Second-quarter earnings at Target (NYSE:TGT) showed that not only is its digital footprint growing, but also that e-commerce can be a profitable endeavor for a major retailer

At a time when analysts estimate Walmart (NYSE:WMT) will lose as much as $1 billion on its e-commerce efforts this year, Target says the billions it's invested in its online capabilities are helping boost profitability as margins expanded for the first time in almost three years.

Female Shipt worker selecting groceries at Target

A Shipt employee picking a grocery order at Target, which purchased the grocery delivery service last year. Image source: Target.

Leveraging the physical footprint

Online shopping through Target's mobile app and website -- coupled with in-store pickup and delivery through Shipt, the grocery delivery business the retailer purchased last year for $550 million -- helped both gross margin and operating margin expand in the second quarter.

Digital fulfillment and supply chain costs are still providing headwinds for Target, but at dramatically lower rates than before. According to CFO Cathy Smith, margin pressure was actually about half the rate in the second quarter as it was a year ago. Yet as Target drives more customers to its stores, leveraging its physical presence with its digital investments, the retailer is lowering costs while increasing productivity.

Walmart was one of the early leaders in using its vast brick-and-mortar footprint as local distribution centers to counteract the impact Amazon.com (NASDAQ:AMZN) was having on the way consumers shopped. Because 90% of the population lives within a few miles of a Walmart, it could arrange for order pickup in the store to rival the two-day delivery Amazon was promising.

Most other retailers, including Target, eventually followed suit, and now same-day pickup and delivery are becoming commonplace. But Target seems to have figured out the equation especially well.

Same-day fulfillment is the key

Same-day services such as in-store pickup, drive-up, and Shipt delivery have more than doubled Target's sales in the last year. And they accounted for more than a third of the retailer's digital sales, up from about 20% in 2018.

Second-quarter comparable digital sales grew 34% for Target, on top of a 40% increase a year ago, and the three same-day fulfillment options accounted for three-quarters of the sales. That means they're increasing as the preferred method of fulfillment by customers even faster than digital sales themselves are growing.

By pushing fulfillment to its local stores, Target is able to reduce its costs more than if it had to fulfill the orders through one of its distribution centers. 

Last year, all of Target's stores averaged productivity of just over $300 per square foot for order fulfillment, but its top quartile of stores, around 450 locations, delivered average productivity of more than $430 per square foot. It notes that for every extra $1 billion in sales fulfilled by its stores, it can raise productivity by around $4 per square foot.

As a result, since the beginning of 2018, order-picking efficiency for pickup and drive-up has increased more than 30%, while ship-from-store has improved by a like amount. 

A digital experience to drive profits

Target reported second-quarter revenue of $18.4 billion, a 3.6% increase from last year, generating earnings of $938 million, up 17.4% -- an indication the investments Target made in the three same-day delivery options are no longer much of a concern for profitability.

In essence, retail ought to thank Amazon for the changes it forced the industry to make. It shook it out of its slumber and caused retailers to rethink how they were serving customers.

As COO John Mulligan told analysts on the Target earnings conference call: "As we've been saying for years, we believe that in-store shopping will continue to be important and account for the vast majority of retail sales for many years to come. However, in a world where consumers have more choices than ever, inferior brick-and-mortar experiences will go away."

Target's second quarter proved that the retailer has heard the message and that the billions it has spent on an omnichannel experience were not wasted.