Target: Margins Will Be In Focus Tuesday

Summary

• TGT reports earnings Tuesday.
• TGT's historical sales trajectory could be off due to disappointing holiday sales.
• The company has been growing revenue and expanding margins. Gross margin could be a key area of focus.
• I rate TGT a hold due to headwinds to the economy and broader markets from the coronavirus.
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Source: Target

Target (NYSE:TGT) reports quarterly earnings Tuesday. Analysts expect revenue of $23.5 billion and EPS of $1.65. The revenue estimate implies about 3% growth Y/Y. Investors should focus on the following key items.

Customers Are Flocking To Target

Traditional retailers have been getting hammered as of late. Last earnings season several was defined by stagnant sales growth, shrinking margins or both. Target bucked the trend with sales of $18.7 billion, up 5% Y/Y. The performance was stellar. Given Target's size, it was difficult to grow revenue in the mid-single-digit percentage range. The performance stood out relative to competitors. Retailers like J. C. Penney (JCP), Abercrombie & Fitch (ANF), and Kohl's (KSS) reported flat to declining revenue growth last quarter. It may have implied that Target's revenue growth came at the expense of these retailers.

The company delivered comparable sales growth of 4.5%. Retailers have found it difficult to grow comparable sales as more sales have shifted to online. Macy's (M), J. C. Penney, and Bed Bath & Beyond (BBBY) are culling underperforming stores to become more efficient. Based on the sales channel, Target's store channel generated comparable sales of 2.8%, and digital delivered 1.7%. Target proved it can reach customers via several different sales channels. The company now ranks in the top 10 of all U.S. e-commerce companies.

Its digital growth was spurred by same-day in-store Pick Up, Drive Up, Shipt and same-day fulfillment options. Target has been expanding these amenities for years, creating more ease of use for customers. I understand that, since these options leverage Target's fulfillment centers, they are more profitable than traditional e-commerce fulfillment. Traffic was the primary driver of growth, another side benefit.

The retail environment has been characterized by heavy discounting in order to drive traffic. Target has been able to drive traffic without resorting to aggressive promotions. This likely preserved profit margins vis-a-vis competitors. However, the company reported disappointing holiday sales. Comparable sales grew 1.4% in the November/December period, which followed 5.7% comparable growth in the year-earlier period. This likely explains why total revenue is expected to grow about 3%, much less than the mid-single-digit percentage growth the company previously enjoyed.

Margins Will Be In Focus

Target's margins actually increased last quarter; gross margin was 30.7%, up 100 basis points versus the year-earlier period. On a dollar basis, gross profit rose 8% Y/Y to $5.7 billion. Rising margins came as management looked for ways to become more efficient by expanding fulfillment services. These efforts potentially made revenue stickier and made customers more loyal. They also had the potential to offset rising supply chain costs.

SG&A costs of $4.2 billion rose 5% Y/Y. As a percentage of revenue, SG&A expense was 22.3%, up about 20 basis points versus the year-earlier period. Higher marketing expenses and store labor costs drove the increase. Target incurred higher costs from the recent launch of Target Circle, its loyalty program with 35 million guests enrolled. The loyalty program could make revenue stickier and allow management to stay abreast of customer buying patterns in real time.

As a result, operating income rose 22% Y/Y to $1.0 billion. Operating income margin of 5.4% rose 80 basis points versus the year-earlier period. Target's margins expanded, while margins for several other retailers faltered. Target launched new initiatives like Target Circle and 25 Disney (DIS) stores within select Target locations. Such initiatives could create brand loyalty and put more distance between Target and competitors.

Strong Liquidity

Target has nearly $1.0 billion of cash on hand. Its free cash flow ("FCF") through the first nine months of the year was about $1.8 billion. Liquidity and strong cash flows give the company the flexibility to modernize stores, invest in new ventures, or make acquisitions to improve its digital platform. Smaller retailers may not have that luxury. If the retail wars turn into a battle of the balance sheets, then Target is well-positioned to compete.

Conclusion

TGT is up 40% Y/Y. I anticipate more revenue growth and margin expansion this quarter. However, the global economy is facing headwinds from the coronavirus. That may hurt stocks as well. I rate TGT a hold into earnings.

Analyst’s 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.

TGT upside could be capped by the coronavirus.

Comments

[Kurt Licherovsky]

Management already stated holiday sales were lower than expected but higher margins sales exceeded expectations and the EPS guidance for quarterly earnings would be met.

The supply chain interruptions will be the focus. There are three Target super stores on my commute and business is good. I added more TGT to my position today because I'm averaging down.