Will Target Corporation's New Financial Model Succeed?

In the following segment from Industry Focus: Consumer Goods, our hosts play a game of "fact or fluff" to debate the financial strategy struggling big-box retailer Target Corporation (TGT 1.03%) put forward in its most recent earnings conference call.

By giving up $1 billion in annual profits, the company hopes to invest in stores, create new private labels, boost digital sales, and generally become more competitive on price. Tune in to find out why senior Fool.com contributor Asit Sharma believes the plan has significant shortcomings.

Vincent Shen: The idea here overall is that 2016 was just not a good year for the company. Their sales decreased about 6%. Going forward, they are expecting declining comps. If you look at the earnings call, the transcript from the management team, you'll see that the various executives who speak, including the CEO, spent far less time talking about the specific numbers for the year than you would usually expect, a lot more time talking about how they're going to be seeing a lot of weakness, a lot of pressure on their margins, and on their operating numbers, but how this is, long-term, a forward-thinking look because they need to invest in the seismic change they talk about in the retail environment. With these next two companies we talk about, we want to do a bit of a sniff test, or, Asit, the way you put it was "fact or fluff." Can you set us up in terms of the quote you wanted to look at, and also the main question that we're looking at for the listeners and investors?

Asit Sharma: For Target, you look at fact or fluff, they are in a tight business situation, almost every brick-and-mortar retailer has felt the impact of Amazon.com over the last year. Vince, when you and I had our year-end special, we talked about this at the very end of the show when we were looking at our predictive trends for 2016. We talked about the pressure that Amazon was going to put on companies like Kohl's and Target, and all of their siblings. This has come to pass. This conference call that you mentioned, where Target had owned up to that 6% decline in sales, was a really interesting call, as you mentioned, because management essentially said, "Hey, we're going to change our financial model, we're going to adjust to the future by taking a hit on our earnings. We're going to invest in our supply chain to move items quicker to our stores. We'll engage in a little delivery of furniture. We will introduce more private brands." I know when you and I were talking before the show, there is a private brand called Cat & Jack, which grew to be a $1 billion brand almost overnight within a year. If you think about $1 billion, it sounds like a lot of money, but Target's sales last year were $69.5 billion. It's going to need a lot of this type of onion springs sprouting out of the ground to make an impact on their profit and loss statement.

To give you the fluff or fact quote, this is from their CFO Cathy Smith, she said on the call on the EBIT line, so, earnings before interest and taxes, on the earnings line, "This year, we are planning to generate about $1 billion less than last year. This reduction reflects investments in enhanced store service, the continued shift into digital, support to develop, launch and market new exclusive brands, gross margin investment to ensure we are competitively priced, and additional investments in existing stores." So, this idea of fact or fluff, I'm going to take the first stab at this and I'm going to say this is fluff. Here's my reason. One of the things that was repeated on that call was that Target is going to take gross margin investment. What that means is, the company is going to start competitively pricing so it doesn't lose more businesses. To me, that's always a little bit of a dangerous signal. I do acknowledge all these other initiatives that we've mentioned, including more penetration into digital channels. I think last year, Target sold about 14% more digital goods than it had in the prior two years. However, a short term what we call taking of price, where you lower your prices to compete, that short-term gambit by the company often becomes a long-term expectation on the part of the customer. This is my concern with Target. It doesn't solve their fundamental problem of, how do you compete with the likes of Amazon.com? What do you think, Vince? Fact or fluff?

Shen: I'm torn. I agree that ultimately, with the results that were presented, and the way the stock traded afterwards, a big decline -- the stock, I will add, is down something like 30% so far in 2017. That might be slightly off, but they're definitely struggling, and they're definitely looking for ways to reinvigorate their business. Investors in this company have been on a roller coaster ride the past few years. You think about, I think it was 2014 when they exited their Canadian business and took a huge loss on that, 2015 things seemed to have stabilized, and now in 2016, 6% decline in sales. Now the outlook is for ongoing declines in their comparable sales. So, that volatility, that shift ... I can commend management, to an extent, for the fact that they're trying to take this longer-term outlook, they make these longer-term investments in their business and try to tell these Wall Street analysts on the call, "Listen, we need a little bit of time for these investments and these initiatives to pay off, to see that return on investment." But all in all, I think, with a more critical eye, I will have to agree with you, more fluff.