On Wednesday, Target (TGT 5.44%) posted third-quarter results that featured phenomenal sales growth and a massive surge in earnings, obliterating analysts' expectations. With the retailer on track for record full-year revenues and earnings, its stock price rose to new all-time highs.
That's a familiar story: The same thing happened three months ago. However, with Target stock rising to greater and greater heights, investors may be setting themselves up for mild disappointment in 2021 and beyond.
Another spectacular earnings report
In the third quarter, Target's comparable sales jumped 20.7% year over year, while total revenue rose 21.3% to $22.6 billion. Digital comparable sales surged 155%, and accounted for a little more than half of the company's total comp-sales growth. Target's stores performed well, too, as customers spent significantly more on each trip.
Image source: Target.
The hardlines merchandise category grew the fastest, led by a 50%-plus increase in electronics department sales. The home department also posted comp sales growth of around 25%. Staples like food, beverages, essentials, and beauty supplies achieved high-teens comps. Apparel was a relative laggard, but its comps still rose nearly 10% year over year.
Target's sales growth wasn't quite as strong as it was in the second quarter, when it reported a 24.3% comps gain. Nevertheless, it's clear that the cheap-chic retailer is continuing to gain market share at a robust pace. It also expanded its operating margin by more than 3 percentage points last quarter, from 5.4% to 8.5%. As a result, adjusted earnings per share more than doubled to $2.79. That far surpassed the analysts' average estimate of $1.60.
Some of these gains aren't sustainable
Target seems likely to keep reporting strong sales and earnings results for the next two quarters. With the pandemic raging more intensely than ever, many consumers will continue to consolidate shopping trips for safety's sake. They will cook more at home. And while they're not spending as much on experiences, they may spend more on items for their homes. All of these factors are positives for Target.
However, looking further into 2021, the pandemic may start to abate thanks to the availability of highly effective COVID-19 vaccines. That could prompt an abrupt shift in spending away from "things" and back to experiences. As people return to restaurants and cease worrying about shortages, they may purchase fewer groceries and stop stockpiling household essentials. With the exception of apparel, the end of the pandemic could prove a drag on sales of every major merchandise category at Target.
The end of the pandemic can also be expected to reverse the chain's gross margin expansion, which was largely a result of it cutting back on promotions -- there's no reason to offer discounts on essentials you're struggling to keep in stock -- and its ability to sell more seasonal items at regular price rather than needing to put them on clearance. Some of the margin improvements related to clearance selling may be sustainable, but most are related to pandemic-specific conditions.
To be fair, Target is likely to maintain a higher market share than it had in 2019. Between competitors closing stores and customers who have developed new shopping routines, sales should remain well above prior levels. Nevertheless, there could be some erosion in 2021 and even 2022 as the temporary factors boosting Target's sales dissipate. That will also put pressure on profitability.
Are investors expecting too much?
On Friday, Target stock reached a new all-time high above $174. Even after rising about 40% in the past six months, the shares still trade for a little less than 20 times the company's projected 2020 EPS of $8.96. That actually represents a discount to the broader market.
Target stock performance, data by YCharts.
However, Target stock trades for about 27 times its 2019 adjusted EPS of $6.39. If Target cedes some of its 2020 market share gains and its profit margin reverts to 2019 levels over the next two years, its EPS could wind up somewhere between its 2019 and estimated 2020 results.
That wouldn't make Target terribly overvalued. But considering the competitiveness of the retail industry, Target stock would be a little pricey at these levels if EPS really does recede for the next year or two before returning to growth.
For long-term investors, Target certainly doesn't look like a bad investment. The company has proven that it can hold its own with the nation's other leading retailers. However, I'm somewhat skeptical that its recent business momentum will continue. As such, investors looking to put new money to work may find better luck elsewhere.
