Target (TGT 1.92%) may have topped last quarter's earnings estimates. But between flat sales, a dramatic year-over-year dip in profits,  and weak guidance for the quarter now underway, the earnings beat is a hollow victory.

There's more to like about the retailer's fiscal fourth-quarter results than is readily apparent, however. One of its more complicated challenges of late is being successfully contained. That's its inventory. Just a few quarters ago, it was sitting on way too much. Now it isn't.

The backstory on inventory

You can't exactly blame them for putting themselves in the predicament. When the COVID-19 pandemic first showed signs of easing in 2021, retailers had good reason to believe a major recovery was taking shape for 2022. Target, along with peer and rival Walmart (WMT -0.15%), loaded up on merchandise for the impending boom in consumer spending.

It never quite happened, though -- at least not to the extent the industry thought it would. In fact, the post-COVID rebound didn't even come close to being as strong as expected. It was held back by inflation and a generalized disinterest in shopping.

End result? Both Walmart and Target started the latter half of 2022 with far more inventory than they'd normally be holding at that point in the year. In that much of this excess merchandise was summer-seasonal and therefore less marketable by that time, the two outfits had a tough choice to make: Risk keeping it around for sale at full prices at a later date, or mark it down and get it out of the way, even if it meant selling it at a loss.

Walmart chose the latter, which is why last quarter's gross margin percentage rate was lower than it's been in years. But the strategy solved the problem -- Walmart shed a huge chunk of the unwanted inventory that was getting in its way.

Target just did the same, and arguably did it better.

By the numbers

Last quarter's top line of $31.4 billion is up slightly from the year-ago comparison, but the $24 billion spent on those goods sold is up by a bit more than 5%. That's why gross profit margins slipped from 24.6% of sales for the final quarter of the previous fiscal year to 23.7% for the three-month stretch ending in January.

That's not a lot of numerical change for most industries. When you're talking about the retail industry's typical paper-thin margins, though, it can lead to a sizable setback. Total net profit margins fell from 5% of sales a year ago to only 2.8% of sales for the final quarter of Target's fiscal 2023.

Chart showing Target's gross margins on the mend after being pressured in 2022.

Data source: Thomson Reuters. Chart by author.

It may have been well worth the price, however.

Take a look at Target's historical sales, inventory, and inventory-to-sales ratio. Although revenue was effectively flat year over year last quarter, inventory levels peeled back from almost $15.1 billion a year ago to only $13.5 billion this time around. That's the least inventory Target's been holding at any point in the past six quarters, in fact, and the inventory-to-sales ratio of 43% is the lowest it's been for the past eight quarters. Moreover, this is all more in line with how the company usually ended its pre-pandemic fiscal years.

Chart showing that Target is successfully clearing out less marketable merchandise to make room for better-selling goods.

Data source: Thomson Reuters. Chart by author. Revenue and inventory figures are in millions of dollars.

This is no small matter. Target's buyers can't simply purchase more marketable goods because stores need new merchandise. Aside from a lack of funding -- unsold merchandise sitting on store shelves represents untappable capital -- there may simply be no space in stockrooms and warehouses to accept new inventory. Getting a wide swath of aging goods out of the way last quarter opens the door to the purchase of better-selling merchandise.

Target is positioning itself perfectly for this environment

This is where things get interesting for current and would-be Target shareholders.

The company's guidance for the current quarter isn't exactly thrilling. It's looking for sales anywhere from slightly below the year-ago comparison to low-single-digit growth. Adjusted GAAP earnings per share could roll in anywhere between $1.50 and $1.90 versus the analyst consensus of $2.14 per share, down from the year-ago figure, and reflecting net profit margin rates of between 4% and 5%.

That's more or less in line with the retailer's long-term norms, although CEO Brian Cornell is clearly making a point of keeping expectations in check. As he put it, "[W]e're planning our business cautiously in the near term to ensure we remain agile and responsive to the current operating environment."

The outlook, however, may well underestimate the upside of how much inventory-buying flexibility the company just secured for itself.

That guidance also arguably understates the benefit of the adjustment Target is making with respect to an economic environment marked by inflation.

After posting its fiscal Q4 results on Tuesday morning, the company posted a strategic update Tuesday afternoon noting it intends to launch or expand 10 private label lines with several starting price points of less than $10 per item. In addition to further differentiating itself from Walmart, this pricing and private label strategy gives the company a chance to win back some of the value-oriented business it may have been ceding to the likes of Dollar General (DG 1.00%) and Dollar Tree (DLTR -0.66%).

Whatever's in the cards, the stock's still well down from its 2021 high, leaving shares lots of room to recover. There's plenty of reason to expect such a recovery, too, especially now that Target isn't saddled with too much unmarketable merchandise.