Margins Are Getting Punished
Digital sales have lower gross margin than sales from physical stores. I expected to see total gross margins decline due to the encroachment of digital sales. They were not as bad as I had expected; gross margin was 26.2%, slightly down from 26.6% in the year earlier period. Operating income margins were a different story. Operating income margins declined from 6.5% in the year earlier period to 5.1% this quarter. The main culprit was SG&A expense which ticked up from 18.5% to 17.5% last year. On a dollar basis operating income plunged 15% Y/Y despite the rise in revenue.
After the GOP tax cut the company raised salaries for several of its lower-paid workers. This drove up operating expenses. Target is also making major investments in physical stores. It is redesigning more than 1,000 stores across the country over the next three years, including over 300 this year. Physical stores are part-in-parcel of Target’s digital strategy. The company has stores in prime downtown locations across the country, making it convenient for customers to pick up online purchases. The capital expenditures will likely keep depreciation expense (included in EBIT) at heightened levels over the next three years.
In Q3 2017 Target acquired Grand Junction which connects third-party carriers and provides same-day delivery service. Target can now fulfill digital orders in-store and make outbound deliveries as well. This service could increase sales and potentially amplify brand loyalty. The company is also running a pilot for Driver Up, which delivers goods to customers in the parking so they do not have to leave their cars. Each of these programs won wave reviews from customers. Target is “paying it forward,” which is exactly what it should be doing. However, it comes at a cost. I expect operating income and operating income margins to continue to compress into the foreseeable future. This will likely be a drag earnings for some time.
Conclusion
Management expects Q1 revenue growth in the single-digits and a 60 basis point to 80 basis point decline in operating income margins. Target is running in quicksand. I rate TGT a hold.
