Why Target's Turnaround Is the Real Deal

Target (TGT -0.54%) stock is up over 30% year to date, making it one of the S&P 500's top performers -- a surprising feat given the challenges brick-and-mortar retail chains currently face.

In this episode of Industry Focus, host Vincent Shen and Motley Fool contributor Dan Kline check in on the big-box store's two-year turnaround effort. From same-day delivery to remodeled stores and private label brands, the company is investing heavily to embrace the omnichannel, and shoppers seem to like what they see. 

A full transcript follows the video.

This video was recorded on Oct. 9, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, October 9th. I'm joined by Motley Fool contributor, Dan Kline, who's connecting with The Fool HQ studio via Skype. Hey, Dan! Thanks for joining us, man!

Dan Kline: Hey, Vince! I feel like I just left you!

Shen: It was great seeing you last week at our fool.com conference! How'd you end up doing at the casino by the way, on Friday?

Kline: [laughs] Not very well. I was sort of the host for the group of us who went. I was flitting in and out of different games. Two hands of blackjack here, a little slot machine here, a little whatever. So, I did not use any logical gambling strategy. And let's say the MGM is doing a little better because of that.

Shen: I love talking about that. I didn't realize that you were quite the blackjack card shark. 

Kline: I am. I'm going to a convention in Vegas with another Fool next week. I'm sure we'll get to play some serious cards. This was not a serious trip. This was much more about just hanging out with a bunch of coworkers. It was also very crowded. The singer Maxwell was performing, and that just filled the place up.

Shen: I know you're going to be back at HQ next week. But I wanted to bring you on the show today to talk Target. Thank you for bringing the company back on my radar, by the way! Frankly, if you'd have told me that at the beginning of 2018, Target would end up being in the top 50 best-performing stocks in the S&P 500 this year, I don't think I would have believed you, frankly. But here we are in October. Target is indeed in the top 10% of gainers in that index, with shares up 31% year to date. 

The last couple of times Target has come up on this show, we talked about the turnaround plan that management launched in early 2017, there were some encouraging initial results from that effort as of the late summer last year. Think about things like smaller store formats, remodeling existing locations, there's digital growth. These are all themes from last show. But most importantly, management has really wanted to take back market share, and they've become more willing to compete on price in order to do so, and also think out of the box. After the second quarter results Target released back in August, I think a lot of even the biggest skeptics have to acknowledge that the chain is gaining some momentum. 

We're going to cover a lot of different investments that Target's leadership has been making to contribute to the strong results, but I'll let you start, Dan. What kind of stuff has impressed you the most?

Kline: Really, it's that Target could have just made some minor changes. They could have improved delivery, spruced up the stores, tweaked the merchandise, kind of just stuck with what was already sort of working. It wasn't the disaster that some of these retailers are. Instead, they really blew everything up. They're not done with the remodels, they're about a third of the way through. If you go into a remodeled target, they've changed everything -- the way that you flow through the store, the way merchandise is. If you're in a more urban location, things like snacks are in the front, there's multiple entrances. They took something, and instead of just going, "OK, how do we get it a little bit better?" they really took a big risk. They changed a lot of their merchandise. And, they made all the changes that you don't see. They invested a lot of money in supply chain and making sure they have the right merchandise in their stores. And that's really all paying off. They put up the best comp sales numbers they've had in I want to say eight, nine years. Their traffic was up some 6%. It's really been a turnaround that all came together in the last quarter or two.

Shen: I will jump into those numbers a little bit. We're talking about foot traffic growth here of 6.4%. That's the highest level of growth recorded since 2008. On top of that, the year over year comparable sales growth was 6.5%, the highest level since 2005. Like you said, pretty impressive. 

Breaking that down, the physical stores contributed 4.9% of that comps boost. With the remaining 1.5% or so coming from e-commerce. E-commerce specifically, digital growth came in at 41%, which is an acceleration from both the first quarter of this year and the prior-year quarter. Both of those came in closer to 30%. 

It does seem like CEO Brian Cornell and the rest of the leadership team are taking a more holistic approach to the turnaround that they've implemented. They're still experimenting with a lot of things, like the smaller format stores. 12 of them were opened in the first half of 2018. COO John Mulligan, he said during the last earnings call, "These locations deliver high sales productivity along with gross margin rates above the company average. We continue to see strong growth as these stores mature. At the end of the second quarter, we are operating 26 mature small format stores. On average, this group saw high single digit comp growth during the quarter." Again, feeding into that, though at this point, still a very small base.

Kline: Yeah. When you look at it, on the back-end side, they made all the same moves Walmart did. You can order online, pick up in store, there's multiple delivery options. It's really about giving the customers what they want and where they want it and how they want it. If you look at their website, it's not a total overhaul, but they really dug in on taking steps out of the process, automating things like subscription, just making it very, very easy to shop there. You have to do that when your competitor is Amazon, which is about the easiest place to shop there is.

Shen: On the supply chain side, I was looking for some more specific detail and guidance, in terms of what they're doing there. It seems, as much as I could glean from the management comments, they're trying to handle a lot of the digital fulfillment from the growth in that channel, of course, but they're also trying to improve things like the in-store functions, like how they offload inventory from the trucks, some of the shelf-stocking process, and also how they staff employees in different departments of the store. Overall, it seems they're really trying to focus on improving the guest experience, to give better service, have fewer out of stock items.

Kline: It's a work in progress. I am a three or four times a week Target visitor, sometimes because it's too hot here to take a walk outside, so I'll use Target as my indoor walking space. I know that makes me sound 1,000 years old. They've done better in that, on the big-ticket items, you won't find them running out of, say, one flavor of cereal from a popular brand. Where they still struggle a bit is on some of the smaller companies. They stock a type of canned coffee I like. They sort of run out of it before they bring it all back in. So, there's absolutely still little hiccups in it, but it's gotten much better. And, your ability to walk up to an associate and say, "Hey, I usually buy this. How do I order it online? How do I get it sent here to the store?" The level of training, in my personal experience, is very high for the individual associate to be able to help you with that.

Shen: Management has been talking a lot about improvements to training to help customers with issues like what you just mentioned. 

The next thing I'd like to talk a little bit about is existing locations. We mentioned the major remodeling project that is currently in process. Over 300 stores are expected to get a facelift in 2018. Longer-term, the goal is to remodel 1,100 locations by 2020. That would cover more than half of the company's total store base. This is the COO Mulligan, he said about the remodeling efforts, "Specifically consistent with our plan, we continue to see traffic-driven incremental sales lifts of 2-4% in our remodeled stores following completion of the remodel. While the data is limited, we're seeing some early indications that remodeled stores continue to outcomp other stores beyond the first year after the remodel." Management said that at one point in time in July, there were 258 stores that were in the middle of the remodeling process. You have to imagine that'll negatively affect the customer experience at those stores in the near term.

Kline: I don't know that it does. They do a really good job. They remodeled fully the store near us in Davenport, Florida, near Disney World. As we've talked about, we have a little place there. They made it really exciting. There were covered boxes in the parking lot saying, "Big things are happening soon." It wasn't very distracting in the store. They did a very good job closing off certain areas and moving merchandise around. At no point that I feel like "Wow, this is a construction zone." There was always a little bit of, "Ooh, what are they going to uncover next? Are they adding this kind of store?"

What's important to know about the remodel is, these aren't cookie-cutter remodels. The remodel here in West Palm Beach is very different from the remodel in Davenport. When I walk into the store near Disney, the first thing you see is towels and disposable swim items and things that someone on vacation is most likely to need. When I walk in here, you get the on-sale household goods, and maybe bottled water, or maybe bathing suits, whatever it is. It's based on the place where you live vs. the place where most people there are just visiting for a short amount of time. They put a lot of thought into how they arrange each store.

Shen: That's good to know. I didn't mean that as a knock on this process. I think it's a risk that's worth taking. Management may have confirmed that there is a bit of a negative headwind from having so many stores going through the remodeling process at once. But ultimately, this is a near-term hiccup that gives the company a much better long-term focus and runway. I prefer to see that from management, frankly. 

Related to the remodeling project, a big part of that is their e-commerce effort. Target's brick and mortar locations, they're doubling more and more as fulfillment centers. They said that two-thirds of their 41% online sales growth in the second quarter was fulfilled from stores, which is pretty big. What do you think?

Kline: I think that's also an important move to make when it comes to inventory flow. Yes, you can save money by, if I order something here in West Palm Beach, and they ship it from West Palm Beach, that's cheaper than if they ship it from a fulfillment center in Detroit. But more importantly, if I'm ordering, I don't know, let's call it bedsheets, and they sell 23% more bedsheets because they fulfill online orders, they'll be able to stock more colors, have more product move through. Routing things that way is good for the bottom line, but it's also good for the in-store customer. It makes it easier to get stuff. Even if they're out of stock, they have more capability to bring the order in, and the capacity to get it to you. It used to be chaos. When you ordered something at Target to pick up in the store, nobody knew how to handle that. That was as recently as two years ago, when we first moved down here. My wife ordered a bunch of stuff and I had to go pick it up. It was not fun. Now, that process is super simple, because it happens 100X a day.

Shen: I want to keep talking about that kind of fulfillment experience. Customers really seem to have their pick of the litter now when it comes to fulfillment options from Target. I was just looking through some of the options that they talked through in the earnings call. It is pretty crazy. They have Shipt, which the company acquired in late 2017. That brings same-day delivery to major metro markets. Updating on that purchase, management said that Shipt is now live in more than 160 markets. It covers 1,100 Target stores. It's just $7 for the service. Membership has more than tripled. The number of orders, the revenue, and the gross merchandise volume flowing through Shipt, they're all 2-3X higher year over year. Pretty impressive. 

Another one, an interesting that I'd like to get your thoughts on, Dan, is Drive Up. Drive Up is like Walmart's curbside grocery pick up, but I believe Target makes pretty much all the products in its store eligible for this service. They expanded that from 50 to 800 locations as of the second quarter. They expect to grow that number to 1,000 stores for the holiday shopping season. Walmart, their curbside grocery pick up was something we talked about as a cool idea that was driving traffic and helping Walmart at the time. It makes sense that Target here is going to offer their version maybe a little better.

Kline: Yeah. It's just about offering customers whatever they want. I go into Target a lot. But I can envision a day where I've got a hundred errands to do, and our Target, you actually have to park and then go up an escalator. It's an elevated Target. So I can see the possibility, where just rolling up, my order is ready, it's already paid for, it's thrown in the back of the car, that might work. I tend to be an Instacart shopper, in terms of delivery. But there's no reason I might not place a Target delivery order, especially, we're in hurricane season now, so if I decide I need to stock up, I need heavy water, I need other things like that -- it's all about giving the customer choices. 

I think what will happen is, in each market, it'll shake out what people want. They might find that in a driving market, pickup is important, but delivery isn't. Maybe in a city market, lower quantities for delivery are really important. It's going to be different everywhere. I imagine they'll get rid of and add options based on the feedback they see.

Shen: Here's one more, it seems to be a little bit newer, it's called delivery from store. This is another interesting option, where you can shop at a Target, at the store. Then, during check out, you can choose to have your purchases shipped to your office or your home later that day. It's available in 58 stores across five markets. The notable thing here is that the average basket size for this option management, management said, was about $200 or more. This is the highest of all the options Target has rolled out.

Kline: And there's a reason for that. Brian Cornell has talked about this. He was talking about being in New York, and that when you walk into a store in New York, you may need a TV, but you have no ability to leave with a 50-inch television. You can't walk down the street carrying that with you. Or, a vacuum cleaner, anything that's not going to fit in your little rolling shopping cart that people in cities use.

Shen: The last two related things I'll mention are restock and the perks for Target's REDcard holders. The restock service offers next-day delivery for things like packaged foods, staple items, with a delivery fee of just $2.99. That service went nationwide in May. It's actually free for REDcard holders. That's Target's branded credit card. Same thing for REDcard holders, two-day shipping for online orders is free for them. Non-card holders have to spend $35 or more. I know that right now, Target is testing a new loyalty program. But REDcard holders made up almost one-quarter of sales last year. Those kinds of perks can definitely contribute to greater customer loyalty. I think it's something that makes sense to add on as a benefit for the people who are loyal enough, shop at Target enough to pick up the card.

Kline: And they push it very hard. I don't know the last time you've shopped at a Target, but you cannot check out with another credit card without being asked twice if you want a REDcard. 

Shen: Yeah. Something we have not had a chance to dig into yet is the big one-day sale that Target threw in July. This was to compete with Amazon's Prime Day, maybe try and steal a little bit of their thunder. A major portion of the strength in e-commerce in the second quarter was from that event, which was Target's biggest day ever for online sales, about 3X stronger than they forecasted. 

I think it makes sense. Shoppers are already in the mood to spend some money that day on Amazon. More retailers want to get in on that action. Management also said they took the opportunity, basically, to see if their supply chain, the website, other parts of the business, the back-end stuff, could handle the increased activity as they head into the all-important holiday season. 

The last initiative I wanted to discuss was the growth of Target's private label offerings. I know this is what originally attracted you to update listeners on the company. What's going on with the owned exclusive brands?

Kline: If you've been to a Target, you may have noticed that it's no longer just a collection of merchandise. It is a very carefully curated set of different brands. Admittedly, some of the brands have fake-sounding names, especially the men's shirts brands. I believe I'm wearing one right now. Goodfellow & Co is the brand they use. Again, that sounds like something you and I made up for a placeholder. But they also have partnerships with Chip and Joanna Gaines on some of their home stuff. 

They really have created what Brian Cornell called a differentiated shopping experience. That goes to everything. They have multiple lines. If you look at shampoos and cleaners, they have their Up&Up line. That's competing with the name brands full size. The reason I pitched this is, they just introduced a line of smaller, I don't want to say lower-end, but more single-use, not exactly travel size, but much cheaper, toiletries and other items like that, toilet paper, toothpaste, that type of stuff, designed to keep you out of Dollar General or Aldi, places that people were going when they just needed a little bit of something. So, they really have something for everyone, and they've been very clever about how they've done it.

Shen: This latest one, it's called Smartly. It covers some of those consumer staples that you mentioned, Dan. A lot of these items are going to be priced under $2. Management pretty much said outright that they want to take a swing at the discount retailers like dollar store chains, and keep people out of drugstores, too, which obviously have a lot of their own generic private label brand offerings. 

All in all, in terms of these owned exclusive brands from Target, the company's launched four of them in the second quarter alone, about 20 in the last two years. Clearly, that effort, the investment in these brands, is picking up. 

You take a step back to consider some of the bigger-picture considerations for Target shareholders, maybe investors who are now intrigued. A reality check that I have, that's what I'll call it, is that even with a lot of the growth that we've seen, for example, in e-commerce, we spent a few minutes talking about that, and the innovation in the fulfillment options that we discussed, only about $4 billion of their sales came from digital last year, or about 5.5% of the top line. That number will be higher in 2018, of course, given some of the growth that they've been putting up. But it's still only a sliver of Target's $74 billion in annual revenue. 

All of those additional fulfillment expenses, those promotions from the first half of 2018, they're putting downward pressure on margins. It's not too severe. The guidance for full-year 2018, operating income margin is to decline 30-40 basis points. And while e-commerce does bring profitability down, this is where the private labels come in, Target's able to offset some of those costs with the growing popularity of its private labels, which generally carry a better margin profile.

Kline: I think we're also in the very early days of private labels. Let's say I'm wearing Target pants. I don't know what the pants brand would be, let's call it Pantsly. You go in and you find your pants. Once you've done it in the store, you then unlock the possibility of buying again online. You'll notice about all of these Target brands, whether it's the toiletries or the clothes, everything is very, very smartly packaged. They did a line of very low-end, under $10 mostly, electronics, things like chargers and cables and stuff that's hard to figure out. It's in such clean, smart packaging, that once you buy it once, it becomes very easy to trust it and buy again. I think that's going to happen with clothes. I think that's going to happen with their food lines, with their sundry lines. And that will drive sales online, once people have had this experience in the stores.

Shen: I definitely think there's a great opportunity with the private labels. I'm curious what you think about this take. Another Fool, Tim Green, he had a pretty interesting piece cautioning that going too far with private labels, and in the process cutting out a lot of well-known national brands, can end up hurting Target if they take it too far. The examples that he gave were for Kohl's and also JC Penney. What do you think? 

Kline: Here's the thing. I worry about it a little bit. I used to buy the generic Champion sportswear that Target is phasing out in favor of its own brands. If I'm looking for running shorts or a bathing suit, I don't necessarily need something as hip as Target is trying to go. It might surprise the listeners, but I'm not super hip in the all-black outfits here. But, if you go look at shampoo, they still have all the major brands. They still have anything you'd want in other areas. So, yeah, I think on clothing, and maybe on the home stuff, they might have gone a little too far. They expose themselves a bit to a brand that they've created falling out of fashion, and they no longer have the generic that they used to. But as long as they keep innovating and keep rolling out new brands, I think they should be able to meet all those different needs.

Shen: Yeah. Again, with this step-back look, I will say something else. I wanted your thoughts on this, Dan. We talked about the strong comps growth in this quarter. Best in a decade or more. The company said that that strength was across all five of their major product categories. I thought it was interesting that they note that toys were called out specifically by management, in terms of being a category of strength for the company. This seems like a boost because of the Toys R Us closures. What do you think going forward? Toys and baby products were mentioned by management as being lower margin but high-growth areas where they're pushing for the holiday season. Thoughts there?

Kline: We've talked a lot about toys, because obviously, I have a background running a toy store. Target, just like everybody else, they don't do much with toys. They just throw them on the shelves. That said, the Target toy shelves are very well-organized. If you walk into the Lego area, it's very clean. There's some interactive displays, there's some put-together items. The same thing for its baby toys, its different items. You can get a little bit hands-on. So, I do think it's more pleasant to shop toys in a Target than, say, a Walmart. And they have grown their selection. They've added either seasonal toy areas, or in some cases, just expanded their toy area in general. Because, obviously, there's an opportunity.

I'd love to see them do a little bit more, demonstrate some of these toys, have some working sections where you can play with things. But, for what it is and for what they do, they've seen the opportunity and they've really grown what they have, moved into some new categories, tweaked the edges with some more educational stuff, with some things that are a mix between athletic and toy. So, I see a huge opportunity this holiday season.

Going forward, toys are a bit of a commodity, so it's hard to tell. But they're absolutely capitalizing on what's there right now.

Shen: A couple of more minutes here before we wrap up. Something that I also want to say to put these really strong recent results in perspective, as impressive as the second quarter was, on a more macro level, retail spending across the board has been very strong recently. Even Cornell, the CEO, he said, "There's no doubt that, like others, we're currently benefiting from a very strong consumer environment, perhaps the strongest I've seen in my career." To that effect, shares of Nordstrom, Kohl's, Macy's and TJX Companies are also all up 30% or more year to date. They're also among the top performers in the S&P 500 so far this year. Target's not alone, in terms of this brick and mortar retailer being part of that tailwind. 

To wrap up, Dan, anything else you'd like to add before we close out?

Kline: Target has positioned itself well for the next downturn. By having a lot of inexpensive house brands that don't feel cheap, I think they've captured the old magic. Target was not a thing in the northeast where I grew up until maybe 15 years ago. When I first walked into one, I instantly knew, this is nicer than what we used to have. This is better than the supermarket. It's better than Walmart. It's better than the old Bradley's and Kaldor's sort of stores we used to have. That sort of slipped away over time. The days where you could make the joke, "I'm shopping at 'Targét'," which became a cliché, but it actually did mean something. It was a superior brand experience. I think now, they've cleaned up some of those edges. Even simple things like having good packaging put some of that pride back. It's not all about price. It's a bit about price and lifestyle. Yeah, I'm being sensible, but I'm not buying something cheap. And I think that's very important.

Shen: I also think it's important for listeners to realize that in the first half of this year, on the more financial side, Target generated $2.7 billion of operating cash flow. The company has quite a bit of wiggle room in making all these investments that we've talked about. They forecasted $3.5 billion of capex spending in 2018. A lot of their brick and mortar competition really cannot afford to make these long-term plays as they're just struggling to keep the doors open. But here, Target can do all that while easily maintaining their 3% yield, which has grown 47 years straight at this point. The stock is actually just shy of becoming a dividend king.

Definitely interesting to watch. I think the management team here has executed really well. Thanks for bringing it onto my radar, Dan! Great having you here!

Kline: Thank you! I'll see you next week!

Shen: Thanks for listening, Fools! 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!