Are These the First Signs of a Turnaround at Target Corporation?

Like many retailers, Target (TGT -0.07%) has struggled with lower store traffic and weak comparable sales in the past few years. Shareholders are eagerly awaiting a turnaround, and the first hints of one could be here.

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by senior Fool.com contributor Adam Levine-Weinberg as they discuss the key changes management has in store for shoppers.

And elsewhere in the world of retail, find out why Sears (SHLDQ) is putting its Kenmore appliances on Amazon (AMZN 0.17%) and what Michael Kors (CPRI -2.78%) is hoping to achieve with its recent acquisition of high-end shoe brand Jimmy Choo.

A full transcript follows the video.

This video was recorded on Aug. 1, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, August 1st, and we'll be covering some of the big moves in the consumer and retail world. I'm your host, Vincent Shen, happy to be back in the host chair. Thanks again to Dylan and Sarah for covering last week.

Joining me here at Fool headquarters is senior Fool.com contributor Adam Levine-Weinberg. Thanks for being here, Adam!

Adam Levine-Weinberg: Thanks for having me on the show again!

Shen: Sure thing. We have a lot to cover today. I want to start by treading a little bit of familiar ground, if you will allow me. Dylan and Sarah covered this news briefly on the previous show, and I wanted to get your thoughts on the approximately $1.4 billion deal between Michael Kors and Jimmy Choo. Some background in case any Fools missed this story, this acquisition was announced one week ago. It's an all-cash deal that should close later this year, and it will bring a high-end luxury brand, Jimmy Choo, in-house for Michael Kors, which is more focused on fashion accessories and handbags. What do you think, Adam? This seems to me like, the recent acquisitions at rival fashion house Coach are putting some pressure on Michael Kors' management team to pursue a similar strategy.

Levine-Weinberg: Yeah, I think that's definitely true. There's a budding rivalry now in the fashion space, at least in the United States, between Coach and Michael Kors. And I think Michael Kors sees this as an opportunity to bulk up, get itself a really premier brand in shoes. This will have a variety of potential benefits for them. Some of the bigger ones are, they get a great brand in Jimmy Choo that they think has a lot of growth potential. According to their estimates, they think that Jimmy Choo could eventually become a $1 billion sales brand, which would be slightly more than double its sales today. Then, aside from that, they have a lot of diversification benefits, because Jimmy Choo has more than half of its sales outside of the U.S., whereas Michael Kors has the vast majority of its sales domestically. And also, in terms of product lines, as you mentioned, there is some footwear at Michael Kors, but that's really a very small part of their business, where it's Jimmy Choo's main thing. So you're going to see more diversification within Michael Kors' business lines. It's not going to just be handbags as the dominant thing that they live and die by.

I think that definitely is pretty good for Michael Kors. They've certainly had a lot of trouble in the last two to three years. The problem that they've had is specifically that they diluted their brand. They realized they made a mistake, they had too much distribution, too many Michael Kors bags, and they had discount channels and on sale with deep discounts at places like Macy's and even in Michael Kors' own stores. And it's really hard to get out of that trap, and both Coach and Michael Kors have had this problem. They're trying to fix it, but Coach is really ahead right now. Coach has also done more of this diversification work in terms of buying Stuart Weitzman, which is another shoe brand, a couple years back, and buying Kate Spade, which is a rival handbag maker, just recently.

Shen: Yeah. On the diversification front, I think the Jimmy Choo deal should help,Michael Kors, they mentioned, bring their shoe business to about one-fifth of their top line. Then, something they also really touted in some of the press releases and the discussions of the deal is the fact that for especially the luxury women's shoe segment, faster growth than a lot of the businesses that they're currently in. Otherwise, there have been a few indications from Michael Kors CEO John Idol that this is not their first and only deal, it's probably one of many deals to come. He said during a recent conference call, "Let me first start out by saying our primary objective when we're looking for acquisitions was to create a global fashion luxury group," and it definitely brings to mind, for me, the fashion empire conglomerate that you mentioned from Coach, that they're putting together now that they have a distinct handbag-focused brand, they have their apparel, they have a shoe brand as well within their portfolio. So all of this coming together, and it seems like they're both pursuing a similar strategy of diversifying both geographically with their product lines, trying to create more of this empire kind of feel.

Levine-Weinberg: Yeah, that's certainly the way the model is in Europe. You have a few fashion houses, or collections of brands, and it's a company that will own dozens of top fashion brands. You don't really have that in the U.S., and Coach and Michael Kors are starting to go down that road, but in a small way. I think the potential downside of the deal is, if Michael Kors hasn't really learned its lesson from diluting its brand in the last three years, then you could do a lot of damage. They've said that they want growth. They think the women's shoe market is a growth market. But that was also true of handbags five years ago, and they had a lot of growth, but the growth got them addicted to driving sales higher and higher, they got into discounting when people weren't buying the bags at full price. And if you do that with Jimmy Choo, five years down the road, you could be in the same spot where they are right now with their main brand, where people aren't willing to pay that same premium anymore because it's not seen as being something unique, it's not a status symbol anymore. So, that's definitely a risk for Michael Kors -- can they definitely keep Jimmy Choo seen as a really premier, luxury, high-end brand?

Shen: Yeah. And if they basically avoid making the same mistakes they made previously.

Some other big news we wanted to cover from last week was Amazon earnings. I feel like this usually runs in Dylan's wheelhouse on the Tech show, but we're going to talk about the e-commerce giant's latest results and use them to segue into some related topics. Amazon's stock has been beaten up a little bit since releasing earnings. What did the company report to get a bearish response?

Levine-Weinberg: On the sales front, Amazon is still chugging along. They had good growth last quarter. Revenue was up about 25% year over year. That's really good. Amazon has definitely managed to keep its growth rate steady or even increasing despite being now more than a $100 billion revenue company. That's really rare and extremely impressive. What caused the stock to fall is that their operating income is coming under pressure again. That's definitely an area of some concern for investors, because Amazon, obviously, for many years was barely profitable, it was actually losing money. Investors accepted that because they were growing. It seems, a couple of years ago, that with the growth of Amazon Web Services, which has pretty high margins, that Amazon was finally getting to be steadily profitable, was on a long-term earnings growth trajectory where they would be growing revenue very quickly as well, but also increasing their margins year after year. That story just broke down last quarter. 

Just a look at the numbers. While sales reached $38 billion, up 25%, operating income plunged more than 50% year over year last quarter, down to $628 million. And actually, if you look and break that down by segment, more than 100% of that operating profit came from Amazon Web Services. So the retail business as a whole, which is still the vast majority of Amazon's sales, was unprofitable last quarter. And some of that is foreign currency. They've certainly been hit hard, as other retailers have, by the strong dollar in their international operations, which are losing money right now. And even in North America, you're seeing a lot of growth initiatives that are keeping sales growth at such a high rate, they are having an impact on the profitability. Two of the ones I would call out are first their investments in video, on Prime Instant Video.

Shen: On content.

Levine-Weinberg: A great driver, it's a reason why the Prime Membership program is growing so quickly, because they offer all of these side benefits aside from the free shipping that Prime became known for. But that's really expensive, and you're basically putting money in there where you're not getting a direct return for that investment, because it's just included as an add-on once you buy the Prime subscription. So I'm sure it drives some incremental revenue for Prime, but the main reason why people sign up for Prime is to get the free shipping. So the real benefit for Amazon is, as you can keep people loyal to the Prime program, they should start spending more and more money Amazon.com.

The other thing I would call out is, you have their Prime Now same day delivery. That's obviously really expensive compared to even two-day shipping, because when you have warehouses all over the country, you can use regular ground shipping to get an item to somebody within a day or two; whereas if you need to get it there in two hours, then all of the sudden you need to have a special courier network and warehouses that are very centrally located to get the items out to customers. That's obviously very expensive, and Amazon hopes to drive down that per-unit cost of delivery over time primarily just by increasing its scale. The more deliveries you're doing, the lower the cost per drop off. But that's going to take a while to get that to a cost that's really affordable for Amazon. So for now, that's definitely dragging on that profitability in North America.

Shen: The big takeaway that you will often see now in their quarterly reports, the AWS business continues to subsidize the retail segment, especially, you mentioned on the international side, as they try to expand out that business, too, there's going to be rising costs with that. But even, as you mentioned, the gem that AWS generally is, did see lower profitability and costs rising across the company. I think that's ultimately why Wall Street analysts and the market's response in general was a bit more bearish. I still find this reaction to the report interesting. You mentioned that, for years, Jeff Bezos has been growing the company, and he's been doing so at the expense of the bottom line. He really doesn't make a secret of that. The stock has done incredibly well, it's marched higher and higher, and then you have this one somewhat underwhelming report, that enough investors get shaken to push the shares down 6% to 7%. But at this point, I feel like you have to have this faith in Bezos and his long-term vision and strategy to even be a shareholder in the company.

Levine-Weinberg: I think that's absolutely true. Amazon right now, even after getting knocked down, it's still worth almost $500 billion. That's a huge amount of money for a company that, last quarter, earned a little over $600 million in profit. It's a very small operating profit relative to what the company is worth. You have to be betting on this company's growth not for the next few years, but for the next few decades to be a long-term Amazon shareholder. So basically, if you believe in Bezos and his vision, you think Amazon is going to be able to keep disrupting other retailers, other categories outside of retail, which obviously, they've done with AWS but maybe with other things, there's been some rumors about a healthcare push by Amazon. It's clearly a company that has a lot of innovation going on, a lot of growth potential, a commitment to growth at the cost of near-term profitability. And you just either have to accept that or not. And what I think we saw last week was that there was this hope among some investors that the profitability turning point had already happened, and now Amazon was going to be in this constant margin growth, which is clearly not the case. There's going to be up years and there's going to be down years in terms of profitability. And that's OK, as long as the revenue is still growing at a really rapid rate, which so far, it is.

Shen: Yeah. If you are a long-term Foolish shareholder in Amazon and you look at the results from this quarter ultimately, I don't think these are numbers that should be shaking your resolve at this point.

Levine-Weinberg: No.

Shen: Up next, we'll talk about a related story and the unlikely collaboration between Amazon and a struggling department store chain.

A couple weeks ago, Sears announced that it would make its Kenmore appliances available through Amazon. Kenmore is one of the last remaining high-value brands propping the company up at this point. They used to have a leading share of the appliance market, but it's deteriorated quite a bit along with the department store chain. Even then, I think it's still one of the biggest and most popular brands in the industry. This is a pretty strange partnership here between Sears and the company that a lot of people would say is most responsible for its woes over the last decade. What's your take, Adam? The word you mentioned to me before the show was "surrender", and I thought that was interesting.

Levine-Weinberg: Yeah, I really do see this as surrender on the part of Sears to Amazon. And to be honest, I think it's actually rational for Sears to be surrendering to Amazon.com at this point. I think it's been proven over many, many years that Sears does not have what it takes as a stand-alone company to compete with Amazon.com, or with other department store chains, even the ones that are struggling a bit themselves. If you look at Sears' results, their revenue has plunged in recent years. Right now, they've been posting pretty steady high single-digit to even double-digit comparable store sales declines regularly, and that's even while closing hundreds of stores. If you look at their total sales line, it's down 20% in a lot of quarters. 

They're floundering, they don't have much of a future as a retailer. At that point, their main assets are really their real estate, which they've been selling off, and their house brands that are still popular. They were able to get about $900 million of value for Craftsman, their tool brand, earlier this year. And Kenmore is probably the next most valuable brand they have still remaining with the company. I think selling Kenmore appliances on Amazon.com is going to be good for the Kenmore brand, because it's something that's been done a disservice by being stuck in Sears and Kmart stores only, because it was a great brand not even that long ago, 20 years ago, when people still went to Sears sometimes. Kenmore was a top appliance brand. A big reason why it's lost market share is because people simply aren't going to Sears. They're not seeing it.

Shen: It's a limited distribution issue.

Levine-Weinberg: So getting distribution out to Amazon.com will definitely get it in front of more people. However, millennials might not even know the Kenmore brand as much as their parents do, just because they haven't been shopping in Sears and so they don't see it in the same way that, maybe if they're walking through Home Depot, they see other brands of appliances. So that's definitely a concern. But better late than never to get this broader distribution.

Now, the problem for Sears is, once you can go buy Kenmore appliances on Amazon.com, why would you go to Sears for anything? So, that's really the issue. To some extent, they'll win some market share for Kenmore against other appliance makers. But really, what they're going to do is drive more share of Kenmore sales out of the Sears stores and into Amazon.com, which is going to make the lack of profitability for the Sears stores get even worse, forcing more store closures. In my opinion, this story is going to end with Sears going bankrupt. At the end of the day, they can still sell or keep the Kenmore brand, and that may actually be one of their most valuable assets. And getting out of the retail industry entirely might be the best play in the long run for Sears holdings.

Shen: The collaboration here between these two companies, I think you put it best, it's good news in the short run for Sears. It expands distribution for Kenmore products. But bad news looking out to the future, since shoppers will have even less of a reason to visit their stores. Whereas, for Amazon, on their end, it's good news for them as they expand their appliance business. Now they have this pretty popular brand, they can boast another instance, overall, of how even the brick-and-mortar competitors might be ultimately better off feeding off of the Amazon boogeyman and joining them. There have been other instances of that recently that we've talked about on the show. Nike even threw in the towel and acknowledged that, Nike being the most popular apparel brand sold on Amazon, didn't actually have an official relationship with the company, and as a result, they're starting to test that a little bit and actually sell their apparel through that channel.

To wrap up our discussion, we have another brick-and-mortar retailer that is finding its footing, and that's Target. It's still one of the top 10 retailers in the U.S. The company was actually recently surpassed by Amazon. The stock has underperformed in the past year as foot traffic declined. Holiday sales fell short, and comps turned negative. Target is in the early stages of executing a turnaround strategy. The latest guidance from management has taken a more positive tone. Do you think these are the first signs of progress for the company?

Levine-Weinberg: Yeah. I think Target has a ways to come, but they're definitely on the right track. In a lot of ways, I see Target as going in the opposite direction of Sears. What I mean by that is, if you look back at 2001 or thereabouts, Target made this really terrible decision that they were going to outsource their e-commerce to Amazon.com, and basically Amazon would get a commission and run the site, and Target would sell its products through there. The result was that Amazon was getting all this data about Target's sales, and they were getting people accustomed to an Amazon kind of layout, and Target didn't have any control over what should have been a key part of its growth. The result is that Target has much less online sales as a percentage of its revenue than a lot of its competitors. It's still under 5%, and that's after doubling its online sales in the past three years or so. So you can imagine how bad they were back in 2012, right after they had taken control of their website back from Amazon.

So Target was behind, especially in e-commerce. They are trying to fix that now. E-commerce, of course, has been the biggest growth driver for them. The problem was, recently, you did see these comp sales declines. And since they include the online sales in their comp sales numbers, that meant that if comp sales were declining, their retail in store sales were declining at an even faster rate. So that definitely puts pressure on profitability because there's a lot of overhead expense associated with having this massive store footprint throughout the United States. 

In the fourth quarter, they had a pretty significant comp sales decline. Back in February, when they were providing their guidance for the first quarter, Target's management thought it was going to get even worse with a low to mid-single digit comps sales decline for the first quarter. Now, comps sales did decline in the first quarter of the year, but only by 1.3%, which was a lot better than the original guidance. And EPS came in way ahead of their initial forecast at $1.21, whereas they had been expecting $0.80 to $1.00. So much better profitability than expected, still not quite as good as the previous year. And now you're seeing that same trend play out again in the second quarter. Comp sales have now turned positive again, which is definitely a good sign. Profitability is probably going to be down a little bit year over year, but maybe not, because once again, they raised their EPS guidance for the quarter. They announced a couple weeks ago that, instead of having EPS between $0.95to $1.15, it's going to be somewhere above $1.15 for the second quarter, they just haven't specified yet. So we'll find out when they report earnings in a few weeks just how well they managed to do. 

So you're definitely seeing that Target is not having a great year in 2017, but it's a lot better than what they expected, and that's a pretty good sign, considering that the company is making some significant investments and long-term bets right now in order to drive its competitiveness in the long-term against rivals, especially amazon.com. 

Shen: Sure. With the impressive but small scale of the online growth that you talked about so far, still a single-digit percentage of their overall revenue, the company obviously has a long way to go. That's a big investment for them, obviously. A few other key parts of the turnaround effort, I feel like they've mentioned things like new small format store locations, updating the aesthetics of some of their stores, also a lot of investments on the e-commerce side in terms of a better online experience, faster fulfillment. Where is the money going? What do you think is going to be really important for them going forward? 

Levine-Weinberg: One thing that they are doing is, they're renovating a lot of their stores. They're not opening as many stores as they did a few years ago, but they're still opening some. But they're renovating a lot of stores, and they're trying out a new store format, which definitely sounds promising. Instead of having a single main entrance, they're trying in these new stores to have two entrances with a different focus. There's a grocery entrance, that's for quick trips where you're just picking up some essentials, and it's supposed to get you in and out. Then, another main entrance, which is for discretionary purchases and things that Target is more known for in their home and style. That's definitely the entrance they're hoping you go into, but they're trying to give you an opportunity if you don't have time for that to get in and get out and go to Target more frequently, rather than, oftentimes, in a Target store, they literally put the grocery at the other end of the store from where you go in, and it definitely takes you a lot longer, so that might drive some customers to go to a regular supermarket instead of going to Target, because it's just more convenient. So that will be an interesting experiment, to see how that works for Target.

As you mentioned, they're also opening a lot of these small format stores. I think one of the most interesting things they're doing is they're making a big push into Manhattan, where 10 years ago they didn't have anything in Manhattan. They opened one full-sized store back in 2010 in Harlem in a big box center there. But now, they're getting more into downtown, midtown and lower Manhattan areas with these smaller stores. They have one opening later this year across the street from Macy's, on 34th Street. They have other stores coming within the next couple of years. I think they'll have six stores in Manhattan by the end of 2019. So we'll see if they keep growing from there. But, this is going to allow them to do more same-day fulfillment, which is really necessary now to keep up with Amazon as it rolls out Prime Now to more and more products to offer same day delivery. You just have to keep up if you want to stay competitive with amazon.com.

Shen: Yeah, and this mirrors a lot of efforts we've seen from other retailers, too, trying to use these smaller store locations to tap into more urban areas where they can't open these huge locations that would make up their traditional footprint. Last thing that management has mentioned quite a few times in conference calls and press releases is some of the success of certain categories and product lines that are exclusive to Target. Can you talk a little bit about that?

Levine-Weinberg: Brian Cornell, who is the CEO of Target, when he came in, a lot of people thought he was going to make a bigger push around groceries and building out the grocery side of the business. Instead, he's really doubled down on a few key categories that make Target stand out from other retailers. Style is one, and also baby and kids merchandise, and to some extent, wellness, both in the health side and healthier food. So those are areas, especially with style, where Target can offer a lot of exclusive products where they're not competing with Amazon.com for that particular thing. Obviously, Amazon has its own version of whatever it is. But you need to have exclusive merchandise these days if you want to survive, unless you have a massive cost advantage, like somebody like Costco. And even Costco has a lot of exclusive Kirkland Signature brand items that are exclusive to them. 

The exclusive merchandise is a way that you can moderate the price competition that's become so rampant now that you can just go on your phone, let alone your computer, to find out what the price of a thing is. That's really important for Target, and I think that building out those brands, keeping them popular, coming out with new items that people want, is definitely going to be critical to that long-term success, because selling commodities and trying to compete with Amazon on price is not really a viable long-term strategy, because these retailers with the giant physical footprints can't get the cost to what they would need to succeed with that kind of operating model.

Shen: Yeah. Not even just Amazon. If you're looking at some of the other brick and mortar retailers, Target, in terms of their scale, it'll be tougher for them to compete with the likes of a Costco or a Wal-Mart, for example. But that's all the time we have for today, so we're going to wrap up this discussion there. Thank you for joining us, Adam!

Levine-Weinberg: Yeah, thanks for having me again!

Shen: Fools, thank you for listening! To our producer, Austin, thank you very much. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!