Analysis: Target’s top issue is the quality of its stores

At headline level, Target's results are a lot better than feared. The pace at which total and comparable sales are declining has eased over the prior quarter, and the company helped itself to a 7.7% increase in net earnings. Against a tumultuous retail backdrop, this is a not so terrible performance.
 
That said, the better than expected numbers are not all down to operational prowess on Target's part. The milder fall in total sales is down to the company lapping weak comparatives from the prior year when, following the sale to CVS, the removal of pharmacy sales dragged down performance. On the profit front, the uplift in earnings is primarily a function of reduced interest expense, which fell by 65.3% over the prior year.
 
When these points are factored in, the fault lines in Target's business model become more apparent. Comparable sales continue to slide, gross margin is down by 2.5%, and traffic and conversion at stores both slipped on the prior year. While we would not suggest that Target is as broken as many other retail businesses, we do believe that there are many aspects of the operation that are sub-par.
 
The foremost issue is the quality of Target's stores. These are far too functional, change too infrequently, and offer very little in the way of inspiration. Such a position means that Target struggles to pull in customers - something our data shows is getting worse over time, especially among younger millennial consumers.
 
Fortunately for Target, the tedious nature of stores does not extend to its non-food ranges. Target's selection is, both in our view and when rated by consumers, compelling, of reasonable quality, and excellent value for money. The high proportion of own-brand across areas like home also helps to differentiate the company from retail rivals. The issue is that more and more consumers are discovering and buying this range online rather than in stores - something that is exacerbated by poor availability and frequent out-of-stocks in shops.
 
This trend is evident in the numbers. This quarter, Target's total store sales were down 1.9% on the prior year; online sales rose by 21.5%. The comparable numbers show a similar picture with Target's stores contributing -2.2% to the overall decline. The two issues flowing from this are online sales are margin dilutive because of the cost of fulfillment, and shoppers who use the online channel tend to buy less frequently and are more disciplined in their approach and less likely to succumb to impulse buying.
 
So the key challenge for Target is to get more people into its stores and to sweat its real estate much harder. In our view, this will not only help sales but will also ultimately aid profitability. 
 
Fortunately, Target is now more focused on shops and has announced a comprehensive store remodeling program. From what we can see in the initial plans, the proposed changes look sensible and should give Target more of a destination status. However, we also believe that Target should not wait for the refurbishments to elevate the store experience; there is much more it can do in the here-and-now to create excitement and interest. An example is the Victoria Beckham range which launched during this quarter. The range itself was a success, the execution in most Target stores was lackluster and dull. It is the age-old tale of Target not showcasing its wares with enough pizzazz. 
 
As much as we believe Target will struggle over the remainder of this fiscal year, we also believe that its difficulties will be mild compared to many other players. Certainly, there are challenges on grocery, as we have discussed in previous notes, and these may worsen as margins are crimped from discounting in a more competitive market. However, the offer remains sound, and this alone should help to take the edge off the declines.
 
Longer term, the store refurbishments and general improvements to the business should yield results. While Target has been criticized for pulling back on some of its more futuristic initiatives, we believe that it is right to channel investment into getting the basics right. At this time, Target needs to fix its shaky foundation, not build ivory towers on top of it.
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