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Target Corporation (TGT)

Q2 2006 Earnings Conference Call

August 10, 2006 10:30 am ET

Executives

Gregg Steinhafel - President

Doug Scovanner - CFO, CAO and EVP

Bob Ulrich - Chairman, CEO

Analysts

Mark Husson - HSBC

Jeff Klinefelter - Piper Jaffray

Charles Grom - JP Morgan

Dan Binder - Buckingham Research

Bob Drbul - Lehman Brothers

Virginia Genereux - Merrill Lynch

Christine Augustine - Bear Stearns

Mark Miller - William Blair

Adrianne Shapira - Goldman Sachs

Gregory Melich - Morgan Stanley

Todd Slater - Lazard Capital Markets

Deborah Weinswig - Citigroup

Presentation

Operator

Welcome to the Target Corporation second quarter earnings release conference call. (Operator Instructions) I would now like to turn the conference over to Mr. Bob Ulrich, Chairman and Chief Executive Officer. Please go ahead, sir.

Bob Ulrich

Good morning. Welcome to our 2006 second quarter earnings conference call. On the line with me today are Gregg Steinhafel, President; and Doug Scovanner, Executive Vice President and Chief Financial Officer.

This morning I will briefly outline our perspective on the current economic and consumer environments and describe the impact of these factors on Target. Then Doug will review our second quarter 2006 financial results and describe our outlook for the second half of the year for the business overall with specific guidance on key individual drivers of our performance.

Next, Gregg will share his perspective on the current competitive environment and provide an update on the key strategic initiatives that continue to fuel Target's strong performance and consistent growth. Finally, I will wrap up our remarks and we'll open the phone lines for a question-and-answer session.

As Doug will describe in more detail shortly, we announced excellent financial results this morning for Target's second quarter and first six months of 2006. In addition, we remain optimistic about our performance for the remainder of 2006 and believe that we are on track to deliver strong full year results.

Certainly, we recognize that the current environment presents a number of real challenges, which may adversely affect consumer spending including higher energy costs, rising interest rates and a weaker housing market. Though we are not immune to adverse macroeconomic factors our careful execution and commitment to maintaining the right balance and our “Expect More, Pay Less” strategy has produced a remarkably stable and consistent record of top line and bottom line performance over the past decade in a variety of economic conditions.

Our financial results, one layer under the surface, also reveal considerable stability. For example, our comparable store sales have grown at an average annual rate of 5% over the past decade. We have rarely experienced same-store sales gains outside of a range of plus 3% to plus 7% for any sustained period. Similarly over the past 10 years Target's average earnings per share have grown by a mid-teens percentage and rarely increased outside a range of plus 10% to plus 20% per year. Overall, we are pleased with our year-to-date performance and believe we are poised to achieve another year of profitable market share growth in 2006.

We continue to leverage our global sourcing and product design expertise and to delight our guests with the right balance of innovation and value in our merchandise assortment. We continue to invest in highly productive new Target stores in quality locations throughout the country. In keeping with the strategic objectives which underlie our decision to offer credit to Target guests, we continue to enhance guest loyalty, reinforce our brand and generate incremental sales and profits in our retail business through our credit card operation.

We also remain confident in our longer term growth potential. Without compromising our financial return criteria for underwriting new stores, we are on track to open our 2,000th Target store in the United States and to generate annual sales approaching $100 billion in 2011, just five years from now.

We remain firmly committed to our “Expect More, Pay Less” strategy and believe it will allow us to remain relevant to our guests for many years to come. Now, Doug will review our results, which were released earlier this morning.

Doug Scovanner

Thanks, Bob. As a reminder, we are joined on this conference call by investors and others who are listening to our comments today live via webcast. We plan to keep today's call to no more than 60 minutes, including our Q&A session. Susan Kahn and are available throughout the remainder of the day to address any follow-up questions you may have.

Also, any forward-looking statements that we make this morning should be considered in conjunction with the cautionary statements contained in our SEC filings.

This morning, Target Corporation announced our financial results for the second quarter of 2006. As Bob indicated, they met our expectations for growth. Highlights of our results include the following:

We enjoyed a 16% increase in EPS to $0.70 this year versus $0.61 last year on the strength of an 11.3% increase in total revenues. Again, total revenue growth was driven by the contribution of new stores and also this time, by a 4.6% increase in same-store sales. This same-store sales performance is particularly noteworthy in light of last year's very strong 6.7% increase.

In our core retail operations, we essentially replicated last year's record high second quarter gross margin rate. While we continued to experience a somewhat faster increase in expenses than sales, our overall growth in core retail EBIT was in line with our expectations and much stronger than in the first quarter.

In addition, in our credit card operations we continued to enjoy robust results in line with our recent experience and in line with our enhanced expectations.

Separately, we repurchased 11.3 million shares of our stock in the quarter for $550 million.

We just passed the second anniversary of this program and to date we have reduced our share count by 7.6% gross or by 6.1% net of new shares issued over this period.

Finally, we are well aware that many of you are concerned that our pace of sales growth was slower in July than in May and June. As always, variability in sales remains the single biggest factor in predicting our short-term growth and profitability. Yet on balance, we continue to believe we are likely to achieve or exceed our profit objectives for the year. I'll share more about that in a few minutes.

Given that we're now halfway through 2006, let's spend a few minutes analyzing our year-to-date trends to provide color on our outlook for the third and fourth quarter. So far this year, we have enjoyed an 11.7% growth in revenue, driven by the contribution from new stores and by a 4.9% increase in same-store sales. Looking forward, we face another larger than average same-store sales challenge in the third quarter but we will benefit from cycling a lower base of comparable store sales growth in the fourth quarter. For reference, we enjoyed a 5.9% increase in same-store sales in last year's third quarter, followed by 4.2% increase in the fourth quarter.

So far this year, our overall generation of gross margin continues to be excellent and generally in line with our expectations. We expect these trends to remain in place in the fall. Although again, the third quarter will likely be a bit more challenging than the fourth quarter due to the pattern of last year's performance.

Our expenses deserve a bit more analysis. So far this year, expenses have grown at a faster pace than sales, resulting in a 51 basis point increase in expenses as a percent of sales. Nearly half of this rate deterioration is due to the dynamics of start-up expense. As we discussed last quarter, some of this year-over-year effect is driven by growth in this year's capital program, but the majority of this expense increase, especially in the second quarter, is driven by adverse timing issues, which are now behind us. Looking forward, we also expect this year's marketing expense to be heavier in the third quarter and lighter in the fourth quarter than last year.

Turning to our credit card operations. We've continued to grow our receivables in line with sales and we have enjoyed robust results so far this year. We expect to continue to enjoy similar strategic and financial benefits for the foreseeable future, certainly for the remainder of 2006 and well into 2007.

The only noteworthy underlying issue here is that, as expected, we are already beginning to experience sequential increases in delinquencies, which will lead to sequential increases in write-offs in the back half of this year, driven by the OCC mandated increase in minimum payments. Overall, delinquencies will likely be in the range of 4.0% to 4.5% of receivables and net annualized write-offs should similarly rise to about 8% of receivables.

Importantly, we believe we are already fully reserved for this projected outcome, so this set of events should not result in any future P&L impact. For reference we have built the highest allowance for doubtful accounts in our history, both in absolute and relative terms, by expensing faster than write-offs have occurred to appropriately reserve for this identified risk. Our current allowance is $501 million or 8.3% of gross receivables, up $92 million or 22.5% from this time last year. We have already expensed $50 million more this year than we have written off.

In closing, let's tie all of the elements of our third and fourth quarter outlook together. Today, the median First Call EPS estimate for the full year is $3.11, which would represent a 15% increase from last year's $2.71 actual results. While we readily acknowledge there is a downside case, in which softer fall season sales growth would drive a lower double-digit EPS increase for the year, we believe there is also the potential for surpassing this number. On balance at this time, $3.11 seems to be a reasonable single point estimate for the full year in our view.

Contribution of the third and fourth quarters, however, is not in balance in current external estimates. For all of the reasons I outlined earlier, including the relative strength of last year's performance and known timing differences in expenses this year and assuming we achieve $3.11 for the year, we would expect EPS in the fourth quarter to grow several cents faster than reflected in current external expectations and EPS in the third quarter to grow more slowly than current external expectations.

Now Gregg will provide a brief summary of current business trends, describe Target's current growth plans, and review some of our recent and upcoming merchandising issues.

Gregg Steinhafel

Thanks, Doug. Our second quarter results from our core retail operations were generally in line with our expectations and we are pleased with our performance, particularly in light of last year's outstanding results. Reflecting typical growth in both guest traffic and average transaction amount, comparable store sales in the quarter rose 4.6% on top of a strong 6.7% increase a year ago. This sales growth reflected better than average performance in most non-discretionary categories like health and beauty, pharmacy and consumables, as well as in some more discretionary categories like apparel, housewares and electronics.

In contrast, sales of pre-recorded music and video and some areas of our home business, such as bedding, rugs and decorative accessories; continued to be somewhat disappointing during the quarter. We are comfortable with the mix, balance and level of inventories as we head into the third quarter.

As Bob mentioned, we continue to invest in profitable new Target stores. During the quarter, we opened 26 new general merchandise stores and three new SuperTarget stores, resulting in a net addition to our store base of 26 locations. At quarter end we operated a total of 1,444 stores in 47 states.

In the next few months we will complete our store-opening program for this year with the addition of 45 new general merchandise stores and 15 new SuperTarget locations.

For more than a decade Target has demonstrated a commitment to our “Expect More, Pay Less” brand promise by offering our guests great design, innovation and value. Over time, we have also established strong infrastructure and built a talented team to sustain our competitive advantage, support continuous innovation and ensure that we remain relevant to our guests.

Even as some of our competitors test new merchandise brands, strive to upgrade their merchandise quality and intensify their focus on inventory management, pricing, and marketing, we are continuing to deliver on our brand promise by consistently executing our strategy of growing our own brands, aggressively pursuing improvement in content and quality, increasing our direct import penetration and improving our supply chain, in-stock levels and speed to market.

We continue to drive increased guest frequency by providing greater convenience, reliability and value in consumables and commodities and delivering an exciting shopping experience throughout the store.

Specifically, we continue to differentiate ourselves through our own brands including Market Pantry, Archer Farms and the Target brand. We are expanding our food offering with up to 34 sides of food in new and remodeled general merchandise stores. We are right-sizing more than 150 stores this year to incorporate our expanded offering of dry grocery and refrigerated and frozen foods, and we continue to improve our guest shopping experience at SuperTarget by expanding self-service delis, broadening our assortment of organic and natural foods and locally grown produce, and increasing our offering of pre-packaged produce to enhance food safety and check-out speed.

In addition to consumables and commodities, we are also giving our guests more reasons to shop our stores more often by introducing new products and brands, refining our assortments and reinventing entire categories throughout the store. For example, in July, we debuted "See Spot Save" an updated approach to our dollar shopping concept, previously called the "One Spot." Our revitalized presentation includes new signing and features an assortment of better quality products, price at two for $5, in addition to the core $1 items that have been so successful with our guests during the past two years.

During the second quarter, we also completed the final phase of our intimate apparel and hosiery reinvention, which began earlier this year. Over the past six months, we have introduced numerous improvements in fit, fabric, design and presentation in categories like sleepwear, foundations and hosiery and address the needs of our junior guests, a previously under-served segment.

We recently introduced our third Go International Flight of Fashion with the launch of Paul and Joe by French designer Sophie Albou. This collection, though not an important driver of sales volume, is an exciting addition to our fall assortment, designed primarily for our junior and contemporary guests. It consists of a wide variety of styles with fresh colors, vintage-inspired prints and unique detailing for guests who want wearable individual looks for fall.

In September, we are introducing a high quality, versatile collection of wear to work suit components in women's apparel. The Merona assortment will reflect new season lifts, wrinkle-resist fabric for maximum comfort and appearance and will cater to various body types and personal tastes, and will offer exceptional flexibility as guests mix and match jackets with pants and skirts.

We are once again offering innovative design and exceptional value in this year's back-to-school and back-to-college home furnishings assortment. For young, newly independent adults, Target's stylish offering of basic necessities, furniture and home decor is designed to transform a dorm room or unfurnished apartment into a comfortable and space-efficient oasis for living, studying, and entertaining.

In summary, Target remains committed to maintaining the appropriate balance of differentiation and value in our strategy. Surprising and delighting our guests with distinctive, exclusive and unexpected offerings. Providing the right combination of price, quality and design and driving increased shopping frequency through added convenience and reliability.

For more than 10 years, we have successfully executed this approach by anticipating shifts in guest preferences, refining our merchandising and marketing to adapt to various economic challenges, and overcoming competitive threats to produce strong sales and earnings growth.

Though the current marketplace continues to be highly competitive and the macro-economic environment in the near term appears uncertain, we are confident that Target has the vision, agility, discipline and capabilities to sustain our competitive advantage over time and translate our core strategy and “Expect More, Pay Less” brand promise into continued, profitable market share growth. Now, Bob has a few concluding remarks.

Bob Ulrich

In summary, we are pleased with our year-to-date results and optimistic about our performance for the balance of this year. We remain confident in our strategy and believe that Target will continue to deliver strong profits and consistent growth well into the future. That concludes our prepared remarks and now Doug, Gregg and I will be happy to respond to your questions.

Question-and-Answer Session

Operator

Your first question comes from the line of Marks Husson - HSBC.

Mark Husson - HSBC

Good morning. I wanted to ask a general question about your planning in the case of emergencies or disasters, in the light of what we saw this morning. But in particular, how do you plan to cope with an outbreak of say bird flu closing down some of your markets, as in Asia, and have you managed to secure sources of supply?

Gregg Steinhafel

Well, we're actually spread around the world, substantially more than many other people. We do have a crisis command center and various contingency plans. We're not anticipating anything of that nature, but should it occur we think we're reasonably well prepared; as well as anyone could be. I'm not sure what emergency you were referring to from this morning.

Mark Husson - HSBC

The terrorist threats in London. Follow on question is on the food side of the business. You've expanded your food offering to the dry grocery; could you be a bit more specific how many stores you've expanded it into and where you've got the space from, what you cut back on in order to introduce it.

Gregg Steinhafel

: By the end of this year approximately two-thirds of our stores will have the expanded space committed to food. Approximately half of that two-thirds will be through new and remodeled stores. The other half will be achieved through our right-sizing programs.

In our new and remodeled stores, we have expanded the footprint of the store in the case of new stores; and in the case of remodeled stores oftentimes we have expanded those buildings as well. In our right sizing projects we've traditionally in the past down-sized those businesses that have been underperforming for a period of years, and those businesses include areas like home improvement, sporting goods, men's and then a few other categories throughout the stores. That is where we taken the space to support the growth in food and other frequency-oriented commodities.

Mark Husson - HSBC

And is the mix in sales significantly different now? I mean year over year you expect gross margins on food to be rather lower and SG&A to be a perhaps a bit lower but is that a significant year-over-year shift in terms of basis points inside the whole mix now, or is it not quite?

Doug Scovanner

This is an issue that we have been executing for many years. So in the background, over the last ten years, we've averaged 20 or 25 basis points direct impact on gross margin rate due to this mix phenomenon. Current period is not remarkably outside that range.

Mark Husson - HSBC

Thanks very much.

Operator

Your next question comes from the line of Jeff Klinefelter - Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Yes, two quick questions for you. One would be on the home category, Gregg. I know it's been highlighted as an underperforming category for you now for several periods, and I was just wondering if there was anything you could share in terms of your strategy to sort of drive conversion in that area? Anything going on with pricing or changes to the mix of brands versus basics, in order to jump-start that on either the domestics or the traditional home side.

The other question would be on the earnings. Doug, I think you mentioned coming out of the fourth quarter last year when that was a slower earnings growth rate that we would continue to see this evolve over time, that Q4 would likely be less profitable or have less profit growth, just in terms of the competitive dynamics of the holiday season and that Q3 would be stronger. Has anything changed on that front, or are you just wanting people to fine-tune slightly how they're looking at the next two quarters?

Gregg Steinhafel

Jeff, I'll answer your home question. As you know parts, of our home businesses have been very strong all year and are still performing very, very well. We have performed well in housewares, which includes storage, small appliance and cookware. Our bath business has been strong all year. Our stationery business has been performing quite well. We have struggled in areas like decorative accessories, bedding. The underlying business trends in those categories seem to be strengthening. We have incorporated numerous transition, content pricing, adjustments throughout the year, and we are seeing the negative aspects of how those businesses were performing in the past, strengthened somewhat.

So we're encouraged that we're on the right path. We're seeing some strengthening but those businesses are not performing where we would like them to be. But we feel real good about the changes that we're making and we believe that by the end of this year we'll be back on track in all of those categories.

Doug Scovanner

Jeff, in addressing your Q3/Q4 questions, I think there are two separate issues at play here. One is a long-term or a secular set of issues, where we have, over time, meaningfully increased our relative performance in the first three quarters relative to the fourth quarter. I think by the time the dust settles from this year, that same overall long-term trend will remain intact.

Separately, though, at this point midway through the year, I think there's some specific short run issues that are relevant to all of us on this call, specifically in the third quarter -- while there are many other issues that go both ways, I don't want to ignore everything else that's going on -- the two biggest issues that we are dealing with in the short run in the third quarter, we are cycling a substantial favorable Visa/MasterCard settlement that we disclosed last year that offset some other expense issues, as you know.

Separately, as I talked about a little while ago, we're returning to a more normalized third quarter/fourth quarter split of advertising and marketing. Last year we had more power, more horsepower more weight in advertising and marketing in the fourth quarter than we usually do.

Combined with the relative strength of the sales base in those two quarters, it means I think we're poised for some operating margin expansion in this year's fourth quarter, but that's not the case in this year's third quarter.

Jeff Klinefelter - Piper Jaffray

Great. Thank you.

Operator

Your next question comes from the line of Charles Grom - JP Morgan.

Charles Grom - JP Morgan

Hi good morning. Could you comment on your inventory position, particularly in-stock levels? There's been a lot of chatter that in-stocks haven't been good and I hoped you would address it for us.

Gregg Steinhafel

Our inventories overall are in excellent shape. Our in-stock levels which we watch very, very closely through our network are also in very good shape as well. We are maintaining very high levels, in the high 90% of in-stock levels in all of our basics: food, consumables, paper, pets, categories throughout the stores. So we're not experiencing any difficulties in supply chain in replenishment from our vendors. And I'm not sure what you're seeing out there. It could be an individual store execution issue. But overall we're pleased with where our in-stock levels are.

Charles Grom - JP Morgan

That's helpful. Doug, could you speak to the components of gross profit margin in the quarter, specifically on markdown, shrink and mark-up?

Gregg Steinhafel

Certainly. First of all in the aggregate, gross margin rates improved 8 basis points from last year's record high second quarter performance. When I say record high, it was the highest quarter in our history last year. So we're not chasing a variance that amounts to much of anything at all.

At the margin, certainly mark-up was favorable. Markdowns were unfavorable. Neither by a whole lot, by the way. Shrink and all other factors were less important than those first two. So basically all of the elements were reasonably in line with last year's performance as well.

Charles Grom - JP Morgan

Thank you.

Operator

Your next question comes from the line of Dan Binder - Buckingham Research.

Dan Binder - Buckingham Research

Hi. Good morning. A couple questions, first on credit. The levels on delinquencies and write-offs that you mentioned in the call appear to just be a trend back to where they were prior to some of the changes last year in the bankruptcy laws.

I'm just curious, in terms of the pace at which we get there, is that something that we should expect by year end, by mid next year, maybe just a little bit of color on that?

The second part of that question is, at what point, you know on that path up towards those numbers, do we start to see the reserves versus the write offs come down a little bit, since you've been doing so much reserving here early on?

Doug Scovanner

A great series of questions. Those very precise forward-looking estimates that I made earlier for delinquencies and also for write-offs are stated on an annualized basis as we report them quarterly. I would expect that in sequence the third quarter will be considerably higher in both of those metrics than the quarter we just reported. By the fourth quarter, you're absolutely right, we will be back in line with our experience from a couple of years ago.

As I mentioned earlier, and you referenced, we've reserved for this outcome. Hard to say exactly how the balance will occur between expenses and write-offs. Our expense, when we get there, will be a function of our then current assessment of developing risks and benefits in the portfolio. But I don't think there will be a meaningful difference between expense and write-offs in the third quarter. It is possible that we would have more write-offs than expense in the fourth quarter. Although that would not be the case for the full year. I expect to end the year with an appropriate and complete reserve just as we have today.

Dan Binder - Buckingham Research

Then just a second set of questions on merchandising. I think you mentioned electronics were a bit soft. I've seen what seems to be a fair amount of recent activity in the electronics area. It's coming along. Looks pretty good. Wondering if you've seen any early results on that.

Secondly, if you could just comment on what you saw in your HVA resets, or as a result of those resets earlier in the year, if that's produced the kind of numbers that you wanted.

Gregg Steinhafel

The comments I referenced in the call were specifically in the entertainment division, which is essentially our music and pre-recorded video businesses. Those businesses nationally have been soft, have been declining. Our sales are reflective of that national trend. Our electronics business has been healthy and continues to be healthy all year.

As it relates to the health and beauty resets, the major reset we undertook was a year ago. We make planogram adjustments through the year. But those businesses have been performing very, very solidly. We continue to gain market share in every one of those categories and we're very pleased with the performance in our health and beauty aids, household chemicals, paper products, beauty businesses.

Dan Binder - Buckingham Research

Great, thanks.

Operator

Your next question comes from the line of Bob Drbul - Lehman Brothers.

Bob Drbul - Lehman Brothers

Good morning. I was wondering if we could talk a little bit more about Target's thoughts around the consumer as far as any signs of the paycheck cycle that you're seeing, discretionary mix versus consumables, et cetera. I wonder if you could address a few of those topics for us.

Gregg Steinhafel

We haven't seen any change in sales patterns around paychecks, 1st or the 15th. There is a normalized cycle or blip during those timeframes and over the last six months we have not seen any material changes to those normalized patterns.

Doug Scovanner

By far and away the biggest variable when our sales are either on the softer end of that 3% to 7% range that Bob talked about or on the stronger end is same store transaction counts. The rest of our business is much more stable month-to-month and season-to-season.

Bob Drbul - Lehman Brothers

Doug, could you talk a little bit more about in the remodel program that Wal-Mart is having and if it's having any impact, if you're seeing that anywhere in your numbers?

Doug Scovanner

You'll have to talk to Wal-Mart about Wal-Mart's remodel program. I don't have a lot of facts at my fingertips on that one. But we do not sense any direct impact in our results from that activity.

Gregg Steinhafel

It's hard to attribute specifically what impact that remodel activity will have on our stores. And as you know, they are in various stages of remodeling the stores. Only a certain number have been completed. They're in the middle of transitioning many of those stores right now. So I think it will be later in the year before we would feel any impact, if we were to feel any impact, and we really don't believe that there will be any meaningful impact to us at all.

Bob Drbul - Lehman Brothers

Doug, one final question for you. The 53rd week does that impact you at all this year and is that in the numbers that you just talked about?

Doug Scovanner

53rd week has some impact on basis point relationships, but net-net, it is not a meaningful impact at all at the bottom line. Certainly it is a lower gross margin rate week and a lower expense rate week and a lower EBIT margin rate week than the rest of the year. So that plays through basis point analyses, especially stand-alone quarterly basis point analyses. But by the time the dust settles, it's not a meaningful issue to our EPS either in the quarter or for the full year.

Bob Drbul - Lehman Brothers

Great. Thank you very much.

Operator

Your next question comes from the line of Virginia Genereux - Merrill Lynch.

Virginia Genereux - Merrill Lynch

Thank you. Firstly, if I may Doug, just to clarify your remarks. That was helpful on credit. The credit yield after funding was basically 11% in the April and July quarters. Did you say, sir, that in the back half that it's going to maintain that 11%?

Doug Scovanner

Don't know that it will fully maintain 11%. But certainly I expect the back half of this year to continue our generally robust profit trends from the front half of the year. Now that may mean 10% not 11%. I'm not trying to make a precise basis point prediction like that. But I don't expect any of the core underlying issues that we've talked about to have any adverse effect on our generation profitability.

Last year, after funding costs, we were a little over 8% in our card portfolio. So far this year it's been a distinctly a 10% to 11% performance. I expect much stronger performance to stay with us.

Virginia Genereux - Merrill Lynch

That's very helpful, sir. Then heading into '07, a couple folks asked about the first part of '07. You again, generally sustainable in that 10% and maybe 10% plus range?

Doug Scovanner

Yes.

Virginia Genereux - Merrill Lynch

Great. Thank you. Secondly, if I may, Bob you commented on the longer term trends here and a comp of 3% to 7%. You guys also talk about traffic versus ticket contribution, and the traffic has really been the only variable. A couple of folks have asked us, what has been the average unit retail trend over that time? I know you guys are talking now about ticket contributing more but I think you've also said when you said ticket, it's really the basket. There could be more lower-priced items in the basket. Can you tell me what has been the average unit retail trend? Has that moved up over the past decade?

Gregg Steinhafel

We have seen strength in both number of units in the basket and in the average price of the item in the basket as well. It has been on average, fairly balanced and during some periods we have experienced greater growth in the unit count per basket; and at other times we've experienced greater growth in the average price per unit. But it has been a reflection of both of those elements.

Sue Decker

Gregg's absolutely right. More recently, number of items in the basket has been the bigger driver. Don't have to go back too far in time for that relationship to be reversed.

Virginia Genereux - Merrill Lynch

Okay. And Doug and Gregg, are you also having success, you said more recently it's been more sort of items in the basket, but do you still feel like you still have runway to take up the unit pricing? As you educates consumers on the higher thread count sheets or whatever, are you seeing that?

Gregg Steinhafel

We believe that over the long-term we absolutely have opportunities to increase the average price per item. It is a very nominal amount when you mix rate out all of the products that are in the basket. It is a fairly modest amount. So we can increase our retails or prove-up in any part of the store and that will have an impact on that over time, because it's in the $5 to $6 range. So it doesn't take a lot to move that nickels, dimes, quarters.

Gregg Steinhafel

In a lot of categories we have seen a larger unit sale price. When you get into ready-to-wear and accessories and intimates, that has been somewhat offset by increases in our frequency category in consumables and grocery. So the general merchandise, decorative home and apparel have been going up in price, offset again by the lower value of individual items in the frequency strategy.

Doug Scovanner

So to be clear, none of what we're describing is a function of price increases on identical items. This is a mix issue.

Virginia Genereux - Merrill Lynch

Thank you. That's very helpful.

Operator

Your next question comes from the line of Christine Augustine - Bear Stearns.

Christine Augustine - Bear Stearns

Thank you. Doug, could you please clarify your comments with regard to the third quarter, just more specifically given that comparisons are tougher, should we expect to see the range of comps that would be a bit lower than the 4% to 6% that you typically look for over a long period of time?

My second question is, in the first quarter you did discuss that store payroll costs were a bit pressured by the fact that customers were buying more items in their basket, and could you just give us some detail on whether or not you saw that in the second quarter? Thank you.

Doug Scovanner

Yes, first of all, in terms of our same-store sales outlook, in light of our current pace of business in last year's third quarter results, our outlook for the third quarter today is a 3% to 5% same-store sales performance.

Separately, we have continued to place a great deal of emphasis internally on getting our pace of expense incurrence in line with our pace of gross margin rate generation, and I feel quite confident that as we look forward Q4, Q1, Q2, Q3, '07, that that issue will be behind us. In the short run in the second quarter, yes, we did experience some modest pressure in the expense rate due to slightly faster growth in store payrolls than sales.

Christine Augustine - Bear Stearns

Thank you.

Operator

Your next question comes from the line of Mark Miller - William Blair.

Mark Miller - William Blair

Hi, good morning. Can you provide a little bit more detail around the private label penetration currently, what's the number of SKUs and some perspective on where you're at from a year ago?

Gregg Steinhafel

Well, broadly we're very committed to the growth of our private brands and private labels, whether it's apparel, home goods or food. I suspect you're specifically referencing where we are today in our private label penetration in food, and that continues to gain ground. We are making progress. We are in the mid double-digits in terms of grocery penetration in our SuperTarget stores, and we expect that to increase over time.

Mark Miller - William Blair

All right. Can you also, I guess, refresh our memories on the frequency initiative back to early 2003 and from that what did you learn in the event we see slow down in consumer spending, which aspects of that might be most appropriate for your business going forward?

Gregg Steinhafel

Our strategy has always been "Expect More, Pay Less" and we're focused on delivering both aspects of that equation. In times of tougher economic macro environments, we'll focus slightly more on the pay less side of that equation and make sure that our content and presentation and marketing emphasis speaks a little bit more directly to price at a time where price becomes slightly more important to the consumer.

But overall our strategy has always been focus on both of those elements. It’s a balanced approach that we take. We're just talking about slight shifts in emphasis from where we are today. It is something that we are mindful of all the time where that appropriate balance should be on an "Expect More, Pay Less".

Mark Miller - William Blair

Then a final question if you would entertain a somewhat subjective exercise with your comment on that historical range in comps and historical range on earnings growth. I assume that implies you think that those ranges still hold, and I guess I'm wondering what might be different now relative to the last decade? It does seem like there's potentially a somewhat smaller incremental opportunity to increase direct imports. On the other hand, you have more food and consumables. So if we were looking at the downward part of that range, 3% comps, do you think you'd still be in that double-digit EPS growth? Thanks.

Doug Scovanner

Generally I do. There's certainly going to be exceptions. There have been exceptions in our past. The context of the comment was that across sustained periods of time our results are rarely outside those ranges. There's certainly the possibility we would be above or below those ranges moving forward. But I don't believe that any of the core underlying dynamics that have created that pattern of actual results have changed.

Mark Miller - William Blair

Okay. Thanks.

Operator

Your last question comes from the line of Adrianne Shapira - Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Thank you. Gregg, just now with some distance from July, and as Bob mentioned earlier, you know, comp stability is what you've highlighted but traffic clearly seems to be a little bit more volatile, now with some distance from July, can you shed some light on how you explain the traffic slowdown? In hindsight would you have done it any differently? Any sort of commentary on back-to-school trends?

Gregg Steinhafel

Well, we're still very early in the back-to-school timeframe, but at this particular point in time, we're pleased with our back-to-school business, both on the hard lines consumable paper, pencil, crayon, side of the business as well as our apparel. So we're expecting back-to-school, back-to-college to be approximately where we planned it.

Looking back in terms of July, we've been cycling strong comps all throughout Q2 of '05, and you know our 3% plus comps in July on top of what we delivered last year was a very respectable number and there isn't anything we would have done significantly different than what we did this year.

Adrianne Shapira - Goldman Sachs

Did you see any of your competition do anything significantly different?

Gregg Steinhafel

Not really. I mean July is a transition month in everybody's stores. People are exiting their spring goods. There's a lot of clearance activity that sometimes impact comparable store sales. It's a transition time in the back-to-school. Everybody launches back-to-school, back-to-college aggressively, initiate roll-backs. People respond. The general rhythm and flavor of the competitive environment in July was pretty consistent and predictable to what we've experienced over the past half a dozen years.

Adrianne Shapira - Goldman Sachs

Then just being in stores recently, it sounds as if home is going through a reset over the next few weeks. I mean what would you expect the category to look like when the reset is done?

Gregg Steinhafel

Well, we go through numerous category resets on an ongoing basis. So some categories are transitioning now. Other categories will transition later in the month. Some in September. What we've been experiencing all year is as we transition our categories, as we strengthen our content and get our good, better, best balance more in line to where it should be, we see underlying strengthening in those businesses as those categories transition. So we expect that to continue as we go through the fall season.

Adrianne Shapira - Goldman Sachs

Maybe just following on that, we had heard in your comments in previous calls that we were expecting a little bit more sharper pricing in home. Would that be an outcome of this reset?

Gregg Steinhafel

Actually in terms of pricing for home, what you're going to see is you're going to see a shift, a slight shift in mix, and as appropriate we will be more selectively aggressive on key items as we focus on key items in our marketing, and we focus a little bit more on conveying classification dominance, instead of some of the lifestyle emphasis that we've had in the past.

That doesn't mean we're going to be super aggressive or disruptive to the market. We're just going to shift the emphasis from lifestyle merchandising to more classification, to more key item focus, and that shift has already occurred in the second half of the second quarter and will continue in the third and fourth quarter.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

You do have more questions. Your next question comes from the line of Gregory Melich - Morgan Stanley.

Gregory Melich - Morgan Stanley

Hi. Thank you. A couple of questions. One, Doug is on the cash flow from operations it's been down year-to-date and was down again in the second quarter. Looks like it's payables versus inventories. Is there a timing issue going on with that that we should be aware of, as to what's driving it?

Doug Scovanner

Yes, you're correct that it is mainly an issue of timing in the flow of our inventories and payables. I do not expect over time to sustain the relationship that has driven this on a year-to-date basis.

Gregory Melich - Morgan Stanley

So what is it specifically? Was last year more normal or is this year more normal?

Doug Scovanner

Well, in both cases we're keying off of year-end balance sheets and the single biggest driver of this year-to-date differential is the fact that our year end '05 balance sheet had an abnormally high, an abnormally beneficial payables level relative to inventories. We had negative paid inventory position. We had sharply higher payables than inventories at year end.

So the balance sheet more than anything else is driven by those factors. There are other factors involved, but that's the biggest one.

Gregory Melich - Morgan Stanley

Then the second one is, Bob, you led off by talking about by 2011 the Company having 2,000 stores and $100 million of sales. I know it's impossible to predict five years of future. But if you were to guess, to get to that level, would your EBIT margin or operating margin be the same as it is today or higher or lower, and would the capital you need to deploy to get there, would it result in higher or lower asset turns?

Bob Ulrich

First of all, we think that our margins have improved significantly over time, and now we continue to improve margins in some areas with more direct importing. But that's offset a little bit by the mix of our greater increased focus on commodities and frequency in grocery items, but we believe it is sustainable at that approximate level.

Doug Scovanner

The one issue I'd add to Bob's comments is that there's clearly a mix issue involved with SuperTarget versus the rest of the chain. So part of the answer to your question lies in trying to predict with precision the mix of SuperTarget and discount stores looking out that far.

Importantly to me even if it's very heavily, hypothetically, even if the equation were much more skewed to lower margin higher turns SuperTarget stores, the EPS path is virtually identical, regardless of that mix issue.

Gregory Melich - Morgan Stanley

So if we had to guess, the margins would be similar today and so would the asset turns?

Doug Scovanner

I'd say that similar with a plus side on the asset turns and similar with a question mark in terms of how many SuperTarget stores will be on the margin side. But either way you mix it out, it is a distinct double-digit EPS growth expectation on average over the next several years.

Gregory Melich - Morgan Stanley

Great. Thanks.

Operator

Your next question comes from the line of Todd Slater - Lazard Capital Markets.

Todd Slater - Lazard Capital Markets

Thank you very much. Doug, if we back out the credit numbers, we calculate EBIT growth on the retail side of about somewhere in the high single-digit range, we get about 9%. While this is better than the first quarter, it indicates that the operating margins in retail may have contracted a bit. I'm just wondering how did the retail side of the business come in relative to your plan and how do you see growth in that piece in the back half of the year within your general expectations?

Doug Scovanner

Yes, you're absolutely correct. Using the numbers we disclosed today, the EBIT have, after one backs out the credit card contribution to EBIT, was up about 9% in the quarter on an 11% sales growth. It's simply the mathematical result of my earlier comment, the gross margin rate is about even and expenses grew faster than sales.

Projecting that forward to the back half of the year Q3, what I have said is that we expect expenses to again grow faster than sales driven in part by last year's credit to expense from the Visa-MasterCard settlement and driven in part by the Q3/Q4 advertising and marketing expense incurrence this year. So again I would expect EBIT on this basis to grow slower than sales in the third quarter.

In the fourth quarter, I expect these trends to reverse. We have several timing issues that we've talked about for the last two calls that turn around in the fourth quarter, and in addition, I think the possibility exists for some gross margin rate expansion, slight gross margin rate expansion in the fourth quarter.

Also that 53rd week, that 14th week in the quarter will meaningfully leverage depreciation expense in the quarter. So for all three of those factors, I think there's the distinct possibility for EBIT excluding our credit card contribution in the fourth quarter to grow faster than sales.

Todd Slater - Lazard Capital Markets

So just to follow up on that. In the fourth quarter, if you exclude the depreciation, are you looking for SG&A to actually on the retail side to get leverage because we've had, I don't know, ten consecutive quarters where you've had a deterioration in the rate? Some of it you mentioned was timing, other issues. So is that going to finally reverse in the fourth quarter in your opinion?

Doug Scovanner

It is more likely than not to reverse. If it reverses, I don't want to blow this out of proportion, I don't expect it to create some huge benefit, but it is more likely than not to be favorable in the fourth quarter.

Todd Slater - Lazard Capital Markets

Okay. Great. Thank you.

Operator

Your next question comes from the line of Deborah Weinswig - Citigroup.

Deborah Weinswig – Citigroup

Good morning, two questions. There was a question earlier about the dynamics of the change in the third and fourth quarter. Can you in light of that, Doug, explain the discussion earlier about the marketing expensing, heavier in the third lighter in the fourth? Or is there something else to do with that dynamic?

Doug Scovanner

Well, in the third quarter, again, there are many factors involved here, but the two biggest factors are cycling last year's Visa-MasterCard settlement which was recorded and disclosed as a credit to SG&A expense; and separately last year's marketing timing was more skewed to expense in the fourth quarter and less skewed to expense in the third quarter than the average of the many years before it.

This year is more of a return to a normal pattern, but that means year-over-year marketing and advertising in the third quarter will grow faster than sales. Marketing and advertising in the fourth quarter will grow more slowly than sales.

Deborah Weinswig – Citigroup

Okay. And then last question: I believe that Gregg had talked about increasing the direct import penetration. Can you remind us where you are now and what the additional opportunities might be?

Gregg Steinhafel

We are approximately at the 30% level of direct imports, and we expect that to grow approximately 1 percentage point per year for the next several years.

Deborah Weinswig – Citigroup

Great. Thank you very much.

Operator

There are no further questions at this time. Are there any closing remarks?

Doug Scovanner

Thank you very much, everyone. That concludes Target's second quarter 2006 earnings conference call. Thank you very much for joining us.

Operator

Ladies and gentlemen, this concludes our conference call for today. You may now disconnect.

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Source: Target Q2 2006 Earnings Conference Call Transcript (TGT)
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