Target Corp (TGT) — Q2 2018 Earnings Call Transcript

Good morning, everyone, and thank you for joining us on our second quarter 2018 earnings conference call. On the line with me today are Brian Cornell, Chairman and Chief Executive Officer; John Mulligan, Chief Operating Officer; Mark Tritton, Chief Merchandising Officer; and Cathy Smith, Chief Financial Officer. In a few moments, Brian, John, Mark, and Cathy will provide their perspective on our second quarter performance, outlook for the full year, and progress on our long-term strategic initiatives. Following their remarks, we'll open the phone lines for a question-and-answer session. As a reminder, we're joined on this conference call by investors and others who are listening to our comments via webcast. Following the call, Cathy and I will be available to answer your follow-up questions. As a reminder, any forward-looking statements that we make this morning are subject to risks and uncertainties, the most important of which are described in our SEC filings. Also, in these remarks, we refer to non-GAAP financial measures, including adjusted earnings per share. Reconciliations of all non-GAAP numbers to the most directly comparable GAAP number are included in this morning's press release, which is posted on our Investor Relations website. With that, I'll turn it over to Brian for his thoughts on our second quarter performance and our outlook for the rest of the year and beyond. Brian?

Thanks, John, and good morning, everyone. We are really pleased with the second quarter financial results. Comparable sales grew 6.5% in the quarter, representing Target's strongest quarterly comp performance since 2005. This increase was driven by traffic growth of more than 6%, an unprecedented number and, by far, the strongest performance since we began reporting this metric in 2008. Total sales were up 7% from a year ago, reflecting 0.5 points of growth from our new and non-mature stores. Store comparable sales increased nearly 5%, and digital sales grew more than 40% in the second quarter as guests continued to respond to a growing menu of convenient fulfillment options, newness throughout our merchandising categories, freshly remodeled stores, and a higher level of service across the chain. On top of the strong digital sales trend we've been seeing for many years, we saw a meaningful incremental lift from our one-day sale in July, which came in far ahead of expectations. With very strong traffic, both in-store and online, we saw accelerating comp sales trends in all five of our core merchandising categories. While there are healthy increases across the board, comp growth in our Home category was amazingly strong, up nearly 10%. Hardlines also saw high single-digit comp growth, driven by strength in both Toys and Electronics. And with stronger-than-expected sales, our business delivered stronger-than-expected profitability. Our second quarter adjusted EPS of $1.47 was near the high end of the guidance range of $1.30 to $1.50. This represents about 20% growth compared with a year ago despite the fact that our results continue to reflect significant investments in both capital and operating income to position Target for long-term success. These investments include our plan to perform wall-to-wall remodels of approximately 1,000 stores over a three-year period; our work to completely transform Target's supply chain, placing our stores at the center of a modern network designed to deliver an unmatched combination of convenient fulfillment options; opening new small-format stores across the country, allowing us to reach guests we couldn't serve with our larger formats. Last year's investment ensured that we're priced right daily in support of the Pay Less side of our brand promise; our work to deliver a constant drumbeat of new and exciting merchandise throughout our own and exclusive brand portfolio; the rollout of new convenient digital capabilities that make it easier and more inspiring for our guests to shop, save and use their REDcard; and most importantly, investments in hours, wages, and training for our team members. These investments enable our team to deliver higher levels of service and productivity, and our guests are responding to the change. We embarked on this investment plan at the beginning of 2017, and our progress so far has been well ahead of our original expectations. There's no doubt that, like others, we're currently benefiting from a very strong consumer environment, perhaps the strongest I've seen in my career. But market share data demonstrates that our current results benefit from more than just the environment as we're seeing broad market share gains across categories we sell. The question we continue to hear from many of you is whether we can separately measure the benefit of each of these investments we're making, and the honest answer is we can't evaluate each one of them in isolation. Instead, it's the collective benefit of all these initiatives that is keeping Target more top of mind with guests, enticing them to visit our stores and our site more often. Before I turn to our outlook for the rest of the year and beyond, let me comment briefly on the topic of tariffs. Like many of you, we've been carefully monitoring recent tariff announcements, and we're aware of the potential for this situation to further escalate. As we've said many times, as a guest-focused retailer, we're concerned about tariffs because they would increase prices on everyday products for American families. In addition, a prolonged deterioration in global trade relationships could damage economic growth and vitality in the United States. Given these risks, we've been expressing our concerns to our leaders in Washington, both on our own and along with other retailers and trade association partners. However, our concern is centered on the impact of tariffs on consumers and the economy, not our ability to manage our business in the face of these challenges. As you know, when we're faced with tariffs or any other external factors, there are multiple levers we can pull to remain price competitive and maintain profitability, and we are continually developing and implementing contingency plans as we learn more and things evolve.

Thanks, Brian, and good morning, everybody. As I've discussed with many of you, the operations team faces a fundamental challenge in delivering on our strategic initiatives. As we work to make changes to virtually every facet of our operations, modernizing our supply chain, delivering new fulfillment options, and increasing efficiency in our stores, we need to simultaneously focus on maintaining everyday reliability in support of a $75 billion business. In the face of this challenge, I'm really proud of how our team is performing on both priorities, particularly in light of the rapid acceleration in sales we've seen in recent quarters. Our strategic plan includes significant investments in the physical infrastructure of our stores. This is because our stores will continue to be the key fulfillment node for our guests, whether that's a traditional store trip, a Drive-Up order, an in-store pickup order, a trip by a Shipt shopper, or a traditional e-commerce purchase shipped from a local Target store. Our goal for the year is to deliver well over 300 remodels, and we are on track to deliver that plan. We completed remodels of 113 stores in the second quarter on top of the 56 we completed in the first quarter and many more are underway. In fact, in July, we had 258 locations undergoing a remodel during at least a portion of the month, the highest at any time in our history. While our remodel project creates an optimal platform for all of our fulfillment initiatives, it also provides our guests with a more inspiring environment that's easier to shop, and our guests continue to respond by shopping more often. Specifically, consistent with our plan, we continue to see traffic-driven incremental sales lifts of 2% to 4% in our remodeled stores following completion of the remodel. And while the data is limited, we are seeing some early indications that remodeled stores continue to outperform other stores beyond the first year after the remodel. We also continue to see encouraging performance from our new small-format stores. We opened 6 of these new locations in the second quarter on top of the 6 we opened earlier in the year. These locations deliver high sales productivity along with gross margin rates above the company average. And we continue to see strong growth as these stores mature. At the end of the second quarter, we are operating 26 mature small-format stores, and on average, this group saw high single-digit comp growth during the quarter.

Thanks, John. As Brian and John have mentioned, the momentum we're seeing across our business is amazing, and we can't point to any one single driver. Instead, the common denominator is our guest who is thinking of us and choosing to shop with us more often. As we benefit from this momentum, our goal is to maintain this focus on our guests and push ourselves to do more even more quickly in service to them. As we've said before at Target, we're at our best when we maintain a proper balance in our business with a focus on delivering 'and,' not 'or.' After all, we don't ask our guests to expect more or pay less; we work to consistently deliver on both sides of that brand promise. But it doesn't stop there. We feature a curated assortment that satisfies wants and needs, offers basic items and must-have style, and highlights national brands and owned brands. We invest to ensure we're priced right daily and offering compelling deals, design our assortment to support both stock-up and fill-in trips, and we feature all of it in stores and online. Guest surveys give us confidence that we're achieving a proper balance in the current environment. For example, in the second quarter, our guest scores for convenience and everyday pricing increased, and our differentiation score increased as well. This is a testament to the efforts of our entire team over the last 18 months and their focus on delivering the right combination of everyday prices and compelling promotions with the right assortment of innovative national brands alongside exciting new owned and exclusive brands.

Thanks, Mark. Our second quarter financial performance exceeded our expectations on both the top line and the bottom line, reflecting the benefit of our strategic initiative in a very strong consumer environment. As Brian mentioned, our second quarter comp sales increase of 6.5% is the strongest we've seen at Target in 13 years. This growth reflected a 4.9% increase in our store comparable sales combined with 41% growth in digital. These are both very healthy numbers in isolation, and they're even more powerful together. Traffic growth of 6.4% accounted for nearly all of our comparable sales growth in the second quarter. In addition, for the first time in nearly 2 years, our comp sales grew faster than comp traffic as we saw a small 0.1% increase in basket in the quarter. In our last quarterly call, when describing our first quarter traffic increase of 3.7%, we described it as the strongest result we had ever reported since we began reporting this metric in 2008. Obviously then, this quarter's traffic growth of more than 6% is well beyond anything we've reported before, and we are really encouraged to see continued momentum in such a key metric. Our second quarter gross margin rate of 30.3% was down about 10 basis points from last year and slightly better than our guidance. Among the drivers, we continue to see meaningful pressure from fulfillment costs as guest engagement with our digital channel continues to grow and we rapidly roll out new convenient fulfillment options across the country. However, in the second quarter, this headwind was almost completely offset by the benefit of our merchandising initiatives, including ongoing cost-saving efforts and the benefit of our work on pricing and promotions.

My question is about the guidance. So the guidance seems to imply, I guess, slightly better operating profit growth in the second half of the year. In the second quarter, it was up, and it was up for the first time in a very long time, which is nice to see. But it was down for the full first half on similar comps to what you're assuming for the second half. So can you just remind us of some of the drivers? And Cathy, we got the margin commentary, but just help us a little bit more with some of the levers as we move into the second half of the year, some of the cost savings and other opportunities that will help support that operating profit growth?

Yes, Seth. Thank you. As we did say, we're obviously very, very pleased with the quarter, so thank you for the comment. And as we think about updating our guidance for the remainder of the year, we expect consistent sales. So first, on the top line, we see the back half and we've got plans for consistent sales growth in that same range, which is obviously very strong, consistent with the traffic and sales we've been seeing. And then on profitability, we see a great opportunity to continue to take share and go after some categories, specifically Toys and Baby. So we baked that in the back half of the year. So all of that said, we'll continue investing in both the fulfillment aspects, which are coming through in gross margin, and then the category mix. And then on the SG&A line, we'll continue to invest in our stores. All of that said, we expect the back half of the year for a slight deterioration in op income margin rates.

But Seth, we feel like we're very well positioned for the back half of the year. As I've mentioned with my prepared comments, we're seeing a very strong start to Back-to-School and Back-to-College. We continue to see very strong traffic trends. And we expect to monetize that in the back half of the year. So you should expect continued strong performance from Target throughout 2018, but it also sets us up for a very strong performance as we go into 2019 and beyond. So I think we're well positioned to continue to build off of the current momentum. And you should expect us to begin to grow operating income from a dollar standpoint.

You mentioned that the remodels had some of their peak activity in July. Did that actually create a drag on the traffic and same-store sales results, suggesting that those results could have been even better without the remodeling activity?

Yes. Mike, it's certainly disruptive when we're remodeling stores. And now we're doing it at scale. So we're very focused, John and his team, on shortening the construction cycle, less disruption, rapid recovery. But you can only imagine, with over 250 stores under construction during an important month like July, there was significant disruption in those store sales. We're going to see the recovery as we go into the third quarter, and we certainly expect to have an even better response in those stores in Q4. So when we remodel, there's significant disruption in sales, but we're seeing that return very quickly once we complete the remodel.

Yes, that's a great question. I mentioned this briefly in my remarks. The challenge for us is to change the business while still managing operations. As you noted, we've shared a lot of our plans for transformation. We plan to scale much of this work in 2019, which has the potential to greatly enhance our capabilities. Currently, we have observed an increase in sales, especially from Q1 to Q2, but we've had inconsistent in-stock levels, which we find unacceptable. You can see the result in our inventory management. We are bringing in goods a bit earlier for Q4 to ensure they reach the stores properly. We have made investments in categories such as A&A basics, denim, and chinos, where we faced significant stock issues last year with new brands. We're also putting in effort into Food and Beverage, and as Mark mentioned, we have been gaining market share for six consecutive quarters. We are learning to operate that sector both in-store and within our supply chain. While we are pleased with our progress, we are not content with our current in-stock situation, and we recognize that there is still more work to be done.

And, Oliver, I'll just build on that for you and others on the call. While this was a really strong quarter for the company and when we think about comps at 6.5%, the strong comps in-store, the acceleration in digital, there's a lot to be proud of, but we know we've got a lot of work to do. And we've got to make sure that we are now meeting the demand that's taking place within our system. So John is very focused on that to make sure that we improve our in-stock position. But we've seen obviously a step-function change in demand in our stores and online, accelerated growth. We're chasing some of that growth right now, and we've got to continue to make sure that we're doing a better job of replenishing our system as we go into the back half of the year and particularly as we get ready for continued strong growth in 2019.

I wanted to emphasize your focus on scaling for 2019, discussing various initiatives as well as the investment base. At the Analyst Day earlier this year, you identified 2018 as an investment year, and you are reaffirming your expectation of profitable growth for 2019 and beyond.

I know you are, and you're trying hard. But I would refer you back to Cathy's comments earlier. When we look at our second quarter progress, really strong gross margin rate for a company that grew at our level. And for the first time in a while, operating income is growing from a dollar standpoint. So we're seeing some improvement in our performance. We expect that to continue over time. But you'll have to stick with us for another day when we're ready to give 2019 guidance.

Brian, I was wondering if I could ask a macro question. So the broader retail industry has truly enjoyed a resurgence across the board this quarter. Target seems to stand out because of the traffic, as you highlighted.

Let me start with the macro environment. And we've talked about this a lot over the last few years, and there's been a lot of questions about the role stores would play and whether everything was going to shift online. And I think the one voice that was missing from that conversation was the voice of the consumer, and consumers continue to vote with their footsteps. And as we sit here today, the numbers tend to vary from week to week, but on any given day, 90% of retail sales are done in physical stores. And I think what you're seeing right now from a macro basis is well-run retailers with strong balance sheets that generate cash that they can invest back in their business are winning right now. And there's obviously others right now that can't afford to invest in their store experience or build capabilities or drive differentiation, and they're giving up share. So there's clearly winners and losers. We certainly think we're migrating to the winners column. And we're driving not only traffic, but as Mark and Cathy and John have talked about, we're taking market share in all of our major merchandising categories. The investments we're making to make sure that Target is a long-term winner are being rewarded right now by the consumer and our guests.

I wanted to go back to something, I think, John was talking about with the labor and some of the changes maybe in the way you're hiring people and kind of the way you're allocating labor in the store and some of the transformation in the back room. Can you just give a little more detail on that and explore that issue?

Sure, Joe. I think, internally, you've probably heard us talk about the store modernization, and it's really Ken and the store team doing a great job just stepping back and saying what is it we're trying to accomplish in the store? And certainly, there's the work we have to do moving product out to the sales floor and checking people out and all the things that just happen because they have to happen in a store. Our goal there is to become more efficient and to provide the fuel so that we can invest in more talent and better expertise on the sales floor and in particular, in those areas where it matters the most. So think Beauty, Electronics, with our visual merchandising in both Home and Apparel and then in Food. Those are areas where we have actively hired for expertise, and that's where things like the wage investment are so critical. They've allowed us to differentiate in who and how we hire people. And so those team members, finding ways to bring that expertise in and then keep them on the floor, so that the Beauty team member is in Beauty all the time and they're able to help the guest and they also keep track of what's going on in that part of the store relative to in-stocks and inventory flow. And so rather than having a team of generalists doing price changes one day, checking out the next day, and maybe moving freight on Wednesday, these individuals are accountable for their part of the store. They're out there, they get to know the guests, and provide a very different level of experience.

John, thank you. And operator, thank you. That concludes our Q2 earnings call. I appreciate everyone joining us today, and we look forward to talking to you again when we talk about our Q3 results. So thank you.