Looking at Target, Sales Grew When Profits Declined and Earnings per Share Maintained
Many indicators point to economic growth, particularly in the manufacturing and service sectors. In recent articles, vehicle sales and its reverberations into other industries have been identified as a potential explanation for the positive numbers. These indicators are, nonetheless, joined by a long awaited improvement in employment data.
Yet, Standard & Poors reported on February 3rd that earnings for more than half of the firms reporting so far this season, show an earnings growth rate of only 7.53%. This is a decline from the double digit growth rates previously experienced and expected through 2013. Reasons provided include global macroeconomic concerns with Europe and Emerging Markets being first, through to the consequent destocking in supply chains.
Looking at the performance of large general merchandising retailers, we see that the last four sequential quarters have been hard. On February 21st, Walmart reported its Q4 2011 numbers, which showed a 6.5% increase in sales y/y and an increase in net income of 3.38% y/y. This contrasts with Target, which recently reported, showing a 5% decrease in net income and Kohls also recently reporting an 8% decline. Kohls also gave disappointing guidance for next quarter. Costco will be reporting its earnings on February 29th.
What is particularly significant about the performance of these companies is a trend of flat to declining sales and profits have been developing sequentially quarter over quarter. With Target and Kohls, the trend was not broken with Q4 results, as occured with Walmart. Aside from these companies confronting competition for the consumer's tightly held dollar, their operational efficiency and innovation becomes acutely noticeable in this environment.
Target reported their earnings for Q4 2011 on February 23rd. They reported sales of $21.29B versus a year earlier Q4 number of $20.66B. This results in a year/year Q4 sales gain of 3.3%. However, Target’s profit dropped by 5% for the same period. Despite this, their stock gained substantially due to their upbeat and positive forecast for better days.
Add to Target’s Q4 y/y sales and profit problem their flat to declining sales over quarters 1 through 3, and one must ask questions. That being, how tough is this business environment? Essentially, the question is how tough is the macroeconomic setting for Target, and what are they doing to operationally adjust.
The table to the right is a 5 quarter review for Target based on their income statement. Quarters 1 through 3 show declining to flat sales. These quarters also show declining to flat EBITDA and earnings that were mostly down—especially in view of Q4 2010 results. The table also shows that for these three quarters, operations costs (SG&A) essentially grew….at rates faster than sales and EBITDA.
Target’s Data Reveals a Problem in Metrics Effecting Profit Growth
A good measure of a store’s performance is one that Walmart uses and comments upon in its SEC filings. Firstly, is the store controlling operating expenses such that net sales exceed operating expenses. Secondly, is the store growing operating income (EBITDA) faster than net sales. These metrics can give insight into how efficiently a store is operating and how it is leveraging its efficiencies to grow operating income.
In Target’s case, while sales were falling, they didn’t succeed very well in either making SG&A expenses fall at a faster rate than sales, as in Q1, or they allowed SG&A to grow at a rate faster than sales. This demonstrates a quarter over quarter trend in growing operational costs against a challenging sales environment.
This trend probably explains why their sales for Q4 2011 were 3.3% higher than Q4 2010, but their net profit was down 5%. Between the two quarters, sales weren’t the only thing that was higher. Cost of goods sold (COGS) increased 3.7%---higher than the growth rate of sales. Importantly is that operational costs (SG&A) increased 4.2%---also higher than the growth of sales.
Target described its challenging sales environment in its earnings conference call. They said it was one marked by inflation in the cost of goods sold (COGS). They said that they controlled this inflation by managing costs and raising retail prices to maintain their gross margin. Of note is that management said that customers purchased fewer units in categories that saw retail price increases.
Basically, customer traffic in their stores declined and with it the number of sales transactions. To make up the lost volume, retail prices increased, the average purchase value increased, while the volume purchased decreased.
The table to the left shows the nature of Target’s transactions. Quarter over quarter, you can see slowing in the number of transactions and increasing prices. With SG&A being up 4.2% q/q, one can surmise that Target didn’t demonstrate very much flexibility in adjusting its operational expenses to the decline in the volume of merchandise moved.
Looking at the units/purchase in the table, in 2010 Target saw an increase of 3.6% units, whereas in 2011, the increase was only .90%. However, year over year inventory increased by 4.2%. This suggests that Target didn’t respond very efficiently to declining volume sales and adjust inventory to reflect the declining volume.
Target’s Approach to Conditions Can be Expensive
What’s perhaps more is that in the competitive retail environment, to raise prices to support margins amid declining volume, the consumer has to justify the price increases in their mind. This means that any company engaged in such a dynamic must add to the aesthetic, promotional and service experience. Such value additions naturally result in increasing operational costs (SG&A).
This business structure has an ultimate flaw demonstrated by other large retail chains. There comes a point where diminishing returns are realized by increasing prices while also enhancing the shopping experience, all to compensate for volume losses. That point of diminishing returns can warn of itself when you see persistently higher rates of SG&A growth, with increasing pricing. Certainly the point warns of itself when in Q4 2011 a company makes more money than in Q4 2010, but profits fall 5%.
Where profit fell 5% over the two quarters, earnings per share were $1.45 in Q4 2010 and $1.45 in Q4 2011. To explain this, Target’s reduced profit was spread over fewer shares, which balanced out the loss to show no decline in earnings. In Q4 2010, outstanding shares were at 708 million, in Q4 2011 the outstanding shares reduced to 669 million---a reduction of some 5.8%.
Target’s challenges show both the condition of the U.S. consumer, and methods by which companies respond to conditions. Target is a good company and one to watch. They are innovating by expanding into more product offerings such as grocery. This “PFresh” remodeling program currently includes 900 stores with an expected addition of 230 in 2012. The addition of groceries is leading Target’s same store sales advances with double digit gains.
Target is also introducing a smaller store to be oriented toward more of a neighborhood type of market, these stores are called CityTarget. With this, Target will be expanding into Canada and stores are planned to open in 2013.
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