Target and Lowe's Have Their Eyes on the Long-Term Prize

It's not easy to be a retail company these days. E-commerce can eat your lunch if you blink, brick-and-mortar competition is getting leaner and meaner, and consumers, as ever, can be fickle. In this environment, even the strong can suffer, and three retailer majors that reported this week are. Target's (TGT 1.03%) comp sales are growing, but it missed third-quarter earnings because its vital omnichannel infrastructure investments squeezed its margin. Lowe's (LOW 0.63%) reported numbers that might look decent out of context -- but that were weak compared with chief rival Home Depot (HD 0.74%). But L Brands (BBWI 0.30%) is just plain suffering as its Victoria's Secret chain continues to lose mindshare with consumers.

In this Market Foolery podcast, host Chris Hill and MFAM Funds' Bill Barker consider the various ways these companies are attempting to adapt to the changing business model of retail, weigh in on their prospects and investment theses, and, most importantly, try to get inside the head of the person in charge of green-lighting new candle varieties at Bath & Body Works. 

A full transcript follows the video.

This video was recorded on Nov. 20, 2018.

Chris Hill: It's Tuesday, Nov. 20. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio, from MFAM Funds, the one and only Bill Barker. Thanks for being here!

Bill Barker: Thanks for having me!

Hill: It is a short week for us here at Market Foolery. We are off on Wednesday. We're obviously off for Thanksgiving. The market is closed. Normally, in these situations, I would say hey, check out Industry Focus! That's the other daily podcast from The Motley Fool. Industry Focus is also taking Wednesday and Thursday off. So I'm going to say, if you haven't listened to Rule Breaker Investing with David Gardner, absolutely, you should be checking that out. And Motley Fool Answers.

Barker: Listen to it two or three times. Your schedule has opened up.

Hill: Your schedule has opened up. Particularly in the case of Rule Breaker Investing, the shelf life for the episodes David Gardner hosts --

Barker: Skip this episode; go right over to Rule Breakers. Give it two or three listens right now. Get more out of it. Can we wrap?

Hill: No, we're going to keep going. But your point is spot-on. People will get more out of whatever David Gardner is talking about this week than whatever we're about to talk about. Actually, we're going to talk about the retail ugliness that is happening right now. We saw this coming last week, when Home Depot put up an amazing, stellar quarter, and the stock dropped anyway. Now, we've got retailers putting up less than stellar quarters and getting punished for it. We'll start with Target. Third-quarter results coming in below expectations. You can look at what Target is doing, in terms of their investment in the supply chain, and think, long-term, that makes sense. I applaud that, and that's fine. But in the short term, that means that Target's costs are going higher. The stock down 9% this morning.

Barker: The stock going into today was up 22% for the year and up 37% from this time last year. Let's pull that part a little bit. One thing that allowed that was the stock being beaten up as much as it was. There was a lot of frustration with retail going into last summer 2017. A lot of stocks in the retail space really bottomed around then. Looking at it from that point, everything is going much better. They haven't been destroyed as of yet by Amazon.

But Target's numbers show what the cost of that non-destruction is. They had comps of 5.3%, which is pretty good. But there are costs associated with meeting customers in all the places they want to be. Target's investments in order online-pick up in store, or curbside, these are good things for the customer, things the customer wants, but they are not easy to deliver without raising your costs. Either you're going to have to raise your prices, which is not particularly viable in as competitive a retail environment as we have today, or you're going to take on those costs, and your margins contract. That's where Target is today.

Hill: Brian Cornell, the CEO, was very clear that despite the higher costs in the third quarter, he has a great deal of confidence going into the holiday quarter, not just in terms of consumer spending, but in terms of Target's ability to deliver on that. I think Brian Cornell has rightfully earned the confidence of the shareholders, given his track record there. You're hopefully taking some solace in Cornell's confidence.

Barker: I do. What I take less confidence in is how you construct the numbers in a way that makes it a truly exciting investment opportunity. Traditional retail, let's go back a few years, where you're going to get your comps of mid-single digits at a well-run place, and then you're going to open up more stores. Your total sales are going to rise maybe in the low double digits. Because you're opening more stores, you're getting bigger, your margins are going to improve by a little bit. Then you're going to buy back some shares. And when you combine all that and get down to the bottom line, you've got growth of earnings per share, hopefully, in something like the mid-double digits, like 15%, if you do everything right. Quarters aren't always going to go right, but that's the game plan. 

Well, now, are you really building more stores? If you're not building more stores, are you going to see your margins improve? You're not really growing more than the rate of the economy. If that's the case, you still might be able to buy back your shares. And Target did a bit of that over the quarter. But really, they were buying them back at what appears now to be higher prices than they go for after today. Maybe they'll buy back more shares at a lower price over the coming quarter. But if you start getting at, where are the comps, and that's the main number that's going to determine your rate of growth, you're talking mid-single digits.

Hill: Let's move on to Lowe's. Lowe's third quarter, not nearly as good as Home Depot's last week. Expectedly, shares of Lowe's falling today. Part of the confidence that I think investors might want to have in Target is the fact that despite the higher costs in the third quarter, Target didn't change their guidance for the full fiscal year. That is not the case with Lowe's. In addition to their third-quarter numbers, they also cut their forecast.

Barker: As we just went over, part of the equation here traditionally would be that you have good comp numbers, which allows you to open more stores. Well, Lowe's is now in the process of closing stores. They're saying 31 stores in Canada, 20 in the U.S. They're contracting, in terms of their store count. Where is the growth going to come from there? I'm not saying that's the wrong business decision. If you have over-supplied in terms of stores, you've got too many too close together -- I think most of the stores that they've announced that are going to be eliminated are within 10 miles of another store. They're going to be more efficient. That'll help the comp numbers in the remaining stores once it's completed. But you've got to take a big charge to earnings to close those stores. That's what's befalling Lowe's stock today.

Hill: And throw in the fact that previously, Lowe's had announced that it was closing all of its Orchard Supply Hardware stores, which was a smaller brand in the Lowe's portfolio. This can all make a lot of sense, and these can all be the right decisions, but if you're looking at Lowe's in 2019, 2019 is shaping up as a year for Marvin Ellison and his team at Lowe's where they really need to deliver. If this year has been "We need to take a hard look at how we manage our inventory. We need to take a hard look at our locations. Yes, we're going to close Orchard Supply. Yes, we're going to methodically close certain locations in North America," that's fine. But they really need to deliver next year.

Barker: Yeah. You can be more confident in that delivery occurring if the housing market is really healthy. And the housing market is beginning to show signs, in the wake of interest rates moving up and mortgage rates also moving up, of a softening in the housing market. All these markets are really local, and some are doing better than others. But nationally, there's been slowdown. The numbers out yesterday showed that homebuilder confidence was at a two-year low. That's an issue. 

Margins are also an issue. The cost of lumber has been going up, in large part due to some of the tariffs, and the lumber coming in from Canada. There are a lot of different moving pieces, all of which are moving in the wrong direction for Lowe's, other than the economy in general, which is still quite healthy. That's more use than maybe just about anything, but the housing economy specifically is a problem.

Hill: If housing is really that bad --

Barker: I don't want to say housing is bad. It's softening. It's different. I don't want to oversell the problems in the housing market.

Hill: I appreciate that. But we've talked for years about how, for people who have not invested in housing, one of the easiest entry points for an investor looking at individual stocks is Home Depot and Lowe's. Over time, they've been steady businesses. At various points, one has done better than the other. But generally, they have been seen as safer investments than a straight-up homebuilder or that sort of thing. Sorry to keep going back to last week, but if Home Depot is going to put up a third quarter like they just did, and the stock is going to drop because there are all of these concerns about the housing industry, that makes me wonder if there's anything related to the housing market, in terms of stocks, that's worth buying right now.

Barker: I think Home Depot is still -- disclosure, I own some shares of Home Depot -- probably the place I would be most confident in a sustainable floor, that is, housing builders, homebuilders. Boy, you get some wild, wild swings there. When times are good, they skyrocket. When times are bad, they look like they're going bankrupt. Home Depot is a far lower ceiling, higher floor on that, and it's been doing a better job than Lowe's for quite some time. Although there was, as you say, weakness post-earnings report, I'd rather have a good earnings report and stock weakness than vice versa.

Hill: Our email address is [email protected]. Question from Sam Horne in Boston, where it's about to become very cold. Sam writes, "One of the first dozens of listeners here. I've noticed you guys have not mentioned L Brands over the past year, but have touched on other victims in the retail apocalypse. Would love to hear your thoughts on the long-term ability to invest in fashion/brands. Thanks." Thank you, Sam, for that.

What a coincidence. Actually, on our schedule to discuss today, L Brands reporting third-quarter results. This is the parent company of Victoria's Secret and Bath & Body Works. Whatever nice things showed up in the third-quarter report were overshadowed by the fact that L Brands announced it's cutting its dividend in half. That's a little surprising.

Barker: I'd be hard-pressed to tell you what the good things are that showed up in the third quarter. 

Hill: Versus expectations.

Barker: Well, they lost money. Part of that was due to massive write-offs for two things. One, they are eliminating Henri Bendel. Maybe it's [in a French accent] Henri Bendel. 

Hill: You can pronounce it however you want. [laughs] 

Barker: [laughs] You can get in trouble for pronouncing things wrong on this show! You've done it.

Hill: Sure.

Barker: Mostly with your Swedish pronunciations.

Hill: Yeah. I struggle there.

Barker: That's a charge. The secondary charge, actually a much larger charge, is the $80 million -- although it is non-cash -- impairment charge related to the Victoria's Secret store assets. That indicates that they have spent money building stores, and they now have to write down some of those costs, because it doesn't look like they're going to recoup the investment on certain store investments. This is a problem. They're taking charges, acknowledging that they've misallocated capital. They're shutting down a brand. It wasn't a huge part of the business, but still, not a good sign. 

The weakness is really in the Victoria's Secret brand, more than elsewhere. For the third quarter, comps were down 2%. And that's the largest chunk of the business. Comps were up 13% at Bath & Body Works, which I'm sure we'll get to. That's a better side of the story. But the long-term trend is that Victoria's Secret is not resonating with its customers.

Hill: Yeah. I was going to say, in terms of bright spots, certainly the Bath & Body Works results looked good. They raised guidance for the full fiscal year. That's theoretically a bright spot. Bath & Body Works, this has come up in the past, maybe about a year ago, maybe after the holidays. We were talking about their large, three-wick candles, and the unusual scents that they have. I've talked about the people that the Oreo division of Mondelez being drunk with power. I think, to a smaller degree, whoever is green-lighting the various scents of candles and Bath & Body Works are saying yes to everything.

Barker: You could just go back and replay rather than us revisiting our thoughts on Sweater Weather and Black Tie and --

Hill: Peppered Suede!

Barker: Flannel.

Hill: Flannel! Would you like a flannel-scented candle? If you set flannel on fire, it's usually not a great smell. 

Barker: You're actually packing some Peppered Suede right next to you.

Hill: Yeah, one of the dozens sent in a Peppered Suede candle.

Barker: Really, when you're having some suede, you think, "This could do with a little more pepper." Now they've done it for you.

Hill: You're welcome, America.

Barker: You don't want to have any suede that's...

Hill: Bland. 

Barker: Yeah.

Hill: When we had talked about this before, we were talking about the different scents, but also the fact that this candle, which is nearly a pound in weight --

Barker: In some states, you have to register that. 

Hill: Oh, yeah. This is a blunt object. In fact, it wouldn't surprise me if this showed up in a police report somewhere. 

Barker: Not that we're advocating that. 

Hill: Not that we're advocating that. I'm just saying that if you wanted to use this as a weapon -- 

Barker: If you have to defend yourself, if somebody's an intruder, have a couple of Bath & Body Works' three-wick candles on hand, you have a better chance of getting out of that situation.

Hill: One of the things that I took the company to task for was the fact that you've got these unusual scents, but also, you're selling this candle for nearly $30. They were selling these candles for $27. I just thought, come on! You're not going to get me interested in that! Someone just posted in the Motley Fool Podcast Group on Facebook that the good people at Pringles came out with a creative box of Thanksgiving-dinner-flavored Pringles. You could get me interested in that, but not if it's $15 a box, which is what they're doing. It's like, come on, Pringles. I'll try your novelty flavors, but you have to make it attractive from a price-point standpoint. Well, it's entirely possible that someone at Bath & Body Works was listening to that podcast, because you go to their website, bathandbodyworks.com, and immediately, you're bombarded with the candles. They're less than half the price they were a year ago. 

Barker: They're so cheap, you can't afford not to buy them.

Hill: Exactly! Creative scents like Merry Cookie, Fresh Balsam, Twisted Peppermint -- my hunch is that Peppermint and Twisted Peppermint probably have similar scents, but maybe I'm wrong on that. Champagne Toast. 

Barker: Twisted Peppermint has a little bit more of an edge to it.

Hill: Yeah, it's the edgy one. It's a good-looking rebel candle that plays by its own rules. Vanilla Snowflake. Fireside. I don't think you want to put a large candle right next to the fire.

Barker: Here's a challenging one: Wine Cellar.

Hill: You tell me "Wine Cellar," I think musty. [laughs]

Barker: [laughs] Yeah. I wouldn't think that a cellar is something that connotes good smell.

Hill: No, not really.

Barker: Not any of the cellars that I've ever owned.

Hill: Right. Or that have ever appeared in movies. [laughs] There's never been a time where you're watching a movie and they go down to the cellar and you think to yourself as a viewer, "I bet that smells delightful!"

Barker: No. You'd better be armed with a candle if you're going to go down to the wine cellar that's in a movie. There's usually trouble down there.

Hill: We're poking a little bit of fun at Bath & Body Works in the wake of a third-quarter where it was by far so much better, from a business standpoint, than Victoria's Secret was.

Barker: Part of the reason is, for us to go into the details of what is sold at Victoria's Secret is a danger zone that we should stay away from.

Hill: Right.

Barker: Right.

Hill: Right.

Barker: Nobody wants that.

Hill: Nobody wants that. And frankly, this is more fun. This is a lot more fun, to talk about Wine Cellar as a scent.

Barker: But, to go to the number, which we can do without getting into too much trouble, Victoria's Secret comp sales for the whole brand were down 2%. In-store, they were down 6%, which is another data point about the reduced attractiveness of having a lot of mall-based stores. That's what Victoria's Secret is largely saddled with. On top of that, they had a couple of announced departures. Victoria's Secret's CEO is departing. That's not the L Brands CEO. It's another individual. But the Victoria's Secret CEO is a very, very important part of the company. She's departing. That's yet another thing on top of the dividend cut, the decreased comps. I don't know where the good news is in here. 

And this is something which, a couple years ago, I think you could have said, "What store, what fashion brand do you have more confidence in continually getting it right and not missing the fashion trend and where things are going?" Because that happens to all fashion brands sooner or later. And now, including this one. They're just on the wrong side of where their customers want to shop.

Hill: One last scent on the Bath & Body Works candles. Again, I'm not sure what this is. There's a scent entitled 'Tis The Season. There you go. 'Tis The Season. 

Speaking of which, you can follow us on Twitter, @MarketFoolery. We got a tweet from Tom Krikus. I hope I'm pronouncing Tom's last name correctly.

Barker: You get in trouble if you mispronounce it.

Hill: Well, not everyone's as harsh with their judgment as you.

Barker: Or the Swedes. You don't want to get them mad.

Hill: Don't get the Swedes mad.

Barker: Our good friends from Sweden.

Hill: Tom writes, "I know we haven't even had Thanksgiving yet, but I am so looking forward to what Market Foolery has in store for this year's Christmas playlist." For those who are relatively new to this podcast, for the last few years, in the month of December, producer Dan Boyd works his magic. Really, I don't think it's an overstatement, Dan, to say that we're doing this as a public service.

Dan Boyd: Oh, totally. You hear the same 45 Christmas songs every year on the radio stations. One of our local radio stations has already switched over to all Christmas music, all the time. And it's songs that I've heard uncountable amounts. What we try to do is bring people Christmas music that you're not necessarily going to hear on the radio or in the malls or on the soundtrack to your Hallmark Channel Christmas movie or whatever you're doing.

Hill: [laughs] Exactly!

Barker: You need that sometimes, though. The old standbys. But you also need to learn about some new ones.

Hill: There are some old standbys that are wonderful, classic tunes. But...

Boyd: But you get enough of them everywhere else.

Hill: Expand your playlist.

Boyd: Look at Barker over here. He's doing it. Every time, whenever I come on the show, he's like, "Actually, guys, what you're doing is wrong."

Barker: No, no! I'm just reflection on a time -- there was an election a couple years ago. I'm not going to say what election it was, but the day after, I needed to tune out politics, and there was nothing more comforting than going back to Christmas songs that I had heard hundreds and thousands of times for my drive into work that day. As out of place as Christmas music in mid-November would be, nevertheless. On those occasions, thankfully, post-election despondency for whoever has it at whatever time, it only comes every couple of years.

Boyd: That actually sounds very nice. 

Hill: So yes, Tom, the holiday tunes are coming. They're coming at the end of next week, when we have, for the first time in a very long time, an Apropos of Nothing episode. We're going to be recording that next week. That will kick off our holiday music. You, me, and ...

Barker: A special guest.

Hill: A special guest, who has never appeared on Apropos of Nothing before. If you're listening to this saying to yourself, "What in the world is Apropos of Nothing?" It's the rare episode where we come in here and just talk about nothing to do with business. It's just rambling. As a sneak preview of the Apropos of Nothing, this was a suggestion of the special guest -- the smallest hill you're willing to die on. I like that as a topic.

Barker: Of all hills? Or is that specific to the thing we were going to write?

Hill: No, I think it was, of all the hills you're willing to die on, what's the smallest one? 

Barker: OK. You're taking requests for topics. 

Hill: Yeah, if people want to email or tweet us like, "Hey, kick this question around."

Barker: There was one that's in the quite-likely to-do list, one of the requests that somebody sent in.

Hill: Yes. I've already forgotten what it is, but I have it saved in my email.

Barker: I can remind you later.

Hill: Okay. You can read more from Bill Barker and his colleagues, just go to mfamfunds.com. The website looks fantastic. They had a whole makeover. It's wonderful. Check it out, because we're not going to be here Wednesday or Thursday. Happy Thanksgiving!

Barker: Thank you! This is your big holiday.

Hill: Yes, very excited. Although, as one headline I saw, it's going to be the coldest Thanksgiving in Boston in over 100 years. I'm bracing myself for that.

Barker: And you're going out running in that, you say.

Hill: It remains to be determined if the annual 5K race is going to happen for me personally.

Barker: Since it won't be rainy, why not?

Hill: [laughs] Because right now, it's looking like it's going to be below zero.

Barker: Eh, you just burn off a few more calories trying to --

Hill: Not freeze to death?

Barker: -- keep the hypothermia at bay. That just leaves room for more stuffing.

Hill: Can't argue with that kind of logic. Thanks for being here!

Barker: Thank you!

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you on Monday.