How should a stock react to a company that delivers a solid earnings beat and a guidance raise? If the company in question is superstore retail giant Target (NYSE:TGT), the answer might very well be "by taking a -10% dive." Intraday, shares are now trading at mid-March 2017 levels once again.
Credit: NBC News
It is hard to find much weakness in the 3Q17 results that Target delivered this Wednesday morning - other than richer opex that I find very much consistent with management's turnaround strategy. Starting with the headlines, revenues of $16.7 billion exceeded even my more bullish estimate, although not by much. Comps of nearly +1% were satisfactory in my view, and showed resilience in offline sales (flat YOY vs. -1% last year, before the beginning of Target's transformation) that I was not quite anticipating. Unsurprisingly, the digital channel was responsible for all the comp sales improvement over 2016 levels. But on this end, I admit that I was hoping for an increase in the high 20% to low 30% range instead of the 24% reported.
Gross margins came almost exactly at my expected rate of 29.8% and 40 bps above consensus. I argued last week that gross margins should face pressure due to Target's declaration of a price war as a key pillar of its transformation efforts and the revenue mix shift toward digital, which in part explains the 50-bp YOY deterioration. But I'm glad to see that the company seems to be weathering those headwinds a bit better than most have been expecting.
On opex, I might not have lowered the bar enough this quarter by expecting only a 40-bp YOY increase in operating costs as a percentage of revenues. The company has repeatedly called for "operating margin investments" through 2017, which should continue to play out through 2018 and 2019, but likely at an easing pace. I calculate that, compared to my estimates, opex of $4.1 billion this quarter drove a meaningful seven-cent headwind to EPS. While Target did not beat my expected $0.94 in earnings per share that was aggressively set at the top end of management's guidance, the $0.91 delivered topped consensus estimates by a nickel.
See my summarized P&L below containing comparisons to my forecast, to 3Q16, and with an impact-to-EPS analysis.
Source: DM Martins Research, using data from company reports
Allegedly driving the stock price weakness today was Target's full-year EPS guidance increase of six cents (from $4.44 to $4.50 at the mid-point of the ranges). Despite the improvement, management's outlook largely reflected the five-cent beat of 3Q17, leaving little room for upside over prior 4Q17 expectations. The Street's estimates for the full fiscal year had already been set at the very high end of management's previous guidance, at $4.52.
While some analysts and investors might have hoped for their expectations to be blown out of the water, I believe Target's notoriously cautious management team would unlikely have taken their chances by raising the bar too high for the very important holiday season. Looking at the bigger picture, however, I believe the company continues to execute on its transformation efforts at least as well as expected, delivering results that suggest the company might be heading in the right direction.
A rare buying opportunity
A couple of months ago, I argued that TGT seemed like a compelling buy due to (1) the company's return to the top of the food chain in the superstore arena being on track, (2) upside to long-term earnings not being captured by the Street yet, and (3) valuation being too slow to rebound after Target's 2Q17 strong earnings results.
In my view, my investment thesis is playing out as expected on the first two bullets above, even if cautious guidance and heavier opex on the front end of the transformation phase might still make the two-to-three year forecast look a bit hazy today. On the last bullet, the stock price gains of the past several weeks have been unwound, and it looks like we are back at square one.
In my view, TGT's dip back into $54/share territory represents yet another chance for investors that did not buy the stock back in August to do so now at attractive valuations. I warn those who choose to do so, however, to expect a good bit of volatility. Sentiment in the retail space still seems to be very shaky, and any news short of being overwhelmingly positive may be viewed by some as an opportunity to head for the exits.
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