The Long and Short
Inventory woes hit profits at Target
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After issuing a profit warning in June, Target’s (TGT) fiscal second quarter results came in worse than anticipated, as bloated inventory levels forced management to aggressively “clear” excess merchandise. The actions led to a nearly 90% decline in earnings per share for the quarter. However, management remains confident that the second quarter profit decline is ephemeral as it affirmed full year guidance. The balance sheet remains in order and any earnings hit will not impact leverage enough to warrant a ratings event. The modest spread widening of TGT bonds in the front end of the curve should be viewed as a better buying opportunity.
TGT bond spreads have largely held in since reporting earnings, however the front end of the curve, in particular the 3-year bond, has witnessed some widening (Exhibit 1).
Exhibit 1. TGT Spread Curve (Now vs. Week Prior)
Source: Bloomberg TRACE; APS
Some Bright Spots in Second Quarter Results
The inventory clearance and write-down overshadowed some of the bright spots in TGT’s second quarter results. TGT witnessed comparable same-store-sales growth of 2.6% in the quarter, reflecting 2.7% traffic growth. This was on top of the 8.9% growth posted in the year-ago quarter. TGT also witnessed solid digital growth with digital comparable sales up 9.0% yoy, on top of 9.9% growth in second quarter of 2021. Management noted that digital growth continues to be led by the company’s same-day services, including Order Pickup, Drive Up, and Shipt. These same day services grew nearly 11% in the quarter and were fueled by the Drive Up option, which witnessed mid-teens growth. Product categories that witnessed strength in the quarter included Food & Beverage, Beauty and Household Essentials. Target derives less of its sales from the Food & Beverage category relative to its peer Walmart (WMT – Aa2/AA/AA), which explains why WMT’s inventory reduction in the quarter had less of an impact on margins versus TGT. It is estimated that nearly 50% of WMT’s sales come from the Food & Beverage category versus roughly 20% at TGT. That said, TGT had a higher percentage of discretionary inventory to clear.
Guidance Affirmed
Management noted that while they continue to plan cautiously for the year, they are optimistic about their position heading into the back half of the year. Current trends coupled with aggressive inventory actions, particularly in discretionary categories, support the company’s guidance that was released in June. This includes revenue growth in the low-to-mid-single digit area and an operating margin rate in the 6% range in the back half of the year.
With respect to the top-line guidance, TGT is comfortably in the middle of its target range based on 1H results. Looking at the operating margin, its expectation of 6% is nearly double the 3.3% operating margin witnessed in the first half of 2022. Should TGT hit the 6% operating margin rate in the third quarter, it would exceed third quarter operating margin rates posted pre-pandemic. TGT expects some spillover of inventory actions into the third quarter to the tune of $200 million. By the fourth quarter, TGT will be annualizing some significant cost headwinds which should help the yoy comparison and enable TGT to post an operating margin rate more in line with the fourth quarter rate witnessed last year (6.8%).
Credit Metrics Still in Line with Ratings
TGT ended fiscal 2021 with lease-adjusted leverage below 1.0x, which is roughly a turn lower than its historical leverage rate in the high 1.0x leverage ratio. TGT’s low leverage to start the year has provided them with a significant amount of headroom under the 2.5x leverage threshold for the ratings. We estimate TGT ended the quarter with lease adjusted leverage of 1.8x, which should will decline slightly in the back half of the year as the operating margin rate improves. TGT’s comparable store sales remains in positive territory which bodes well for the credit as the rating agencies believe that TGT’s comparable store sales would need decline in the mid-single digit area for leverage to start moving closer to that 2.5x threshold level. TGT’s management team remains very committed to their current ratings and we would expect that management would pull back on share buybacks if it needed to preserve cash or repay debt to maintain ratings. Management demonstrated its prudent financial policy during the pandemic when it dialed back share repurchases at the height of the pandemic.
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