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Target Corporation (NYSE:TGT)

F2Q08 Earnings Call

August 19, 2008 10:30 am ET

Executives

Gregg W. Steinhafel - President, Chief Executive Officer, Director

Douglas A. Scovanner - Chief Financial Officer, Executive Vice President

Kathryn A. Tesija - Executive Vice President, Merchandising

Analysts

Gregory Melich - Morgan Stanley

Deborah Weinswig - Citigroup

Uta Werner - Sanford C. Bernstein

Robert Ohmes - Merrill Lynch

Jeff Klinefelter - Piper Jaffray

Charles Grom - J.P. Morgan

Adrianne Shapira - Goldman Sachs

Mark Miller - William Blair

Dan Binder - Jefferies & Company

Robert Drbul - Lehman Brothers

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Target Corporation’s second quarter 2008 earnings release conference call. (Operator Instructions) I would like to turn the conference over to Mr. Gregg Steinhafel, President and Chief Executive Officer. Please go ahead, sir.

Gregg W. Steinhafel

Good morning and welcome to our 2008 second quarter earnings conference call. This morning I will provide a brief update on our strategy, operations, and outlook in the context of the current economic and competitive environment. Then Doug Scovanner, Executive Vice President and Chief Financial Officer, will share the highlights from our 2008 second quarter financial results and describe our financial outlook for the second half of the year. Following Doug, Kathy Tesija, Executive Vice President of Merchandising, will discuss a number of our key merchandising initiatives as we head into the fall season, and finally we will open the phone lines for a question-and-answer session.

Overall, we were quite pleased with the execution of our strategy and the financial performance in the second quarter, though we continue to face many of the same macro challenges we and other retailers have experienced since the middle of last year, including credit burdened consumers, declining housing valuations, unprecedented oil prices, and rising inflation, especially in food. We remain confident in our strategies, in the dedication of our team and in our ability to operate effectively and grow market share profitably, even in this difficult economy.

To minimize the impact of these economic pressures on our guests, we remain keenly focused on thoughtfully delivering on our expect more, pay less brand promise. During the second quarter, we continued to benefit from an increase in average transaction size, driven by higher average retail price per unit. But this advantage was offset by a decline in the number of average trips our guests made to our stores, as well as the decrease in the number of categories they visited while shopping in our stores.

Our largest comparable store traffic declines were recorded in discretionary spending categories like home and apparel, consistent with broader industry trends. As a result, we have significantly increased our emphasis on communicating our value message through our marketing, in-store signing, and merchandise presentation, and we also remain firmly committed to delivering the newness, innovative design, and exceptional quality that Target is known for.

In a few minutes, Kathy will provide more detail about our efforts in each of these areas.

To drive profitability in a slow sales environment, we are carefully investing in merchandise inventories to simultaneously drive sales, reduce markdown risk, and maintain reliable in-stocks for our guests. To accomplish these seemingly conflicting priorities, we continue to extend our segmentation strategy across our stores and assortments. This initiative allows us to effectively and efficiently customize our merchandise assortment, timing, presentation, and space based on the sales volume of individual stores and local preferences. For example, in our back to school business, we manage our transition timing to accommodate different school start dates, maximizing regular sales and minimizing markdowns, and we use different presentation approaches in high volume stores versus low volume stores to avoid over-stocks and unnecessary mark-downs.

We are encouraged by the results of this initiative and expect it to continue to contribute significantly to our margin results.

In addition, we continue to thoughtfully control the growth of expenses throughout the company without comprising our commitment to our guests or any key elements of our brand. And we are capitalizing on the opportunity in our share price to engage in substantial repurchase, which we believe will generate significant value for our shareholders over time.

In addition to share repurchase, we continue to invest strategically in both our supply chain and new store growth. The expansion of our distribution network continued this month with the opening of our first Target owned semi-automated food distribution center in Lake City, Florida, and we’re on track to open our Cedar Falls, Iowa facility in 2009.

Our self-distribution strategy allows us to exert greater control over the perishable food component of our supply chain, resulting in improved freshness, higher food margins, and continued rapid growth of our owned brand foods.

During the second quarter, we opened a total of 43 new stores, including 30 general merchandise stores and 13 Super Target locations. Net of closings and relocations, these openings bring our total store count at quarter end to 1,648 stores in 47 states. In October, we plan to open approximately 45 new stores, adding about 35 net new locations.

As part of our October cycle, we are very excited to be opening our first two stores in Alaska and we look forward to expanding in this market, as well as entering Hawaii in 2009.

Speaking of 2009, we are modestly reducing our expected store openings for the coming year as a result of the difficulties developers are facing in the current environment and the discipline of our own capital investment approval process. This change is the result of our strong belief that delivering superior financial returns serves our long-term best interests better than adhering to a specified store opening program. Doug will provide additional details in a few minutes.

The current environment is the harshest we have seen in many years and with inflation growing at its fastest pace in close to two decades, we do not see any indication of meaningful near-term improvement. However, we remain confident that our unique merchandise offering of differentiation and value, our disciplined execution, and our strategic deployment of capital effectively positions us for long-term profitable growth.

Now, Doug will share the financial highlights from our second quarter results.

Douglas A. Scovanner

Thanks, Greg. As a reminder, we are joined on this conference call by investors and others who are listening to our comments today live via webcast. 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 I’ll review with you two key challenges we face in the current environment and three separate areas in which we are exceeding our expectations. Each of these five issues had an impact on the quarter just ended and a better understanding of each is vital to any analysis of our likelihood to deliver shareholder value in 2008 and well beyond. I’ll wrap up my remarks with specific guidance on future capital investment and EPS. As always, following our prepared remarks, we’ll conduct a Q&A session and John Hulbert and I will be available throughout the remainder of the day to answer any follow-up questions you may have.

The pace of sales growth in our retail segment continues to be our number one challenge in this environment. For the last three quarters, Target's comparable sales growth has hovered slightly above or below zero, with same-store traffic down 1% to 2%, offset by a similar rate of increase in average transaction size. Specifically for the second quarter, our comparable store sales were down 0.4% from 2007 and for the first half of the year, our comparable store sales are down 0.6%.

This comparable store sales performance puts us in the middle of the pack in the U.S., clearly slower than most competitors who have a higher concentration of their sales mix in inflationary consumable and commodity items, and well ahead of most competitors with a higher concentration of their sales mix in home and/or apparel items.

While this relative performance evaluation provides valuable context, the fact is that our current sales performance places a great deal of stress on our ability to maintain or improve retail segment EBITDA and EBIT margin rates, and more important to deliver appropriate dollar growth and profits.

As we look across the next several quarters, sales growth will be the number one factor in determining our overall performance. If the current tepid pace of top line growth continues for the rest of the year, our near-term performance will continue to fall short of our long-term expectations. Alternatively, as we begin to cycle softer prior period sales performance later in the year, we may find year-over-year dynamics to be somewhat less challenging.

In the near-term, our second-largest challenge lies in the performance of our credit card portfolio. Here we continue to be adversely affected by the macro environment in which we and all other owners of similar credit quality portfolios operate. While our profit and return profiles continue to outperform those of most others in this business, the fact is that our write-off trends are modestly weaker than even we expected earlier in the year. Specifically, our annualized net write-off rate was 8.7% in the quarter, higher than the projected 7% to 8% rate for the year that we previously disclosed.

As a result, we added to our reserves in the quarter to provide for our exposure to the potential for these rates to remain at elevated levels in the near-term.

As most of you are already aware, we and others have responded to these challenges through a combination of terms changes to existing cardholders, combined with aggressive reduction of credit lines and significant tightening of all aspects of our underwriting.

Balanced against these two challenges, we continue to be very pleased with three separate aspects of our execution, each of which is important to our delivery of value for the rest of this year and well beyond.

First, our supply chain performance and especially our control of inventory flow continue to be exemplary. This quarter was the fourth in a row in which we were flat or down in comparable store sales in most of our markdown sensitive apparel and home categories. Even though these categories represent over 40% of our sales, we again avoided corrosive clearance markdowns through highly effective management of these variables. Our mix of sales, not our fashion risk, has been the biggest challenge to our gross margin rate, representing about a 60 to 70 basis point effect in the quarter and year-to-date. And I believe sales mix will continue to represent a bigger challenge than markdowns in the future as well.

This quarter also demonstrates the continued benefit of our successful efforts to control the growth rate of our expenses. This initiative, which began in earnest more than a year ago, led to remarkable performance in the second quarter. In fairness, I think the year-to-date expense rate trends are more reflective of underlying performance than either of the first two quarters in isolation. But so far this year, we have well exceeded our expectations on controlling expenses in the current environment.

As we move forward, some quarters will naturally look better or worse than others because of timing issues but clearly we have demonstrated that we have the will to control our destiny in this arena and have the ability to execute without jeopardizing guest service or in-stock levels, which remained strong as well.

In addition to those two operating items, trading in our common stock has created a unique opportunity for us to retire more shares than we expected to retire, and at prices that we believe will prove to be a great value over time. As you know, we announced a plan last November designed to allow us to retain strong credit ratings and also retire up to $10 billion of our common stock over approximately three years. In just nine months, we’ve already retired about 11% of our outstanding shares, due in part to reduced share price over this short-term period. I’ll help you with some math here.

Even without further share repurchase activity, the growth in operating results over time, which otherwise would have increased our EPS by $1, will now increase it by more than $1.12 and counting.

Now let’s turn our attention to our new store plans and more broadly, capital investment as well. As you know, Target engages in a rigorous capital investment approval process in which we analyze proposed new stores one at a time, weighing the required incremental investment against the store’s ability to create incremental cash flow for the company over time.

In 2008, this process will allow us to add about 90 to 95 net new stores, each of which we expect will produce handsome financial returns over time. For 2009, we currently project that we will add about 70 to 75 net new stores, while continuing to meet our unchanged expectations for future financial returns at the individual store level. This reduction in store count is driven by two main factors; first, many of our external development partners have experienced challenges in obtaining funding and/or filling in-line space in certain large power center projects that were anticipated to open in 2009. Separately, in the current sales environment, our process of underwriting new stores one at a time is working exactly the way it was designed. Specifically, in some cases our freshest site specific sales forecasts no longer product sufficiently high financial returns to merit proceeding with the project at this time. This process is especially valuable in light of even more attractive share repurchase dynamics in the near term.

In summary, as we have always done, we elect to build individual stores only when we believe we will enjoy sufficient financial returns. In the long-term, I believe this is quite unlikely to change our ultimate store count in the U.S. market.

Translating into dollars, we would now estimate our overall capital investment to lie in the range of $4.1 billion to $4.3 billion in each of 2008 and 2009, or about $1 billion lower than our earlier thinking over this two-year period.

And finally, a few observations on EPS; as you know, our diluted EPS for the second quarter exceeded the expectation that we laid out 90 days ago. On the positive side of things, we enjoyed better-than-expected retail operating margin performance and the P&L benefit of settling some income tax matters in the quarter. These benefits were partially offset by modestly weaker sales than we anticipated and higher write-offs, leading in turn to higher reserves in our credit card segment.

Looking forward, we think it’s prudent in the near-term to maintain a cautious outlook. For example, our pace of back-to-school sales has been quite volatile. Through the first 10 days of the fiscal month of August, our sales pace was much softer than expected. In contrast, our sales have been healthier since then. This elevated volatility makes it more difficult to develop near-term forecasts which are as reliable as we are used to. Nevertheless, for the full year 2008, the current first call median EPS estimate for Target is $3.43. We think this lies in a reasonable range of likely outcomes, although we are more comfortable in our ability to achieve fourth quarter EPS expectations than we are in the third quarter.

There are three principal reasons for this comment regarding the split between third quarter and fourth quarter earnings. First, we are more likely to enjoy stronger same-store sales in the fourth quarter because of last year’s base. Next, we will certainly enjoy a much larger EPS benefit of our share repurchase activity in that quarter. And finally, this year’s fourth quarter is the first full quarter of the substantial financial benefits we’ll enjoy from our recent credit card terms change.

Now Kathy will describe some of the key merchandise initiatives that we are pursuing this fall.

Kathryn A. Tesija

Thanks, Doug. As you just head from Greg and Doug, we are not immune to the economic environment. Our expect more, pay less brand promise has guided us through economic booms and recessions throughout the years. Its flexibility allows us to evolve with our guests’ changing preferences and with the volatility of our environment. While our long-term strategy remains the same, we are making changes to our merchandising and marketing tactics to ensure we remain relevant to our guests.

In the current climate, we are increasing our emphasis on pay less. We remain keenly focused on ensuring our prices are the same as Walmart’s on all identical and similar products in local markets. Furthermore, we remain committed to offering differentiated product that truly delivers value for our guests in terms of design, quality, and price point.

With exceptional value and prices across the store, combined with our ability to provide guests with the benefit of one-stop shopping for both their wants and needs, we realize our greatest opportunity is in communicating our value and convenience messages to our guests.

To do this, every circular now features several spreads that showcase fewer products with bigger images, bold price points, and strong value headlines. We are reevaluating how we leverage our end caps. In addition to featuring products that are on sale, we are ensuring our signing clearly communicates value and that we have a healthy number of end caps with low price points across the store.

And within every merchandise category, we’re ensuring guests have choices with the right balance of good, better, and best assortments. This means we carry a variety of SKUs within a range of price points, all of which deliver exceptional value based on the design and quality of the items, whether it’s the lowest or the highest price point in the category.

Driving guest traffic to our stores is critical, especially in this economy when guests are conserving gas. Our frequency driving businesses remain an integral component of our strategy and we are continuing to expand our offerings.

We have significantly increased our SKU count of Target brand commodities that offer guests national brand equivalent quality with lower price points. By establishing Target as our guests’ one-stop shop for their health and wellness wants and needs, we are driving trips with Target pharmacy, [Clear RX], and our expanded $4 generic drug program. And our grocery business continues to grow with new offerings of our differentiating owned brand, Archer Farms, and value-owned brand, market pantry, at our Super Target and general merchandise stores.

By increasing communication to our guests about our value and convenience, we will ensure they turn to Target for their needs and wants. After they are in our stores, delivering new, innovative assortments entices guests to buy, driving sales and margin.

Great design is part of our DNA and we pride ourselves on developing partnerships with renowned designers to bring differentiated assortments to our guests at great prices. Across our store, we are constantly updating our assortments with newness so guests are consistently surprised and delighted with affordable and accessible design.

For example, our Go International apparel collections are constantly updated with new designers who have build credibility in the industry and whose high-end lines are aspirational for most of our guests. We are currently showcasing the talents of Richard Chi, the visionary designer who helped launch the Marc by Marc Jacobs brand. At the end of the month, we will introduce our next Go International private label collection that delivers fast fashion. And in October, we will launch Jonathan Saunders, whose high-end collections are carried at Harrods and Harvey Nickel’s in London and Neiman Marcus in the U.S.

Newness in apparel extends to our boys and young men’s assortment as well. In late July, we rolled our Sean White for Target. The clothes are designed by Sean, renowned snowboard and skateboard champion, and his brother, Jesse White, and are reflective of Sean’s attitude and lifestyle, building credibility and resonating with our young male guests.

In accessories, our limited time only designer strategy continues to drive a sense of urgency and guest shopping patterns, with high-end designer names available for a fraction of their upstairs price.

In handbags, we are currently featuring Monica [Boutiere], who is a favorite among celebrity fashion icons. In jewelry, we are offering Dean Harris, whose designs have been used in the fashion shows of Mark Jacobs and John Barbados.

In October, we’ll introduce handbags by Anya Hindmarch, who has boutiques around the world. Also in October, we’ll introduce shoes by Sigerson Morrison whose high-end designs sell at Barney’s and Neiman Marcus.

Our exclusive design partnerships continue to differentiate our home assortments, from Thomas O’Brien to Simply Shabby Chic by Rachel Ashwell. We are adding a new layer of excitement in stationary and tabletop next month with the elegant and whimsical work of decoupage artist John Darion, whose assortments are sold in upscale boutiques worldwide. His collection at Target will exude affordable design.

We have significantly evolved our beauty offerings to ensure we are our guests’ destination in this important category. Our guests will buy relatively higher price points in beauty despite the economy, as evidenced by our continued success with salon hair care and high-end skincare assortments.

Next week, we will launch three new designer partnerships in cosmetics -- [Jim McKidd], a brand created by the fashion model and London makeup school owner; Pixie, a boutique cosmetic line with stores in London; and Napoleon Curtis, a brand by the Australian makeup artist who recently opened stores and a makeup school in the U.S.

This fall, guests will be able to find assortments by 22 renowned designers, which is the most we have ever featured in store at one time. To celebrate, we are presenting the Bulls-eye Bodegas, four limited time spaces in New York City in Manhattan -- I’m sorry, in midtown, in Union Square, Soho, and the East Village, September 11th through the 14th. Reinforcing our commitment to great design and low prices across beauty, home, fashion, and accessories, these limited time stores will feature our designer assortments with an average price of $25.

While value is prominent in our guests’ minds, they continue to celebrate events and holidays, which is why having the right product at the right price is critical to ensuring Target is our guests’ seasonal destination.

Because Halloween lands on a Friday, we will leverage its timing to position Target as guests’ entertaining and party solution headquarters with dinnerware, festive food solutions, and theme décor. All of our offerings, from must-have candy and trick-or-treat essentials, to differentiating costumes and décor will deliver compelling prices that meet our guests’ wants and needs.

We understand that guests sometimes equate clean, well-designed stores and fast and friendly service with higher prices but we believe guests can have a superior shopping experience and save money. We are confident in the power of our expect more, pay less brand promise and our increased focus on helping guests understand our value message. Through disciplined execution of our core merchandising strategy, we will drive sales and profitable market share growth.

Now Greg will provide some final comments. Greg.

Gregg W. Steinhafel

While the current climate poses challenges to our near-term pace of growth, our strategy is solid. We are keenly focused on superior execution and our team remains committed to delivering the constant flow of innovative and well-designed merchandise at an exceptional value that our guests expect from Target.

As a result, we believe that Target is well-positioned to grow profitably in this economic and competitive environment and we feel confident that Target will continue to deliver substantial value for our shareholders over time.

That concludes our prepared remarks. Now Doug, Kathy and I will be happy to respond to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gregory Melich with Morgan Stanley.

Gregory Melich - Morgan Stanley

I have two questions; one for Doug and one for Greg. Doug, in terms of the provision that we saw on credit, obviously up a lot, about $40 million more than we thought because the write-offs were up, would you call this provisioning level a new normal, given what you are seeing in the portfolio? Or was there a bit of a catch-up given the spike that we saw in write-offs in the quarter?

Douglas A. Scovanner

Well, it may well be the new normal in the near-term but I certainly don’t expect it to be the new normal in the long-term. And rather than calling it catch-up, I think it’s more forward-looking in nature. Clearly our write-off rate in the quarter, our write-offs in dollars or in rate were higher than we expected going into the quarter and as we analyze our risks as of quarter end, as we always do, we think those risks are heightened looking into the future.

So the additional reserves that we booked this quarter were designed for the express purpose of accommodating through the current quarter’s P&L and on the quarter end balance sheet for a heightened degree of losses in the near-term. How long it will last is a judgment call but that’s what drove our entries.

Gregory Melich - Morgan Stanley

Okay, and that 7 to 8 of write-offs that you had talked about previously, do you think now it’s more like 8 to 9 or do you want to give us a new range?

Douglas A. Scovanner

Well, I clearly missed the mark on our previous forward-looking statements but I think that the range that you are suggesting, 8 to 9 for the year, is now more likely, far more likely than 7 to 8.

Gregory Melich - Morgan Stanley

And then Greg, well done on the margin side, execute on SG&A. I guess given the outlook there’s obviously still a lot of pressure. What can we do to improve traffic trends, even if we stay in this current macro environment for more than just a couple of quarters? What can you specifically do?

Gregg W. Steinhafel

Well, I think Kathy highlighted some of the things that we are doing and have done and will continue to do, and that is really centered around content innovation, strength in our marketing messages to convey that we are convenient, one-stop shop where you don’t have to visit a number of different stores. You can get all of your wants and needs at Target. It’s our end cap assortment. It’s our brand standards, in-stocks, friendly service. It’s a combination of all of those elements that we are going to continue to deliver on that we believe in time will help us achieve our long-term objectives.

In the short-term, it’s going to remain challenging and I just don’t really expect to see the traffic trends change until we see a stronger economic climate in the U.S., and so we’re planning our business cautiously. We are working very aggressively to drive footsteps into the store. We’re taking market share across the store but we want to do so profitably so that we can continue to deliver strong EBIT margin.

Gregory Melich - Morgan Stanley

Great. Thanks, guys.

Operator

Your next question comes from Deborah Weinswig with Citi.

Deborah Weinswig - Citigroup

Good morning. I also wanted to reiterate a very impressive performance on the SG&A side. Doug, can you go through for us some of the buckets in terms of what’s driving that improvement?

Douglas A. Scovanner

Well, timing issues certainly have an effect on this quarter, as they do on any other quarter. I mentioned at the conference call 90 days ago that I thought that our expense controls in Q1 were better than flowed through because of some timing issues. Here I’d make the mirror image comment -- I think that our expense controls remain very strong but there’s more flow through in the current quarter than I think the underlying performance merits.

Year-to-date, we’re about 20 basis points favorable in SG&A as a percent of sales and I think that is a fair representation of how effective our expense controls have been in the current environment. Clearly wages and benefits remain squarely in our focus, not just at the stores but throughout our enterprise. And at the store level, store hourly labor as a percentage of sales improved yet again this quarter, as it has in the past several quarters. In addition, we have various pay for performance incentive plans throughout our enterprise, including and especially including executive management. And that provided year-over-year expense benefit in the current quarter as well. We’re cycling a very strong quarter last year with weaker performance this year. That’s the way those plans are designed to produce benefits.

Deborah Weinswig - Citigroup

And then also with regard to inventories this quarter, obviously just a snapshot but how should we think about inventory growth versus total sales growth?

Douglas A. Scovanner

Well inventories clearly grew faster than total sales. There’s a variety of individual contributors to that fact, some of which has to do with last year’s base, a lot of which has to do with the snapshot in time at the end of this quarter. On balance, I would say that regardless of that mathematical relationship, inventories remain in excellent condition and I will stand by my forward -- fearlessly stand by my forward-looking statement that sales mix, not fashion risk, will be a much larger determinant of our gross margin rate Q3, Q4.

Deborah Weinswig - Citigroup

Okay, and then one question for Greg -- Greg, you talked about the segmentation strategy across the stores and assortment and that you continue to expect results [of the initiative] to deliver. Can you talk about where you are with regard to the initiative and what we should expect to see in the future as well?

Gregg W. Steinhafel

Well, we are relatively early in this initiative and it is across the entire store where we are really segmenting our business and looking at low volume, medium, high volume stores and trying to segment the presentation and have volume strategies to ensure that we are getting the right inventory in the right store at the right time.

For example in apparel, we are just initiating this initiative in our women’s area as we speak and throughout the balance of the fall, and particularly first quarter next year, we will be expanding it to some of the apparel areas.

And so in the past, we have been focused both on a combination of store volume and presentation guidelines and going forward, we are more focused on the store volume and less on the presentation, and we have some fixturing changes that we have introduced and we are going to do some things to make the shopping experience even better while we are able to thin down our inventory, our inventories in the stores that don’t need it and redirect that into stores that need it and in some cases, just eliminate it from the network altogether. So we’re focused on apparel and as we transition through our hard lines categories, we are introducing low volume planograms in those businesses as well. So you will see this progress really over the next 12 months.

Deborah Weinswig - Citigroup

Great. Thanks so much and best of luck.

Operator

Your next question comes from Uta Werner with Sanford Bernstein.

Uta Werner - Sanford C. Bernstein

I have a couple of questions related to the new store goals that you spoke about. I wonder if for the ’09 numbers of 70 to 75 net new stores, you can give us an idea of how that might split across quarters, across formats, maybe geographies.

Douglas A. Scovanner

There’s nothing remarkable about the change or the absolute numbers. There is a good deal of volatility in any year in terms of the quarters in which we open stores. As most of you know, we open stores in three discrete batches, March, July, and October, so there are typically no other months of the year in which we open stores but there’s a lot of ebb and flow between those three cycles in any year and I would hesitate to make a fearless prediction.

Separately, mix of formats, mix of geography, nothing particularly remarkable -- obviously in some of our most sales challenged environments, that’s where there’s the most pressure on individual proposed store pro formas. But big picture, big scheme of things, nothing particularly remarkable, net simply a reduction in the range of about 20 stores from our earlier thinking.

Uta Werner - Sanford C. Bernstein

Any thoughts on what might 2010 look like?

Douglas A. Scovanner

Too early to tell. I would tell you that again, I wouldn’t characterize this as a goal. This is simply our freshest projection based on looking at individual transactions one store at a time and adding them up in a granular kind of way. At this point, we are obviously not as far along at that level of detail for 2010 or 2011. I would hope and potentially expect that that number could grow somewhat. I would stop well short of believe that this is simply a one-year dip.

A reminder here -- a substantial portion of our capital spending in any given year is related to future period store openings, so essentially we’ve come within a couple of stores of the forward-looking statement that we made regarding ’08 openings, yet our CapEx in ’08 is well below our earlier expectations because we will spend less in ’08 than we planned on ’09 and 2010 openers.

Uta Werner - Sanford C. Bernstein

That leads to my last question -- when I looked at TP&E on the balance sheet, the construction in progress number is significantly lower than last year at this time and of course in part, that will be driven by the number of stores you opened. But I was also wondering if you are seeing any kind of construction cost benefit coming your way.

Douglas A. Scovanner

I wish that were the case. It is not. Actually, the main driver year over year of construction in progress line item change on our balance sheet is a fairly small change in timing that we executed between then and now in terms of moving property out of construction in progress and into the property account. So in essence, this year’s July cycle is already in the property accounts. Last year’s July cycle at this time was in construction in progress, so the total property and equipment is unaffected by this small timing change but that line item is offset by increases in other line items.

Uta Werner - Sanford C. Bernstein

Thank you, Doug.

Operator

Your next question comes from Robert Ohmes with Merrill Lynch.

Robert Ohmes - Merrill Lynch

Just two quick questions -- the first question I have is just can you give us a little more detail on the categories where you are seeing the strongest gross margin improvement? So for example, you called out apparel and home having less markdowns. Are the margins, are the gross margins actually tracking up in that category? That was my first question.

The second question was on the inflation outlook that you mentioned -- any changes to where you are seeing the most pressures in inflation? If you could just give an update on that. Thanks.

Gregg W. Steinhafel

With regard to the gross margin rate performance, we had solid improvement in gross margin rate throughout the store for the most part. It wasn’t really remarkable but it was up single digits, low-double-digit improvements in apparel, in our hard lines category. We saw a little pressure in food but it was nicely distributed throughout the area and that was fundamentally because we managed our business very well, our markdowns were well-controlled, our initial markup was healthy. So in total, we saw some nice increases in rate to the tune of about 15 to 20 basis points.

On the inflation front, as you know last year at the end of October, we said that in aggregate, it was more of a deflationary, a slight deflationary environment and it’s really only at that single point in time that we can tell you with any specificity what the prior year was. But all indications are that that slightly deflationary environment will shift to a flat or slightly inflationary environment based on all of the cost increases that we have seen. The number of cost increases and the breadth to which those cost increases have been applied in both discretionary and non-discretionary categories.

Robert Ohmes - Merrill Lynch

Terrific. Thank you very much.

Operator

Your next question comes from Jeff Klinefelter with Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

I just have two quick questions as well -- one is on the new food DC that you just opened and the one to follow. Could you give us any sense for what sort of an impact that could have, or how you think about the impact that that has on the operating contribution from the food departments? Does that give a certain basis point benefit to you as a result of bringing that in directly? Or is it a number of different things that it ultimately impacts to drive margins higher?

And then the second question is on store payroll for Doug -- that being one of the buckets that you have some flexibility with in terms of reductions when sales drop, how do you see the technology investments you’ve made the last few years benefiting your ability to run on lower payroll levels versus just bringing them down with the lower volumes today?

Gregg W. Steinhafel

Let me address the food DC. I mean, as you know, the essential mechanics of it are these are net present value positive for us, so they are good economic projects but they require us to spend significant capital in terms of the investment required to build those facilities and maintain and operate those facilities. Clearly we are taking on an expense challenge because we are now operating those facilities. In exchange for that, we expect and have seen higher gross margins on the merchandise side. So we will see a slight improvement in our gross margin rate. We will see a slight deterioration in our expense rate but the combination of those factors are a very solid economic proposition for us.

Douglas A. Scovanner

Your question regarding technology investment, it’s clearly inextricably intertwined with our ability to control payroll as a percent of sales, so our ability to continue enjoying in-stock levels as high as they are and to continue providing guest service as high as it is, our ability to accomplish all of that while reducing the number of hours per hundred or per thousand dollars of sales is directly related to our investment in systems that allow us to be more efficient in our in-store processes.

Jeff Klinefelter - Piper Jaffray

Doug, I guess stated another way, as we come out of this cycle and sales eventually do recover to some level, some positive level, do you see the potential to carry a lower overall store expense or payroll expense rate than you would have the prior three to four years during a positive cycle?

Douglas A. Scovanner

Yes, absolutely.

Jeff Klinefelter - Piper Jaffray

Thank you.

Operator

Your next question comes from Charles Grom with J.P. Morgan.

Charles Grom - J.P. Morgan

Doug, mix has been a drag, as you called out, call it 60, 70 basis points the last four quarters. Given recent sales trends over the past 60, 90 days, would you expect that to alleviate a bit as you enter the third and the fourth quarter, or should we expect similar compression here?

Douglas A. Scovanner

That is a great question and I genuinely wish I knew the answer because what we are about to do is to begin cycling the periods last year where our year-over-year mix issues were most profound. August was a great month last year. September and October were not great months from a mix standpoint, so it will be a fascinating discussion point 90 days from now to look at the actual facts and see if the happy case comes through with some muted mix impact year over year, as we begin cycling those periods from last year, or alternatively whether we will be in for a continuation of the current year-over-year trends. We do not have a precise or crisp crystal ball on that one.

Charles Grom - J.P. Morgan

Okay. And then a second question would be for you, Doug, again -- pace of buy-backs, roughly 30, 33 million shares per quarter. Given the lower CapEx, would we expect to see a similar rate in the back half or should we expect that rate to come in a little bit?

Douglas A. Scovanner

No, our guidance regarding execution of our share repurchase program has not wavered one item of punctuation or one word since we first launched this program. We said that our $10 billion authorization would likely be completed over a three-year period and that we would expect to complete half or more in 2008 based on a combination of liquidity, share price, and operating results. We are already 47% of the way through the $10 billion, so obviously the current pace of that program is not at all likely to continue Q3, Q4 because we clearly continue to expect to take no deliberate actions that would threaten or jeopardize our credit rating. This was a very carefully engineered program at the time.

Now, all else being equal, lower CapEx equals higher share repurchase. That’s great new from a share repurchase standpoint. The bad news is, all else being equal, lower operating results equals lower share repurchase. Those two issues, which are not unrelated, tend to cancel and allow us to continue to believe that the pace we have described for share repurchase remains as fundamentally intact today as it did nine months ago when we first announced the program.

Charles Grom - J.P. Morgan

Great, thanks.

Operator

Your next question comes from Adrianne Shapira with Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Thank you. Doug, when you shared with us your second half outlook, you were looking for a better Q4 than Q3. Does that pertain to sales as well? [You had seen the opportunity] to comp positively in the fourth quarter, given those easy year-ago comparisons --- does that still hold true today?

Douglas A. Scovanner

Yes, that was actually one of the three items that I cited in believing that we are more likely to meet or exceed current Q4 median First Call EPS expectations, so I think we will be more challenged in meeting or exceeding Q3 than Q4 expectations and sales -- the likelihood of better same-store sales is one of the three key factors.

Adrianne Shapira - Goldman Sachs

Okay, and then share with us perhaps Q3 sales expectations?

Douglas A. Scovanner

Well, August is a great leading indicator. We said at the beginning of the month we expected minus three to minus one in same-store sales, and I remarked earlier that we’ve seen quite a bit of volatility. If the first 10 days were all we had to look at, clearly we would be very concerned about our ability to meet even minus 3. Sales are on a better pace since then, which alleviates some of that concern. But clearly we are in for a more challenging period.

September and October, at this moment, are a little more wide open as a result of this volatility. I’ll make a fearless forecast but this clearly is one that we’ll stay on top of and communicate as the quarter unfolds. I think we should we be somewhere in the range of flat for the quarter by the time the dust settles. That forecast is more at risk of being wrong than sales forecasts we would typically make 60 days out.

Adrianne Shapira - Goldman Sachs

Okay, great and then just on the lowered store openings, does that give you some dry powder to perhaps be opportunistic in the event that blocks of stores become available as other resellers are obviously under more strain and we’re seeing some consolidation come through?

Douglas A. Scovanner

All else being equal, it certainly does but I’d be quick to add two important facts; one, with each passing year, as we penetrate more and more U.S. trade areas and the real estate of others in those trade areas is no longer of any interest to us whatsoever. And secondly, given the process that I outlined in detail earlier, we would go through a rigorous site-specific sales forecast that is likely going to be lower today than it would have been had we looked at that real estate one, two, three years ago.

So I think that your comment is quite sound at the margin and in concept but I am not particularly optimistic that we are likely to acquire big blocks of the real estate of other troubled retailers in this environment.

Adrianne Shapira - Goldman Sachs

Great and then my last question for Greg, as you had mentioned, you are shifting the marketing handle more to the pay less emphasis here and the under $10 handle and the dollar week circulars that we are seeing. Can you just talk about what if any -- what you are seeing change in terms of the complexion of the customer and how that is impacting -- we’re obviously still seeing trips down but talk about the success of that shift in marketing. Thanks.

Gregg W. Steinhafel

Well, the customer is very cash strapped right now and in some ways, our greatest strength has become somewhat of a challenge in that our stores are fun and unique and we have both what you need and what you want and during these tough economic times, some of our consumers don’t want to be tempted as much as they have in the past. So we’re still trying to define and find the right balance between expect more, pay less. The current environment means that the focus is squarely on the pay less side a bit but as you heard from Kathy, we have record amount of innovation, content innovation. We want to still convey our brand positioning, that we are unique, we have great value, we have high quality, terrific merchandise and that you can come to Target and save a lot of money, even in the discretionary category. So even though it’s not topical for them to spend money in home and apparel right now, our values [inaudible] exceptional owner, design relationships and what we are delivering in terms of content innovation are just terrific.

So we believe it’s important that we continue to deliver great merchandise and talk about that as well, and over the long-term this has been the right combination and it will be the right combination.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

Your next question comes from Mark Miller with William Blair.

Mark Miller - William Blair

Good morning. I appreciate Kathy’s comment that clean and fast, friendly stores contribute to the perception of higher prices. I wonder if you would include in that the record amount of innovation and design content that you have. Have you done market research with your consumers to find out whether they think the prices across the store are higher as they see more designer introductions? And then how do you communicate the value versus I guess higher price point department stores? And then generally, what would we see as the comp growth for those unique designer categories, relative to more basic product in those discretionary categories?

Gregg W. Steinhafel

Let me see if I can take these one at a time. I don’t believe -- we haven’t done research specifically as it relates to is the content in our store driving a mal-aligned price perception. It is more reflective of our brand standards. It’s great lighting, clean aisles, no clutter. And has less to do with really the content because even though we are offering designer merchandise and fast fashion, the price points of these offerings are clearly well understood by our guests and they come in and they recognize that a handbag that they are going to be paying $100 for in specialty retail, they can buy it at $29.99 at Target or it’s an outfit that’s a third of the price. So we believe and our research validates the fact that they get the fact that the innovation of merchandise and what we are delivering from a content standpoint is not overpriced and does not degrade from our pricing image.

So it is really about the incredible brand standards that we have worked hard and it’s the speed of the check-out, it’s the friendly service and it’s the number of team members we have on the floor at any given point in time. And that is really where they are kind of connecting the potential or the perception that we are slightly higher priced.

So we are going to continue to focus on the value aspects and make sure that we are resonating with our message and trying to find the messages that really, really connect with them during this tough economic time.

And then your third question was about what, comp store sales again?

Mark Miller - William Blair

If we looked at the categories where you have the most unique content and designer relationships, how would your comps be where you have the unique product versus where you have more basic product that’s not as design driven?

Gregg W. Steinhafel

Well, we’ve said all along that the consumables and food and health and wellness categories continue and this is -- continue to outpace the growth of our apparel and home categories. This is not a new phenomenon. This phenomenon has been going on for some time and frankly the results in our designer, fast fashion, go international categories have been exceptionally strong. It’s really not the fashion side and the newness and innovation that is underperforming. It is just the core basic day-in and day-out I think I’ll pick up a couple of extra items while I’m at Target kind of mentality that we are not able to capitalize on in this market. But it is about the -- we are in a fashion cycle and people want to be inspired and be optimistic about the merchandise they find at Target and we are focused on that and that’s doing quite well.

Mark Miller - William Blair

And then I have just one final question for Doug -- how much was the expense line benefiting from incentive compensation across the company year-on-year? And then should we take your comments to mean that based on the run-rate you have year-to-date in expense control, that that’s an approximation of where the company wants to be moving through the rest of the year? Thanks.

Douglas A. Scovanner

Incentive compensation was between 10 and 15 basis points favorable in the quarter in SG&A rate. It’s about the same amount by which it’s likely to be unfavorable in Q3 because Q3 last year, as you’ll recall, was the quarter in which performance was well below expectations after two very strong quarters that preceded it.

Year-to-date, we’re 20 basis points favorable in SG&A as a percent of sales. The biggest wildcard in predicting what that will look like in the fall season is to predict sales. I feel very confident that our expenses will be very well-controlled in dollars but as a percent of sales year over year, that equation has a great deal to do with how strong or not our sales growth is likely to be. Give or take, I think we are likely to lie within 10 or 20 basis points of neutrality in expenses for the back half of the year, depending on what happens to sales and some other expense specific items. Could be 20 basis points unfavorable, it could be 20 basis points favorable but I think that’s the range of responsible expectation.

Mark Miller - William Blair

Great, thanks.

Operator

Your next question comes from Dan Binder with Jefferies & Company.

Dan Binder - Jefferies & Company

Just a question on the reserve rate -- if we look at that as a percentage of receivables, it was about 3% or so in the quarter, perhaps on an annualized basis, 12%. And I’m recognizing that it’s forward-looking, anticipating future write-offs -- how should we think about that as a percentage of average receivables for the remainder of the year? Should it stay up at around that 3% pace per quarter?

Douglas A. Scovanner

That is certainly possible. It would not be the center of my expectations. Here’s the way I would think about that. Clearly write-off rates are elevated at the moment compared to where we have been and certainly compared to our earlier expectations. I think it’s highly likely that write-off rates will remain elevated for at minimum a quarter or two. The real judgment call is trying to figure out at what point in time will write-off rates turn the corner due to the combination of significant changes in underwriting that we’ve executed in all aspects of our underwriting and the significant reduction in open-to-buy that we’ve executed across subsets of our file as well.

We have seen across the last two quarters some stability in our balance weighted portfolio FICO scores, and that is a great leading indicator of what might occur, what we would expect to occur Q1, Q209 in terms of write-off rates.

So is it possible that our provisioning, our expense in one or both of the next two quarters could be as high as it was in the second quarter? Yes -- whether it remains that high really remains on the -- really hinges on the judgment call we’ll need to make about how long these aggravated levels of write-off might occur.

I do want to focus for a moment though on the income generating side of the card portfolio and not just the expense and loss side of the portfolio. The terms change that we recently executed, all else being equal, beginning in Q4 this year will add 200 basis points or more to our spread to LIBOR, to our overall portfolio yield on the managed portfolio and therefore net net, write-off rates would have to increase yet another meaningful amount and stay there to neutralize the benefit of that terms change. I expect to begin generating handsome profitability in our card portfolio beginning no later than Q4 of this year as a result of all of those dynamics pulled together.

Dan Binder - Jefferies & Company

Okay, and then just as a follow-up to that, given the tightening that you have had, both on existing lines and new accounts, what should we expect receivables growth to look like for [inaudible] -- do you think that tightening impacts, comp store sales in the back half?

Douglas A. Scovanner

First of all in terms of portfolio growth, you will see a steady decline in the year-over-year growth rates as we move forward quarter by quarter, whether you are focused on average receivables or period end receivables, those figures were in the upper most 20s -- in other words, 28%, 29% in Q1 -- 25%, 26%, 27% now. It will fall into the low 20s in Q3 and still likely be in double-digits but no longer in the 20s by Q4. So the year-over-year growth rates will dissipate.

They won’t dissipate quite as fast as we once might have expected because in this current environment, not only is the activity per dollar of balance carried much lower in terms of charges, both inside our stores and elsewhere, but it’s also the case that payments are much lower per dollar of balances carried and therefore these accounts aren’t amortizing as fast as one might have earlier expected.

In terms of your second question, the effect on our same-store sales of all of this activity in our card portfolio, I think -- I could answer that question literally but I think you’d be better served by, if you’d allow me to refocus your question at a broader level. We’re executing these activities at the same time that our partner, Chase and others in this industry, Citi, Banc of America and so forth, are also executing very similar activities. And that is creating a fascinating dynamic at point of sale because for the first time in modern history in the quarter just ended, the penetration of all forms of credit cards, ours and everyone else’s at point of sale fell. Debit has been growing, of course, for years. Debit passed credit in terms of form or payment in our stores several years ago but only recently Q1 did the penetration of aggregate credit, our cards and everyone else’s essentially moved from positive territory to neutral territory. And in the quarter just ended, it’s a negative territory.

Clearly the aggregate access that our guests have to credit cards is not just our own but more broadly across the universe is one of the issues that is determining our same-store sales performance in the current environment.

Gregg W. Steinhafel

We have time for one more call.

Operator

Your next question comes from Bob Drbul with Lehman Brothers.

Robert Drbul - Lehman Brothers

Thanks. Good morning. Can you maybe just address if you are seeing any significant consumer trends on the good, better, best and mix in various categories throughout the business, and maybe just a bigger focus on private label consumption?

Kathryn A. Tesija

You know, we are seeing some changes in good, better, best but it really varies by category. So for example, in food we’re seeing a bit of a trade-down on things like, you know, from steak to chicken or premium chocolate to basic candy. We are seeing national brand equivalent products. They are own brands performing exceptionally well, gaining significant penetration there.

You know, but on the other side of this, Bob, I would tell you that in some of our discretionary categories, in home, you know, we’re seeing for example some trade-down in domestics where they are being perhaps a little bit more selective in what they are buying, a comforter versus a duvet or perhaps pieces of the bed, not the full bed. But at the same time, some of our best products are performing incredibly well, so Field Crest we relaunched in March continues to perform exceptionally well and apparel, as Greg mentioned, Converse One Star is our best brand and it’s performing well, as well as C9 by Champion. So kind of a mixed bag.

Robert Drbul - Lehman Brothers

Great. Thank you very much. Good luck.

Gregg W. Steinhafel

Okay, that concludes Target's second quarter 2008 earnings conference call. Thank you all for your participation.

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