

Walmart has made great strides in supporting its digital, curbside pickup and home delivery business in recent years, while Amazon has long made timely home delivery services the cornerstone of its e-commerce business model. Amazon launched its Prime service in the US back in 2005, which at the time (and to this day) included free two-day shipping (in some instances, Amazon offers even faster delivery services for free to its Prime members, including free same-day delivery). Target seems to be gaining ground in this area and it appears that this success is supporting its ability to win market share and grow its top-line, with the firm noting in its earnings press release that it had “gained approximately $5 billion in market share” during the first half of its current fiscal year.

Financial Update

Pandemic-related costs concerning dealing with COVID-19, such as the need for personal protective equipment (‘PPE’) and sneeze guards at store counters, have eaten into Target’s bottom-line. During the fiscal second quarter, Target spent $400 million on COVID-19-related expenses in its SG&A line-item according to management during the firm’s latest earnings call. With that in mind, strong sales at Target’s private-label brands (such as Good & Gather) and greater economies of scale more than offset those headwinds. Last fiscal quarter, Target reported its GAAP gross margin rose by over 30 basis points versus the same period last fiscal year (supported by growing private-label sales) as its GAAP revenues climbed higher by 25% year-over-year. Management had this to say during Target’s latest earnings call (emphasis added):

“…This fall, we will roll out at the third and final phase of our Good & Gather assortment adding more than 600 items to bring the total number of items to nearly 2,000. Good & Gather brand is clearly resonating with our guests and delivering on our food and beverage vision to enhance the Target experience by making it easy for families to discover the joy of food. We launched this new flagship brand less than a year ago and it has already generated more than $1 billion in sales. With momentum from this new brand, our own brand food and beverage business has been growing more than 30% so far this year, significantly outpacing the market and growing market share.

Beyond Good & Gather, we continue to benefit from an unmatched portfolio of owned and exclusive brands that spans our entire assortment. Together these brands whose sales have outgrown national brands so far this year, obligates quality and style and an unmatched value, while enhancing Target's differentiation and delivering attractive gross margin rates.” --- Brian Cornell, CEO of Target

A combination of top-line growth and an expanding gross margin enabled Target to grow its GAAP operating margin by over 280 basis points year-over-year as its GAAP operating income surged by 74% last fiscal quarter. We appreciate that Target’s SG&A expenses rose by only 14% during this period, keeping pandemic-related expenses in mind, as this indicates management is doing a solid job keeping costs contained all things considered. DD&A expenses were down 3% year-over-year last fiscal quarter. Target’s GAAP diluted EPS rose by 84% year-over-year, hitting $3.35 in the fiscal second quarter, which was supported by a 2% reduction in the company’s outstanding weighted average diluted share count.

During the first half of fiscal 2020, Target generated $3.7 billion in free cash flow while spending ~$0.7 billion both covering its dividend obligations and repurchasing its stock. Target’s strong cash flow performance helped shore up its balance sheet. As of August 1, 2020, Target had $7.3 billion in cash and cash equivalents on hand versus $0.1 billion in short-term debt and $14.2 billion in long-term debt (good for a net debt position of $7.0 billion). For reference, Target had a net debt load of $8.9 billion (inclusive of short-term debt) as of February 1, 2020, before the pandemic spread throughout North America.

In late-March 2020, Target suspended its share buybacks to better position the firm to ride out the storm, though the firm has continued to make good on its dividend obligations. Target announced it was increasing its per share quarterly dividend by ~3% on a sequential basis this past June.

Sales Growth Breakdown

Last fiscal quarter, Target experienced a strong sales growth across the board. In particular, products in the “hardlines” category (such as electronics and office equipment) jumped higher as US-based employees worked from home and home schooling became more prevalent. Consumer staples sales held up well and continue to grow at a decent clip, though the rate of growth slowed down last fiscal quarter versus fiscal first quarter levels as households began working through goods stockpiled up during the early days of the pandemic. Here is what management had to say on this issue and on employee compensation during Target’s latest earnings call (emphasis added):

“Among our discretionary categories, we saw the most dramatic comp acceleration in apparel, which moved from a 20% decline in the first quarter to double-digit growth in the second quarter. Hardlines generated the strongest comp overall, at more than 40%. This was the result of an even stronger increase in electronics of more than 70% as guests continue to focus on office equipment, home electronics and gaming. Not surprisingly, our guests heightened focus on staying at home was also evident in our home category. We saw more than 30% growth, with particular strength in decor, domestics and kitchenware. Beauty also saw a healthy acceleration, doubling its first quarter growth rate to more than 20% in the second quarter.

Our less discretionary food and beverage and essential categories each saw second quarter comp sales growth of about 20%. For both categories, this was slightly slower than we saw in the first quarter, which is marked by dramatic stock up shopping as the pandemic emerged. At a time when every retailer is facing increased uncertainty and unforeseen challenges, we have chosen to continue investing in our business, and particularly in our team…

…[W]e announced that, beginning July 5, we would permanently raise our starting wage for U.S. team members to $15 per hour. Additionally, we announced a one-time bonus of $200 to our frontline store and distribution center hourly workers in recognition of their efforts throughout this extraordinary year.” --- CEO of Target

Concluding Thoughts

Though Target’s near-term outlook will have to contend with uncertainty over the back-to-school shopping season (contingent on schools reopening), elevated unemployment rates, and the fading stimulus effect of the CARES Act, management remains optimistic that the firm’s long-term growth outlook remains strong. We are not interested in shares of TGT at this time as we prefer large-cap tech companies to ride out the pandemic (we have been pounding the table on this front for some time now, see here and here for more), though we are impressed with Target’s ability to be competitive in the e-commerce space and win market share.

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Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR PSMT

Household Products Industry – CHD CLX CL ENR HELE JNJ KMB PG

Specialty Retailers Industry – AAN BBBY BBY GME HD LOW LL ODP SHW TSCO WSM

Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT

Related: AMZN, FDS, SPY, VDC, IEDI, COWZ, IYC

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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) and Johnson & Johnson (JNJ) are both included in Valuentum’s simulated Best Ideas Newsletter portfolio. Johnson & Johnson is also included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Vanguard Consumer Staples ETF (VDC) is included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.