Target's Using the Data Breach to Hide Real Issues

What a difference a quarter can make. I wrote an article entitled "Why Target's EPS May End the Year Down 32%" just before the breach was announced. Here's an excerpt from that post:

The tea leaves are turning from black to red as Target fights for a hail Mary pass in this fourth and final quarter. Sales aren't growing as anticipated, even with new stores opening both in the U.S. and Canada. Expansion efforts are testing liquidity options, transaction volume is down, and the company is raising capital to pay for dividends and capital investments through the sale of receivables. This may be the beginning of a downtrend.

Indeed, nothing has changed from a business perspective. That is, the same issues that existed before the breach still exist after the breach: the key issue is declining same-store sales. In fact, the breach has given management an excuse, a free-pass if you will, for what was shaping up to be a bad year even before the breach occurred.

It also gave investors a reason to expect a decline in traffic; at the very least, investors were having a hard time telling the difference between sales lost from poor business decisions and the breach-effect. Truth is Target (NYSE: TGT  ) can't tell the difference either, and it said as much in its 2013 10-K filing:

The collective interaction of year-over-year changes in the retail calendar (e.g. , the number of days between Thanksgiving and Christmas), combined with the broad array of competitive, consumer behavioral and weather factors makes any quantification of the precise impact of the [d]ata [b]reach on sales infeasible.

Declining same-store sales
Let's examine what was unfolding just before the breach occurred. The stock was trading at ~$62; it was trading down from the mid-$70's following a steep decline in earnings, as you can see from the chart below. In fact, earnings per share began trending down in the beginning of 2013.

TGT EPS Diluted (TTM) Chart

Target EPS diluted (trailing-12 months) data by YCharts

The main reason behind the weakening earnings was a decline in same-store sales, which increased only 0.5% in the first nine months of the year (pre-breach); this compares to a 3.7% increase in the previous year. This performance is directly related to a 1.5% decline in transaction volume, but the company never gives a good reason for why that occurred. The point is, Target was suffering from a drop in transaction volume even before the data breach. Of course it denied that fact in the 10-K:

Prior to our [Dec.] 19...announcement of the [d]ata [b]reach, our U.S. [s]egment fourth quarter comparable sales were positive, followed by meaningfully negative comparable sales results following the announcement.

Perhaps, but if comp sales were positive, it wasn't by much.

Skipping ahead to a post-data-breach world, comparable-store sales continued to slide, primarily due to a drop in transaction volume. But again, volume was already trending negative before the breach. It appears Target lowered selling prices slightly in the fourth quarter, which allowed it to increase transaction volume. But overall comp-store sales still declined by 0.4% for the full year compared to a 2.7% increase in 2012.

What most investors want to know is how many of the effects from the data breach will be long-lasting and detrimental to sales? The company had this to say:

We know our guests' confidence in Target and the broader U.S. payment system has been shaken. We are committed to, and actively engaged in, activities to restore their confidence. We cannot predict the length or extent of any ongoing impact to sales.

In other words, "for as long as we need to use it as an excuse." What Target has told us is that expenses related to the breach are adding up, but there's good news here. In the fourth quarter, the company recorded a $61 million expense related to the breach, but insurance covers $44 million of that expense, leaving the company with a net expense of only $17 million, or $11 million after-tax. Additionally, some portion of the $61 million is an accrual, or estimate, for future expenses, so this works out well for Target in the long run.

So, insurance saved Target, and someone needs to give the financial controller a raise. But the issue remains: Same-store sales are declining like they have been with most large, box-retailers, namely Wal-Mart Stores (NYSE: WMT  ) and Big Lots (NYSE: BIG  ) . Fourth-quarter same-store sales decreased by 0.4% at Wal-Mart and 3% at Big Lots. Neither store had the luxury of a data breach to blame, but only Wal-Mart has found a way to reverse the problem: by increasing the number of smaller-format stores.

In direct response to declining same-store sales, the company announced it would be building 270 to 300 small stores, doubling the initial forecast of 120 to 150 stores. This is key to increasing same-store sales and market share without cannibalizing revenue. Meanwhile, Big Lots is still trying to find a solution.

Takeaway
Trying to find the line between supply and demand can be difficult for a high-end discount retailer in a competitive market. Target was suffering from a drop in transaction volume even before the data breach. And that data breach has given management a headline that can be used to mask the real issue -- a decline in traffic and/or loss of market share.

Had Target's numbers continued to decline into the fourth quarter without a reason, I believe the stock price would have gone much lower. We'll have to wait until next quarter to see if management has found a way to reverse current trends. Of course if they haven't, it'll be the data breach's fault.

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