The Daily Dose: Tough Target

 | May 22, 2014 | 10:30 AM EDT  | Comments
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Don't tell anyone, but I am running on fumes. I think I made a strategic error in putting 190% effort into covering Target's (TGT) bomb of a quarter, leaving me on empty to tackle Best Buy (BBY) and assorted specialty apparel players today. However, I really believe that in light of the state of the now semi-global Target, that level of attention was warranted. The million-dollar question this morning: Did May 21, 2014, represent the bottom in Target shares? Will the stock rally into the holiday season under the premise that freshly lowered guidance is of the kitchen sink sorts, and no efforts by the new/old management team will appear late in the second quarter? First, the setup.

A List of the Bad on Target

• Accounts payable outflow surged to $898 million from $375 million a year earlier. Geeky, but important given the weakening fundamentals at Target.

• Strange comments from interim CEO John Mulligan highlighting business momentum as full-year 2014 earnings guidance was materially reduced.  I would have liked to see a humbler Target, in a way sending a signal to the Street that it truly understands the rocky journey it's about to embark. Instead, we received typical Target -- an outward show of confidence when the situation calls for a different tact. Yet another example of why Target needs reinvention: It needs fresh ideas from executives brought in from outside the company.

• Even on a slight negative 0.3% comparison in the U.S, Target shed 110 basis points of earnings before interest and taxes (EBIT) margin year over year. This is the latest evidence of price investments being made to compete with Wal-Mart's (WMT) accelerated promotional aggression (food, dry groceries) and Amazon's (AMZN) willingness to sell general merchandise without a care for profit margins. Moreover, the pressured margin confirms the challenges in the aisles expressed by countless consumer products companies in the recent round of earnings.

• Canadian operating losses total $1.52 billion to date. Target's disclosure on the problems it's having in Canada is subpar, both in its earnings reports and on its conference calls. Today will be no exception.

Overall, I would be hesitant to unleash an epic high-five at the sight of Target shares seemingly "trading on a discount to the S&P 500 multiple and its own historical average," as some of my colleagues in this business will present in the days and weeks ahead. Target has an entrenched issue with getting traffic into its stores that began before the credit-card breach, meaning margin will be sacrificed to near a guidance range at least. For Target to have a "Buy" stamp from this analyst, I want to see new fixtures , wow merchandise and exciting TV commercials -- all of which has been absent for over a year.  Better reads from my contacts in Canada are paramount, too. Be smart here: Target is hurting, and so is the broader retail sector.

Expanded Comments, Ground Zero in Retail

I wanted to expand on a few comments I made regarding the retail sector Wednesday morning. Here is why Mr. Market is freaking out in the early innings of retail earnings season. Store closures are only preventing gross and operating margins from falling further, they are not leading to the expansion the market priced into the stocks when hearing of massive, new, restructuring plans.

Staples (SPLS) is a an example of a retailer caught in a death spiral -- a brutal quarter where store closures (10 closed; 80 more set to close in the second quarter) did not favorably influence profit margins. Most notably, Staples had weak sales of core office supplies at its stores and commercial businesses, even in the face of stepped-up marketing and promotional support.  

Target will have closed seven stores in the U.S. by summer's end; I believe the company will announce more store closures in the early part of 2015. 

Or how about the teen retailers? I expect Aeropostale (ARO) and Abercrombie & Fitch (ANF) will also have pressured (less so Abercrombie & Fitch) operating margins, despite massive numbers of store closures throughout the country.  American Eagle Outfitters (AEO) had a sorry quarter. In fact, fast-fashion retailers are moving so fast and fashionable this spring (assortments are strong), the cash flow stream at Aeropostale will remain worryingly constrained for the time being.

The big-picture takeaway is if retailers can't boost operating profit margins via store closures, it will only amplify the pressure on their bottom lines brought on by three things. One, increased investments in marketing to combat the online sales trend beast; two, increased investments in tech capabilities (ship from store and the like); three, increased investment in promotions and opening price point items that are still being met with yawns by consumers.

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