Not a day goes by without a retailer reporting disappointing results. This time, it was Target (NYSE:TGT), whose shares fell 7.6% after the company reported a 5.5% y/y decline in sales and lowered guidance for the second quarter. Management now expects comps for Q2 to be flat to down 2%, on account of excess capacity in the retail sector, which is forcing firms to slash prices. Not all the news was bad. In fact, there were quite a few positives to take from the most recent quarter. And, given the context of the challenging retail environment, the results suggest that Target's strategy efforts are working. Despite the lower guidance for Q2, management's full year EPS expectations remain intact. With shares now trading at a forward P/E of 13, investors may be tempted to take a position. However, we caution against this. We believe retailers have further to fall, and that TGT will experience margin pressure as the firm's reliance on signature products exposes the firm directly to Amazon (NASDAQ:AMZN).
Adjusted EPS in Q1 beat analyst expectations by a wide margin, increasing 16% y/y. The decline in total revenues was the result of the sale of TGT's pharmacy unit. Same-store sales increased 1.2%, driven by a combination of price and volume growth. Both digital and store comps were positive, but digital was particularly strong, growing 23% y/y on top of last year's 38% comp. Target's strong performance in higher-margin signature categories (style, baby, kids, and wellness) offset markdowns in other areas where rival firms have introduced promotions. These offerings differentiate TGT from many of its rivals who sell more defensive goods, namely food. A higher portion of signatures in the product mix (which grew 3x faster than TGT's average category) increased gross margin by 50bps. SG&A as a percentage of sales also improved 50 bps, as the gain on sale of the pharmacy business offset new strategic investments. Finally, management continued to display shareholder-friendly capital allocation practices, returning $336 million to owners in dividends and $900 million in buybacks.
The problem with Target, however, is that it is not immune to the issues plaguing the retail sector. While the firm's ability to grow comps and margins during a period of weakness for most retailers suggests TGT has an economic moat, we do not believe this to be the case. Target derives competitive strengths from its recognized brand, scale, and a network of stores in high-traffic locations. But these are merely strengths, and they do not provide the sort of sustainable advantage that a low-cost production model would. TGT's broad product selection appeals to many shoppers, but the company is fighting a losing battle in its signature category segment that the firm relies on to earn higher margins than its more defensive rivals, for which food comprises a higher portion of revenues (according to Morningstar, Target generates 25% of revenues from groceries compared to 55% for Wal-Mart (NYSE:WMT), 80% for Kroger (NYSE:KR), and 42% for Costco (NASDAQ:COST)). Apparel, home products, and digital products together account for roughly 40% of revenues, leaving TGT exposed to competition from Amazon, who sells the same general merchandise items, but can do so at lower price points. We expect the weakness in retail to continue throughout the year, meaning that price will become a more deciding factor in where customers purchase goods. We fear that Amazon's scale and sourcing advantages it enjoys over the brick and mortars will eventually condemn Target to the same struggles that most retailers are currently experiencing.
Figure 1: Amazon's Growing Portion of General Merchandise Sales
Note: General merchandise grew from 65.5% of sales in 2013 to 70.6% in 2015
Management expects after-tax ROIC to reach the "mid-teens or higher in next 5 years". This would be an attainable target were the retail environment to improve: after adjusting for the sale of TGT's pharmacy business, ROIC was 14% for Q1, up roughly 150 bps y/y. But we think the US economy is fundamentally weak (see my articles on Nordstrom (NYSE:JWN) and Lululemon (NASDAQ:LULU)), and that firms such as TGT who sell more discretionary items are most at risk. High unemployment (after taking into account near 30-year low labor force participation) and stagnating wage growth means TGT will have trouble raising prices for goods at a time when consumers are becoming more price sensitive. Without an economic moat, TGT will be forced to slash prices, leading to negative operating leverage on lower sales, and downward pressure on margins. We expect TGT will average flat same-store sales growth over the forecast period, with a mixture of positive and negative comp years of 0-2%. This will prevent gross margin from recovering above 30%, and operating margin will likely average 6.5%.
Investors purchasing at these levels are betting that Target will continue to defy the trends in retail that only Amazon seems to be immune to. They are ignoring deep structural weaknesses in the US economy that make Target's business less competitive, and these problems are not about to subside anytime soon. It is too optimistic to assume that Target will materially increase earnings in the near future, and investing for the sake of dividends and share repurchases does not constitute a valid rationale when the underlying business fundamentals are not sound.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.