Target (TGT -0.70%) spooked the market again on Tuesday. Three weeks after the big-box chain provided a dismal first-quarter earnings report, Target said it would accelerate markdowns to right-size its inventory as it struggles with a normalizing economy following the pandemic.
The retailer said consumer staples categories like grocery and health and beauty remain strong while discretionary categories like home goods are suffering. After two years of stocking up on things like home furnishings, consumers now appear to be shifting their spending back to services like travel and restaurants.
In its updated guidance, Target now expects an operating margin of just 2% for the second quarter, which compares to guidance just a few weeks ago of an operating margin in the range of 5.3%. In the second half of the year, Target expects its operating margin to return to 6%, which it said was better than historical levels before the pandemic. Management offered revenue growth guidance in the low- to mid-single digits and said it expected to maintain or gain market share.
Image source: Target.
A classic retail problem
Managing inventory is one of the most challenging parts of the retail business. Retailers need to make sure they have the right amount of merchandise available as well as choose products that match customer tastes. They also need to make these decisions months in advance. Orders in some categories even take place the previous season.
If a retailer doesn't have enough inventory, the shelves are bare, and they lose out on sales. If they have too much, they need to sell it at a discount to get rid of it.
It was clear from Target's first-quarter earnings report that the company had been surprised by the sudden slowdown in consumer demand in discretionary categories like home. It was already stuck with a glut going into the second quarter as inventories jumped 43% to $15.1 billion even as revenue increased just 4% in the quarter. That's a sign Target badly overestimated consumer demand.
What it means for Target and the retail sector
Target is doing the right thing here. It's better off confronting the inventory glut head-on and taking a bath in the second quarter than hoping consumer demand will return.
While it's frustrating for investors to see the retailer commit an unforced error, Target's blunder was a common one in the first quarter, and it was part of the reason why several retailers posted declining earnings per share and weak guidance. For example, Walmart's inventory rose 32% in the first quarter even as revenue increased just 2%, showing that company is in a similar position.
Not every retailer is facing that inventory problem, and Target's case seems extreme. Notably, the company didn't give a specific warning on consumer demand, only saying that consumer buying patterns were shifting. It did note cost pressures, including in-freight transportation, that are affecting the industry as a whole.
Still, Target's guidance cut seems to be less of a warning for the retail sector in general and more of a statement about retailers that mismanaged their inventory in the economic reopening. Many of those will be forced to do markdowns and are likely to report disappointing second-quarter profits.
How to approach Target stock now
Target shares plunged 25% when it reported first-quarter earnings last month, and the stock has fallen from there, down 4% on Tuesday on the guidance cut. The latest update makes clear that the challenges the company is facing won't be easily undone, especially with the broader economic uncertainty in the market.
However, over the long term, the current challenges are likely to be irrelevant. The company is one of the world's largest retailers and has demonstrated its ability to compete and grow market share in e-commerce thanks to the strength of its same-day fulfillment programs and its use of store-based fulfillment as well.
Moreover, it's also a Dividend Aristocrat. And the shares now trade at a price-to-earnings ratio of less than 15 based on estimates for this year, which will be impaired by its inventory problems. In a normal environment, its P/E would be more like 12.
While things could get worse for Target before they get better, that looks like a good price for a retail stock that's been a consistent winner over the past several years.
