Target Corp (TGT) — Q3 2018 Earnings Call Transcript

Good morning, everyone, and thank you for joining us on our Third 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 third quarter performance, outlook for the fourth quarter, and progress on our long-term strategic initiatives. Following their remarks, we'll open the phone lines for a question-and-answer session. This morning, 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. And finally, 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 third quarter performance and our outlook for the rest of the year and beyond. Brian?

Thanks, John, and good morning, everyone. Our third quarter results are the result of superb execution by our team as they continue to drive outstanding near-term performance. In addition, the team is fully engaged in making meaningful progress as they work to transform Target and position us for sustainable, long-term success. Third quarter adjusted EPS of $1.09 was in line with our expectations and more than 20% higher than last year. This performance also established a new all-time high for Target third quarter adjusted EPS. Our third quarter comparable sales increase of 5.1% was also in line with our expectation and slightly stronger than the pace we established in the first half of the year. This comp growth is very encouraging on its own, but we're even more excited that it's being driven by traffic in both our stores and digital channels. Comparable sales in our digital channels grew 49% in the third quarter, far outpacing the industry and the vast majority of our peers. This growth was driven by our guests' response to our team's efforts to make the digital shopping experience easy and seamless, deliver new and innovative items through our own, exclusive, and national brand assortments, and offer an unmatched suite of convenient fulfillment options. While digital channel sales continue to grow rapidly, we are benefiting from healthy traffic and sales growth in our stores as well. This growth reflects the capital we're investing in our remodel program, enhancements of the assortment and presentation in key categories, and investments in our team, which help them provide an elevated experience and higher level of service. And finally, on top of comparable sales, new stores contributed more than 0.5 percentage point to our third quarter sales growth. This growth is being driven by new small format locations that we're opening in dense urban settings and near college campuses across the country. We refer to these stores as small because of their square footage, but they really punch above their weight because of their high sales productivity. This allows these locations to deliver strong financial returns while allowing Target to reach guest segments we couldn't serve in the past. As we've been saying all year, when we analyze the drivers of our strong traffic and sales growth, we see the benefit of all the strategic initiatives we're pursuing, including: our remodel program; efforts to rejuvenate our portfolio of owned and exclusive brands; the rollout of new fulfillment options focused on delivering ease and convenience, including Restock, Drive-Up, and personal shopping in as little as 2 hours with Shipt; investments that allow our stores to fulfill an increasing number of target.com shipments, allowing us to deliver quickly while also controlling costs; new digital capabilities to make shopping faster, easier, and more inspiring; our work to ensure we're priced right daily while delivering the appropriate number of clear, compelling promotions; and investments in hours, wages, and training for our team to further differentiate the shopping experience in our stores. Rather than measuring a separate benefit from each of these efforts, we believe the impact of all of them together is well beyond the sum of the parts. From a guest perspective, it's the combination of everything we're doing that makes Target more top of mind, causing guests to choose us more often. Beyond the impact of our efforts, we continue to benefit from a very healthy consumer and macroeconomic backdrop. In addition, as other retailers continue to close stores and liquidate in the face of rapid changes in consumer preferences and shopping behaviors, our investments position Target to capture sales and market share by serving consumers who are no longer shopping those competitors. Now we've been clear that all of our efforts to grow and transform Target involve a commitment of resources, which explains why I've already used the word investment five times in these remarks. And it's also why we're fortunate to have sound operations, healthy cash flows, and a balance sheet which provides the necessary flexibility to invest in our future. In addition, we continue to pursue initiatives which will help us offset incremental costs, including: tools and technology that deliver higher labor efficiency in our stores, allowing us to focus more of our team member hours in service of our guests; cost disciplines, beginning at headquarters but spanning all of our operations, based on relentless prioritization and a focus on what's most important; our brand development work, which helps us deliver continued strong performance in our highest-margin Home and Apparel categories; and the development, testing, and rollout of automation in our supply chain, which will take work out of our store backrooms and move the bulk of replenishment activity upstream into our distribution centers. While we are already benefiting from these efforts today, we see much more potential over time. Most notably, our work to optimize and automate inventory replenishment is in the very early stages, and we expect to realize the vast majority of potential savings from these efforts over the next few years. But even today, because of the depth of our resources, our business is thriving even as we transform our business. As we've said previously, we believe that this year we'll establish a sustainable benchmark for our operating margin rate over the longer term as we achieve a balancing point between the rate pressures and opportunities of operating an omnichannel retail business. In addition, we continue to generate a robust amount of cash, which allows us to fund: our current elevated level of CapEx; an attractive dividend, which we will continue to grow every year; and the return of additional cash through share repurchase, all while maintaining our debt rating. So while we are not providing 2019 financial guidance on the call today, I will say that we are optimistic about our ability to deliver profitable growth next year and beyond. But today, as the team will describe in more detail, our teams are focused and ready to deliver an outstanding holiday season in terms of both sales and profitability. Our stores are staffed, and the team members are trained. They are equipped with new tools and capabilities to support an unmatched suite of fulfillment options. And we're operating an outstanding assortment of owned, exclusive, and national brand items. And to support these plans, we'll deliver a compelling drumbeat of marketing and holiday promotions designed to keep Target top of mind with our guests throughout the holiday season while continuing to focus on delivering consistent value by ensuring we're priced right daily. With that, I'll turn the call over to John, who will provide an update on our rollout of new fulfillment options, investments in new and existing stores, and plans to deliver outstanding service for our guests this holiday season. John?

Thanks, Brian, and good morning, everybody. As we said many times, we're in the process of making meaningful changes to Target's business and operating model, and that effort is far from complete. But last year, when we had just announced this plan at our Investor Meeting, we often spoke about how eager we were to move beyond the planning stage and get to the execution phase. That way, all of us could see what was working, what needed change, and what we could accomplish faster. Today, we have clearly reached the execution phase and there are many data points that show we are making great progress. But there is no better metric than traffic, which has been growing, in the last couple of quarters, faster than I've seen in my time at Target. As Brian said, there's no way to fully isolate the benefit of everything we're doing separately, but the one initiative that we can best measure in isolation is our remodel program since we can compare newly remodeled stores to a set of control stores both before and after the remodel is completed. When we performed that analysis, we continue to measure incremental comp sales growth in the 2% to 4% range, consistent with our goals when we launched the remodel program. And given that we completed more than 300 remodels this year, the benefit of that kind of lift in that many stores is one of the many reasons we are optimistic about the upcoming fourth quarter. A piece of unexpected good news is that we have seen a measurable incremental lift in the second year of the remodels we completed more than a year ago. This benefit was not assumed in our planning for these projects and represents another reason for our optimism about the next couple of years, when we expect to complete another 600 remodels or more. On the fulfillment side, the progress we have made this year is truly amazing. At this time a year ago, we were in the early stages of testing Drive-Up at about 50 stores here in the Twin Cities. Today, we offer this service in nearly 1,000 stores, and the ability of our team to deliver consistently outstanding service while scaling up at that pace is remarkable. Drive-Up continues to receive the highest Net Promoter Score of any service we provide. We measure it every month, and it has been consistently in the mid-80s to low 90s. Early analysis shows that a meaningful portion of our Drive-Up orders are either incremental or taking the place of demand that would otherwise have been shipped to guests' homes. Obviously, given the cost of last mile shipping, we like the economics of Drive-Up much better, and our guests are clearly happy as well. Shipt has rolled out even more rapidly than Drive-Up. After all, we purchased the company less than a year ago, and today, it is operating in more than 250 markets, making it accessible to nearly two-thirds of the U.S. population. As of today, Shipt shoppers are fulfilling guest orders from more than 1,400 Target stores, and a meaningful number of those orders are delivered in less than 2 hours. While our ship-from-store capability was rolled out several years ago, it also continues to grow rapidly. For the third quarter, in which overall comparable digital sales grew an impressive 49%, our ship-from-store volume more than doubled while other shipment modes were nearly flat. As we have said many times, the ability to ship from a nearby store is a win-win. Compared with shipping from farther away, shipping from stores provides speed for our guests while dramatically reducing the average cost per shipment. But while Drive-Up, Shipt, and ship-from-store are our newest capabilities, it's important to remember that we offer our guests several additional options. In-store pickup continues to grow rapidly and it reliably accounts for about 15% of our digital volume. We're also seeing strong growth in Restock, our next-day delivery service for household essentials. And finally, let's not forget the conventional in-store shopping, which still accounts for the vast majority of our volume, continues to grow, and delivers high levels of guest satisfaction. Before I turn the call over to Mark, I want to talk about a couple of ways our team has been preparing for the upcoming holiday season. First, on inventory. As you saw in our release this morning, our inventory position was up about 18% compared with last year, consistent with our discussion on this call 3 months ago. This end of quarter increase is being driven by a few distinct factors that I want to highlight. First, and obviously, we are buying into the strong sales growth we've been seeing and expect to see in the fourth quarter. Second, from a timing perspective, this year will have the maximum number of days between Thanksgiving and Christmas that can occur on the calendar. As a result, our peak inventory position is happening relatively early this year, causing more of it to be reflected on the third quarter balance sheet. And finally, as you know, the Toy category sees a bigger-than-average holiday season peak relative to most other categories, so you're also seeing our investment to support that sales peak in Toys. Altogether, we are comfortable with our inventory position, and we feel well-prepared to support strong performance in the upcoming holiday season. Lastly, I want to talk about our seasonal hiring and our stores' readiness for the holidays. I'm happy to announce that despite very tight labor market conditions across the country, we have achieved our goal to hire 120,000 seasonal team members, which is up from a goal of 100,000 a year ago. Now that we have these new team members on board and ready to help us for the holidays, we are providing them with improved training, tools, and processes, allowing them to be trained and productive in about half the average time compared with a year ago. So as I turn the call over to Mark, I want to give a shout-out to the team. We've asked a lot of them this last year, and I am so grateful for the way they have delivered. Because of their hard work, our stores are looking and operating better. We have new, convenient fulfillment options available in our stores coast-to-coast. We are operating hundreds of new and remodeled stores, which our guests love. And we have a supply chain that's supporting everything from behind the scenes. I'm sure the team feels like they've already done a year's worth of work in the first 3 quarters of the year, but I also see every day that they are energized and ready for what's coming in the next few weeks. We say it a lot because we know it's true: Target has the best team in retail. Now I'll turn it over to Mark for his recap of our third quarter performance and our merchandising and marketing plans for the holiday. Mark?

Thanks, John. As I mentioned in our last quarterly call, on the merchandising team, we continually focus on maintaining a sense of balance in our approach between value and inspiration, satisfying wants and needs between unique own brands and quality national brands and offering compelling deals while being priced right daily. Our third quarter performance reinforces our confidence that we are successfully maintaining that sense of balance. From a category perspective, we were really pleased with our third quarter performance of our highest-margin Home and Apparel categories as both categories saw comp growth just below the company average. In Apparel, we saw particular strength in Baby as well as Jewelry, Accessories, and Men's. Growth in Home was led by outstanding comps in our home décor assortment. Hardlines saw even stronger performance, comping in the high single digits this quarter. This was led by Toys, which saw comp growth of more than 20%. As you know, we've invested in the Toy category this year, given the recent closures of Toys 'R' Us stores around the country. So far this year, our Toy results have exceeded our expectations in terms of sales and share. Beyond results in our most discretionary categories, we're also really pleased with growth rates in our less discretionary Essentials and Beauty and Food and Beverage areas. We saw particularly outstanding performance in Essentials and Beauty, which grew faster than the company average. Within this category, we saw double-digit growth in Baby, which again is also benefiting from the closures of Toys 'R' Us and Babies “R” Us stores in the U.S. In addition, we introduced 3 new innovative own and exclusive brands in the quarter: Quip and Native in Personal Care; and our new Essentials-owned brand, Smartly, which is designed for the younger budget-conscious guest who lives in smaller spaces. In Food and Beverage, comp sales grew about 4% in the third quarter, consistent with our second quarter performance. Within the category, we saw strong, encouraging results in our own brand assortment, along with double-digit comps again in adult Beverage. While it's important to focus on our absolute growth rates, our team also maintains a disciplined focus on market share metrics, which indicate Target's relevance against our competitive set. On these measures, we saw another quarter of consistent strong performance. Third quarter data showed we continued to gain meaningful share across every one of our core merchandising categories and nearly all of the subcategories beneath them. This reinforces what we have been saying for some time, that traffic is a key measure for us because whenever we gain a new trip from our guest, they tend to shop multiple categories, lifting performance across the board. It's also important to maintain a balance between share gains in our most discretionary and less discretionary categories. That's because while we always want to shine brightest during key seasonal moments like Back-to-School, Back-to-College, and Halloween, it's the Essentials, Beauty, and Food and Beverage categories that sustain our traffic and sales between the biggest seasonal events. Importantly, in the third quarter, with all of our categories doing their parts to deliver traffic, we successfully comped over several prominent own brand launches in the third quarter of last year. But now let's look ahead because even though we're really pleased with our performance so far this year, I want to share why we are even more excited about our fourth quarter and holiday seasonal plans. After all, while Target is a guest destination during holiday periods year round, we're entering, by far, the biggest holiday season of the year. As always, we're ready to deliver inspiration, convenience, and unbelievable deals to our guests this season. And we'll support it all with our holiday ad campaign, and this year's theme, Gather Round, which celebrates all the ways we choose to spend time with family and friends during the season and make it easy to do so. And obviously, while Toys is important all year long, it rises to a whole new level in the holidays as we typically see half of our annual Toy sales in the fourth quarter. This year, given the opportunity I outlined earlier, we've really upped our game. In 500 stores, we've added more space for toys; and in more than 100 locations, we've completely remodeled that section of the store. Across all of our stores, we've set up new displays and deepened our inventory, adding more than 2,500 new and exclusive toys for the season, doubling the newness we introduced a year ago. In addition, we've planned for 25,000 hours of family-friendly events in our stores, and we've gone all out with this year's kids gifting catalog. At nearly 90 pages, kids of all ages will be able to find at least one must-have gift and likely many more. This year, to make the process even easier, we've added digital capabilities that simplify shopping the catalog. Using our Target app, you can simply scan any of the pages in the catalog and instantly add any of the items from the page into your shopping cart or wish list, easy. Beyond Toys, we're featuring more than 30 curated grab-and-go gifting displays in our store this season. These displays feature more than 1,400 mostly exclusive items, most at prices under $15, ranging from pops of color in cold weather accessories to everything you need to create a cozy winter escape. We'll also feature this assortment on our gifting hub on target.com, which features interactive menus to make it very easy to find the perfect gift for everyone on your list. And again, based on last year's success, we're bringing back our Seasonal Wondershop again this year. This winter wonderland features unique items to trim the tree, luxe gift wrapping supplies, and sweet indulgences in Food. In select stores this year, our Wondershop includes a personalized gifting station, offering guests the opportunity to create a truly unique gift for under $20 by custom-printing a recipient's name or initials on any item in a unique assortment of stockings, ornaments, and gift sets. Of course, throughout the season, our guests will find more than 20 new owned and exclusive brands that we've launched over the last 2 years. This will be the first holiday season in which we feature our new Umbro, Universal Thread, Prologue, Wild Fable, and Original Use brands in Apparel; our Opalhouse and Made By Design brands in Home; as well as Heyday in Electronics. So it's clear we have a lot more in store for the holidays, but guests are focused on more than the assortment at this time of the year. Everyone loves a deal, and we are more than ready to earn some of that love. After all, Black Friday is only a few days away, and we've got a killer lineup of must-have items and prices. But a key part of feeling good about a deal is also enjoying the experience. That's why we're focused on providing ease as well as excitement for our guests this Black Friday. Once again, this year, we're giving our REDcard holders early access to many of our Black Friday deals, and target.com guests will be able to shop our Black Friday deals on Thanksgiving morning. Beyond having items just shipped to their homes, online guests have the option to order items for pickup and Drive-Up as well. And of course, this holiday season will be the first one featuring free 2-day shipping with no minimum order and personal shopping with Shipt. In our stores, which open at 5 p.m. on Thanksgiving day, we'll position team members in the busiest areas of the stores equipped with our skip-the-line technology to allow guests to pay for their items anywhere on the sales floor. We've been testing this capability since earlier in the year, and we have rolled it out across the chain in time for the holiday season. But Black Friday is just the beginning. We'll be offering great deals throughout the season, including our popular Weekend Deals and Cartwheel Daily Deals. But let's not forget Cyber Week. Once again, on Cyber Monday, we'll offer 15% off the majority of our assortment. We'll follow that blockbuster offer with great deals all week, including daily offers on Apparel, Home items, personal care, Beauty, and Electronics. And finally, as if the arrival of a package from Target isn't enough, we've recently rolled out new shipping boxes on target.com. These boxes are unmistakably Target and feature our iconic bull's-eye mascot. This is just one small way we're focused on making the everyday special for our guests throughout the holiday season and beyond. So I want to thank the team for everything they've done to prepare for this moment. To say it takes ability to pull off the holiday season is an understatement. It requires close coordination and alignment across all of our teams, including merchandising, marketing, stores, supply chain, and technology. That's just the beginning of the list. But it's work we love during our favorite time of year, a time when everything comes together in service of our guests. And now we feel ready and can't wait to see how we deliver the holiday season. With that, I'll turn it over to Cathy, who'll provide more detail on our third quarter financial performance and outlook for the rest of the year. Cathy?

Thanks, Mark. Our third quarter performance was right down the middle when compared to our expectations on both the top line and the bottom line. And of course, when you look at our growth compared with last year, you can see that our team continues to deliver really outstanding performance. Third quarter comparable sales grew 5.1%, just above the 4.8% pace we established in the first half of the year. From a channel perspective, comparable sales grew more than 3% in our stores and 49% in our digital channels. This is the strongest digital comp we've ever reported, and it demonstrates the positive impact of everything we're doing to deliver convenience, speed, and reliability regardless of how our guests choose to shop. From a traffic and basket perspective, third quarter comp growth was driven by a traffic increase of 5.3%, offset by a very small decline in average ticket. As we've described in prior quarters, both of these metrics reflect an increasing penetration of smaller, quick, and fill-in trips, which are growing much faster at Target than for the industry overall. This trend reflects the guest response to our work over the last couple of years to enhance convenience and ensure we are priced right every day, which is reinforced by our Target Run and Done marketing campaign. Beyond comparable sales, our total sales growth of 5.7% reflects a new store contribution of about 60 basis points. As Brian mentioned, these stores deliver very high sales productivity, which allows them to make a meaningful contribution to our growth even as overall square footage is down slightly compared with last year. Our third quarter gross margin rate of 28.7% was lower than our expectations. This was the result of higher-than-expected supply chain costs, driven by digital fulfillment and the cost of receiving and processing a larger holiday inventory position compared with a year ago. Our third quarter SG&A expense rate was about flat to last year. This reflects continued investments we're making in our team, specifically hours, training, and wages, which allow our teams to provide new and enhanced experiences in our stores. These investments are being offset by continued cost discipline across the enterprise as we continually work to increase efficiency and eliminate lower-priority and nonvalue-added work. Our depreciation and amortization expense rate was down about 40 basis points from last year, reflecting lower D&A dollars combined with the benefit of 5.6% total revenue growth. Below the operating income line, third quarter interest expense of $115 million was $136 million lower than last year. This decline was driven primarily by early debt retirement costs which we recognized in last year's third quarter. In addition, it reflects a lower ongoing run rate for interest expense this year, driven by last year's debt refinancing and retirement activity. And of course, our effective income tax rate was lower this year, reflecting the ongoing benefit of last year's Federal tax reform, along with the benefit of some discrete items. Altogether, this performance led to GAAP EPS of $1.16, up more than 33% compared with last year; and adjusted EPS of $1.09, up more than 20% from last year. Turning to the balance sheet, our inventory at the end of the third quarter was nearly $1.9 billion higher than a year ago, driven by the factors John highlighted earlier. However, accounts payable were nearly $2 billion higher than a year ago, meaning this entire increase in inventories has been funded by growth in payables. Payables leverage has been a positive story for more than a year now, providing a beneficial tailwind as we invest to transform our business. Beyond investments in inventory, we continue to have ample capacity to fund robust capital investment and return cash to our shareholders. In the third quarter alone, our CapEx was just over $1 billion. We returned more than $300 million in the form of dividends and more than $500 million through share repurchase, all within the limits of our middle A credit ratings. And lastly, our after-tax return on invested capital was 15.8% for the trailing 12 months through the third quarter, up from 13.4% a year ago. As a reminder, this year's ROIC calculation reflects the discrete benefit of last year's Federal tax reform relating to the revaluation of our deferred tax liabilities. Excluding this discrete benefit, after-tax ROIC was 13.9% over the last 12 months. This is about 50 basis points higher than a year ago and demonstrates the impact of all of our initiatives combined with the benefit of a lower ongoing tax rate resulting from the passage of Federal tax reform. Now let's turn to the outlook for the fourth quarter and the implications for our full year financial results. On the comparable sales line, we are expecting fourth quarter growth of around 5%, consistent with what we have delivered year-to-date. On the operating income line, we are looking for a small rate decline compared with last year. This outlook reflects continued rate pressure on the gross margin line, although not to the same degree as we saw in the third quarter. Regarding SG&A and D&A expense rates, we are expecting relative stability compared with last year. This performance supports an expected range for full year adjusted EPS of $5.30 to $5.50 and a GAAP EPS range of $5.41 to $5.61. The expected range for this year's adjusted EPS represents 13% growth at the lower end and 17% at the higher end. And of course, this range is ahead of our expectations going into the year. As we've seen better-than-expected traffic and sales so far this year, our business has delivered better-than-expected bottom line performance even as we continue to make meaningful investments in our transformation. Before I turn it back over to Brian, I want to cover one housekeeping item. Consistent with last year, we plan to issue an update on our financial performance following the holiday season. This year, we have scheduled that update for Thursday, January 10, and we look forward to speaking with many of you after that announcement. And finally, I want to thank you for your time today and your continued engagement in our story. This is an incredibly dynamic time to be in the retail business. As we look across the landscape, it's becoming clear that those of us who have the resources to invest and the ability to adapt quickly are seeing the benefit in our traffic, sales, and financial performance. For us, it's a vivid reminder of the benefit of maintaining a strong balance sheet and sound operations while also maintaining a relentless focus on our guests and their expectations. With that, I'll turn it over to Brian for some final remarks. Brian?

Thanks, Cathy. Before we move to your questions, I want to start by letting you know that we plan to host our 2019 Financial Community Meeting in New York City on Tuesday, March 5. Our Investor Relations team will send out more detailed information in January, but we wanted you to have the date as you plan for next year. So now before we get to your questions, I want to step back and recap our journey since the Target 2017 Financial Community Meeting. At that meeting, we talked about the need to invest both capital and operating margin to transform our business and position Target as a relevant and successful retailer for decades, not months or quarters. We did so with the confidence that we were taking the right long-term steps for our business. And we had the conviction that, over time, our shareholders would look back and appreciate our long-term perspective. So today, as we're entering the fourth quarter of only our second year in this effort, I hope you are already happy with what you're seeing. Based on what we delivered this year, combined with our fourth quarter expectations, we are positioned to deliver our best comparable sales growth in more than a decade and establish a new high for Target's earnings per share. It's great to be in that position in only the second year of this effort, but there's a lot more to do. After all, when we embarked on this effort, we described 2018 as a transition year. As we get ready to move into 2019, we're ready to accelerate and scale beyond that transition period. Next year, we'll be positioned to complete our rollout of Drive-Up and Shipt, remodel and build more exciting stores, and make meaningful progress in our work to modernize our supply chain and radically change the way we replenish our stores. While the supply chain effort will take place behind the scenes, it can deliver a host of important outcomes, enhancing our reliability and reducing costs. Importantly, this effort will free up labor in our stores, providing more time for our team members to serve guests on the sales floor and support all of our different options for digital fulfillment as we continue to drive profitable growth and build even greater loyalty with our guests. So thank you for your time today. And now we'll move on to your questions.

So if we just focus on the quarter, your sales and EPS came in at about the midpoint, but your EBIT margin was below guidance. Seems like it was mostly gross margin, but just hoping that you can elaborate on what was different versus your expectations. And then as you think about the EBIT margin implied for the fourth quarter, I think you said down slightly, Cathy, so it seems to be down a lot less than the third quarter, maybe even up at the high end of the range for the year. So just curious, what is different in the fourth quarter relative to the third quarter?

Why don't I start, and then I'll turn it over to Cathy. I think as we look at our absolute performance in the third quarter, we were right on our expectations. We continue to have another very strong quarter where traffic grew over 5%. We had very strong overall comp performance of 5.1%, an acceleration versus the first half of the year. We delivered digital growth of 49%, our strongest growth rate ever. And we did grow EPS by over 20% while growing market share in every one of our major categories. So if I look at our performance in the quarter, we're executing versus the plan we laid out at the beginning of the year. We're seeing a very strong response to our store remodels. Our new small formats are performing very well in each and every market. We continue to drive very strong performance with our new own brands. And the investments we're making in our team are driving exceptional responses from the guest. So as we look at our performance in the quarter, we're right where we expected to be and we're set up well for a very strong holiday season. Cathy?

Yes. So Seth, we anticipate a slight decline in rates during the fourth quarter. Initially, we expect a 5% comparable sales growth, which is our starting point. There will be a mild decrease in rates for the quarter. As you mentioned, we do expect ongoing pressure on gross margins, but not as severely as in Q3. The primary difference is that while we still anticipate strong sales, we are already aware of the product mix we will encounter, similar to last year's fourth quarter. We expect robust digital sales, but since we witnessed strong digital sales in the previous year's fourth quarter, the year-over-year changes will be less pronounced. Finally, we've received and moved a considerable amount of inventory in the third quarter to prepare for the fourth quarter, so we anticipate those costs will not be as high.

Okay, that's helpful. And then just, Brian, you highlighted a number of positives, particularly on the sales line, and there are clearly costs to achieve that, right, and drive that higher share that you're seeing. So can you just help us better understand some of the initiatives to help offset those cost pressures that you alluded to earlier? I'm not sure if those are already in play, if they're already happening, but just help us better understand when that can have a more meaningful impact and support that profitable earnings growth that you were talking about earlier.

As I mentioned in my earlier comments, we're in the very early stages of the transformation of our supply chain and replenishment systems, very early stages of testing automation and improving overall processes. Those will take place over time. We've also rolled out a number of new fulfillment options. And while we know that throughout the year, shipping to home is very important to our guest, as we continue to build awareness around other fulfillment options: Order online, pick up in-store; our new Drive-Up capabilities in almost 1,000 locations; our Restock program; as well as our membership program through Shipt, those are going to be very important components that help to shape margins over time. So we're in the very, very early stages, both from a supply chain standpoint, the transformation of store replenishment, but also in building awareness of the full suite of fulfillment options that we now have at Target. So those are going to take place over the next few years. We've been very consistent in saying we're in the very early stages. But those benefits are in front of us, and we expect to see those impact our business in a profitable way over the next 2 to 3 years.

Brian, you mentioned several fulfillment initiatives and pointed out the strong performance of Shipt and Drive-Up. I would like to know how frequently consumers are opting for Drive-Up or Shipt, considering you mentioned that Drive-Up is incremental. Additionally, can you share how many of these users are new customers versus existing ones? Are people who typically make 12 trips to Target in a year now making a 13th or 14th trip, or are they making even more trips, like a 16th or 17th, because of their use of Shipt?

Matt, it's something that we're looking at as we sit here today, but we're in the very early stages. Again, it was only 12 months ago, we had Drive-Up in 50 locations. We've been rolling that out across the country over the course of this year. We've rapidly expanded Shipt to over 200 markets, but we're still in the very early stages. So we're still building awareness. We literally just started our advertising campaign to talk to our guest, to talk to the consumer about this new suite of fulfillment options. So those are the metrics we'll be looking at over time, and they will continue to contribute to our digital growth. But it's still very, very early. And we expect to build awareness during the holiday season and throughout 2019.

Matt, I'd like to add to that. John mentioned in the prepared remarks that we're observing two positive outcomes from our Drive-Up and Shipt efforts. First, we're seeing additional guests making extra trips, as you inquired, and we will keep tracking that. Secondly, we're noticing a shift where customers are opting for what used to be a 2-day free delivery to coming to our stores because of their convenient locations. They can pull into our parking lot, and we'll deliver their order to their car in under 2 minutes. Both of these trends are encouraging as we consider the long-term economics.

But Matt, we'll be in a much better position 12 months from now to really understand how it's shaping guest behavior, the incrementality, and how it drives additional trips. We're still in the very early stages. But as Cathy just referenced, the early indicators are quite positive.

Perfect. And then if I can have one follow-up. Just on SG&A, clearly, you're still making a lot of investments, but you're starting to lap a lot of investments, or an acceleration in investments that you're making, and I'm talking specific to wages. As we see comp store sales remain in pretty strong territory, especially given your very strong traffic, is it possible that as we get into early 2019, that we could start to see a little bit more leverage from some of the strength in comps if it stays?

Yes. So as you said, we're continuing to invest. We think having the best team in retail is really important, so we'll keep making those investments on our path to $15 by 2020, as we said. But what you saw with us being essentially flat this quarter is that we are starting to find some of those offsets. And to your point, we'll continue. We think a lot of those benefits of removing replenishment out of the backs of our stores and back upstream and automating them will help to continue to offset some of those costs.

But Matt, those investments that we've been making in our team are clearly one of the big drivers behind the comp store increases we're seeing in our stores, the traffic we're seeing both from a store and a digital standpoint. The team members, first and foremost, are the great ambassadors of our brand. They're helping us drive this performance and certainly contributing to the market share gains we're seeing across all of our categories.

Could we just start with the gross margin? Could you just provide a bit more color on the gross margin performance this quarter? Cathy, you did mention that it was a bit disappointing. What was the impact of digital fulfillment, mix? How much of an impact was the growth in inventory? And just any color there, I think, would be helpful.

Yes, as we mentioned, the results were slightly below our expectations, primarily due to two factors: supply chain costs and the significant growth in digital sales, which increased by 49%, exceeding our projections. This has added pressure on our margins. Additionally, the timing and size of our inventory receipts related to the early Black Friday and Thanksgiving schedules impacted our operations, resulting in a larger volume of inventory being managed in the third quarter, which is reflected on our balance sheet. The gross margin pressures primarily stem from these two issues. However, we are partially mitigating them through our merchandising initiatives and the cost savings from goods sold that we've been focusing on throughout the year, which are quite significant. While we are seeing some offsets, they are not enough to meet our needs.

Okay. And then Brian, just a question for you. As you think about 2019, and obviously, it's early, but you sound positive about the opportunity to deliver profitable growth. Are you implying stable EBIT margins with this? And can you talk a bit more just about how you're thinking about balancing investment in the business with that goal? I mean, if you think about 2018, it was a bit harder to deliver EBIT growth despite what was very good comp growth. So what changes next year?

Well, Ed, we're not going to give 2019 guidance today. But we are very excited about what's upcoming in 2019 and 2020. Based on the response we've seen to store remodels, and next year, you can expect us to remodel a similar number of stores. We'll continue to open up highly productive small-format stores. Mark and the team have some exciting new owned brand introductions. We'll continue to scale and build awareness around our fulfillment portfolio, which makes Target the easiest place to shop in America. So as we continue to build awareness around our new fulfillment options, begin to scale, more remodels, moving into new catchments with new small formats, the elevation of our brand portfolio, we're very excited about 2019 and beyond. And as I've said many times now, we're still in the very early stages of this journey. And while we feel great about the progress we've made in 2018, we're certainly ahead of schedule.

Ed, as I think about it, the third quarter was an important leg in this relay race that we're on because of the operational progress we made throughout the course of the business. But now we're at the point where we have our full suite of fulfillment options that we can now really start delighting our guest but really aligning that mission to closest to the store for those high-frequency things when that makes it easier for them to pull into our parking lot and pick up their diapers or their dinner to go or whatever it is. Now with that full suite of fulfillment options, we'll delight our guests, first and foremost; but secondly is we'll start to move those missions closer to the store on those times when it matters, especially in those higher-frequency, lower-margin categories.

Cathy, I wanted to follow up on the gross margin. The expectation was that they would improve in the second half, and you mentioned that it would be stronger in the fourth quarter compared to the third. As we analyze the fourth quarter, considering that the gross margin is down less than it was in the third quarter, could you provide more insight into the assumptions for digital growth in the fourth quarter? What changes should we expect? Is it simply that the pressure from bringing all the inventory into the third quarter will ease in the fourth quarter? Any additional details would be appreciated.

Yes. To your point, we recognized that we had several cost of goods sold initiatives that would begin to take effect in the latter part of this year, and they are performing as we anticipated. The digital strength at 49% this quarter, following last year's 24%, marks a significant shift. This is contributing to the pressure you are seeing in Q3. As we transition to Q4, we achieved a 29% digital comp last year in the fourth quarter, and we expect to maintain strong digital growth as anticipated. With the full range of fulfillment options now available, we believe guests will prefer some of the more convenient choices, including store pickups, which also offer better economics. However, the year-over-year digital growth isn't expected to change as significantly in Q4. More importantly, we will continue to see the merchandise initiatives contributing, with some cost of goods sold improvements forthcoming in the fourth quarter. These are the main changes. Lastly, we effectively moved a substantial amount of inventory in Q3, and we are prepared for the holiday season, encouraging customers to shop frequently at Target. We are looking forward to a successful fourth quarter and holiday period.

And did China tariffs play any role in bringing in more inventory in the third quarter? And maybe you could update us on how you're thinking about tariffs for the fourth quarter and for next year.

Yes. Let me start, Robbie. We clearly were planning well ahead for a very strong fourth quarter. We wanted to make sure we had the inventory in our system to meet the very strong demand we're anticipating for the fourth quarter. And there's really no update on the overall tariff front. We continue to watch it each and every day, as I know you do. And we're looking at what levers we can pull to make sure we minimize the impact for our guest. So we'll watch it very carefully. Obviously, it's a very fluid topic right now. But our focus is on executing in the fourth quarter. And we've got the inventory and the plans in place to make sure this is a very strong fourth quarter for Target.

Brian, a couple of times in your initial discussion and then even in Q&A, you're talking about the very early stages of these investments that the consumer is enjoying with choices, with merchandising, delivery choices, etc. But I guess, if you look at the history of retail, oftentimes, this high level of investment is made when there are weaker major players that you can sort of finish off and enjoy a better margin over a longer period of time. How do you think about that long-term aspect of the spending curve, given the capabilities and the competition between major players, including yourself?

Well, in some ways, you've answered the question for me. We certainly have been talking for several years now about the opportunities that are in the market as many of our competitors shrink or liquidate and go out of business. And we think there's sizable market share opportunities as we continue to see the rationalization of the retail landscape. But the investments we're making are still in the very early stages. While it feels like we've been talking for years about remodeling stores, the fact of the matter is, over the last couple of years, we've remodeled just over 400 stores. We've got many, many more stores that we're going to touch over the next couple of years. We're excited about small format, but we've got a portfolio of new catchments that we'll be entering over the next couple of years. The work on own brands has been very well-received by the guest, but those brands are only going to build greater awareness over the next few years. And importantly, from a fulfillment standpoint, while we've been carefully testing and building platforms and capabilities, it's really just now that we're starting to extend these fulfillment options at scale. So that's going to build over the next couple of years. So as we go into 2019 and 2020, we'll have remodeled even more stores. And we know, as we remodel stores, we see a very positive lift. So stores are driving additional footsteps each and every week. It's helping us capture market share in those neighborhoods. Our small-format stores are incredibly productive right now and are being incredibly well received by the guest. So when we combine the work we're doing in-store with the progress we're making from a fulfillment standpoint to meet the needs of the guest, no matter how they want to shop, and make sure that our stores are at the center of that component, we believe there's opportunities for further market share gains; to continue to drive very strong traffic and comp store sales; and to scale these initiatives, which, over time, will reduce our cost and continue to make Target the easiest place to shop in America. So we're in the very early stages. And we'll be at a higher level of scale in 2019 and build off of that. But if this was a football game, since we're in the season, we're still in the first quarter. But I like the points that we're putting on the board.

I guess to continue that, good luck in the all-important drive starting...

Thank you.

Thank you.

I know that on the second quarter call, you talked about being light on inventory. Obviously, ended in a different inventory position in the third quarter. Were you short of inventory intra-quarter in the third quarter? And do you think that impacted sales? And then second, you've talked a lot about how some of these urban stores are helping you reach a new consumer. Can you give us some color on the profitability over trends you're seeing on some of these locations?

Maybe I'll start, if it's okay, Ed, with the new small formats. And then John, maybe, can add into the inventory question. So on small formats, yes, first off, we really like that we're able to access guests that haven't had access to Target in the past. And so that has been terrific. We continue to like what we're seeing out of the small stores. They have great sales productivity, as we referenced in the call earlier. And we do see really good returns. So we measure them against the same IRRs and same hurdle rates we do all of our investments, and they have really good returns. So we'll continue to see that. You'll see us continue to open new small formats.

On inventory, we have felt good about inventory really the whole year long about where we've been on inventory. There have been some businesses we've chased into, like Toys, we have aggressively chased into; and Baby, which have the result of what's going on in the marketplace there. But I wouldn't describe our inventory ever as light. I think we were well positioned at the end of the second quarter. We feel really good about our position right now. We knew we would peak inventories relatively early, given when Black Friday falls this year. And of course, you saw that on our third quarter balance sheet. But overall, we feel really good about where we've been positioned on inventory throughout the year.

And if we go back to the new small formats, I think it's important to point out, this is allowing us to reach a guest that, in the past, we hadn't been able to serve. So when you think about the recent quarter and approximately 60 bps of revenue contributed by these new small formats, that's largely incremental. These are neighborhoods and catchments where we haven't been participating before. It's a guest that wasn't able to shop with Target on a regular basis. So not only are they already contributing to our revenue, it's opening up a door for a new guest to shop at Target. And the reaction, as Cathy's referenced, has been very positive. We're seeing incredible productivity out of these stores, and we're reaching a guest in neighborhoods where we've never competed before.

I just want to revisit the gross margin briefly. The fulfillment cost pressures from digital in the third quarter were likely a bit higher than what you experienced sequentially, or in the third quarter, which I believe was around 60 basis points. Is it reasonable to assume it was more than that?

Peter, I believe you are referring to the second quarter. Regarding the gross margin for the third quarter, it was lower than we expected. The main factor contributing to this was the supply chain costs associated with digital fulfillment needed to support the 49% comp. Additionally, the costs to receive and process inventory ahead of the holiday also played a significant role. I hope this addresses your inquiry.

I might add, we've circled around this a couple of times. We did move a lot of inventory in the second quarter, and we did it at a higher cost. You guys all know there's transportation pressure out there. Our first and foremost objective as it related to transportation was ensuring that we secure the supply we would need to move our goods. And so we did that, and we will find ways to offset that incremental cost through other ways as we go forward. But we're moving a lot of inventory, and it was at a higher rate than we paid last year. So both of those factors applied to what Cathy's talking about.

That's helpful. And I guess, as we look to the fourth quarter. Again, I'm sorry to stick with the gross margin, but I guess the expectation in the fourth quarter for your gross margin, is it safe to say it's similar to what you saw in the first half of the year? I think it was down in the around 20 basis point range. I mean, is that the level or the magnitude of improvement you're expecting in the fourth quarter sequentially?

Yes, I don't think we'll go into specifics about our expectations for the fourth quarter. What we stated is that we will experience some continued pressure, but it will not be as significant as what we faced in the third quarter.

Okay, that's fair. Just last question, Cathy, just in terms of the tax rate, I know it's dynamic, but maybe what your range of assumptions are for the fourth quarter in terms of tax rate.

I would consider a more normalized approach given the new federal tax reform as a more accurate perspective. Looking at the third quarter, our reported tax rate was 13.6%, which is exceptional. However, if we exclude the adjustment made to the previous deferreds, we would have been in the vicinity of around 19%. So, as you think about a more typical rate, that's a better way to frame it.

With that, operator, we've got time for one last question.

Wow, just getting in there on the bell. I'd love to talk about two things. Basically, the loyalty programs, particularly Shipt, any color there in terms of how much of the digital growth it's driving or how many members you're up to now? And I think you mentioned the number of markets. And also REDcard, it just seems like the penetration there has been sort of stable. Is there anything that you're considering to maybe reinvigorate that? Tell us how some of the tests are going on REDcard, that would be really helpful.

Yes. So Greg, maybe I'll start and then Brian and John can pile on, too. For REDcard, as you said, penetration is about stable. As we've said in the past, we know that this is a great program. They're our highest, most engaged guests, our most loyal guests. So we absolutely want to continue to grow that. You're seeing us do more exclusives, you'll see it this year with the fourth quarter like we did last year, and really make those a special relationship with our guest. However, we also know that doesn't speak to everyone. And so as you know, we've been testing a loyalty program in Dallas, we call it Target Red, which is a non-tender-based program to really have everyone be a part of the relationship with Target. So we're excited about where that's going. We'll continue to test that this next year. But all of the indications are very, very positive. We're seeing really good sign-ups and engagement with the Red program.

John, you want to wrap this up with an update on Shipt?

Yes. We are very excited and proud of how the Shipt team has scaled throughout this year. We are now operating in over 250 markets in a short timeframe. We continue to see a strong response from consumers. One key metric that excites me is that in mature markets, those that have been open for over a year, we are still experiencing triple-digit growth in sales and GMV. Guests are increasingly engaging, even in the markets where we have been established for a while. Additionally, regarding your question about the impact on digital growth, it is relatively modest because we are only reporting our revenue, which is quite small compared to the GMV sales processed through Shipt. Nonetheless, we are very enthusiastic about Shipt and the opportunity to test Shipt deliveries on target.com and scale that in the coming year.

If I could, I love just a follow-up on that. Just given the strength in traffic, have you guys been thinking about ways to monetize that traffic with digital advertising, in particular, just given what Kroger's trying to move in that direction; Amazon, certainly, with $7 billion of advertising revenue. How are you guys thinking about using all that data and traffic that you have and maybe outside the traditional avenues?

Greg, it's something we're thinking about each and every day. And it probably leads us to wrap up today and invite all of you to join us in the spring for our updated Financial Community Day. So it's something that we're very focused on, continuing to build loyalty with our guest. But for today, I think, operator, we're going to wrap up our third quarter call and invite everyone to join us again in the spring. So thank you.