Traffic growth supporting earnings

A rising trend in same store sales is boosting Target’s confidence that earnings will continue to move in unison. Target’s second quarter earnings of $679 million were up 14.3% on total sales growth of 3.1% as more people came through the doors during the period.

Target’s second quarter earnings should give the market some comfort that despite soft top line growth, quality retailers are still able to generate earnings growth through increasing productivity and efficiency. This was exemplified in Target’s result with a 3.8% gain in retail sales translating into a 17% gain in earnings per share at the bottom line. In between were several factors that were deliberately controlled by management to achieve that outcome.

The 1.7% increase in same store sales was a good start to the positive earnings result. The recently released second quarter sales result (see FAT225) showed the company had slightly underperformed some of its rivals in absolute sales terms. But we were guardedly optimistic that the profit result would deliver a more meaningful message to investors that the earnings path was on the right track. It seems as if this is bearing out.

Foot traffic count was up 2.4% across the quarter, offsetting a 0.8% decrease in average ticket price. The combination of these two factors was a 2.0% increase in units per transaction. The average selling price per unit declined by 2.7% in the quarter. Prices are generally still under pressure from intense competition and the need to ensure that stock levels do not blow out, leading to even more intense discounting.

This is a fine line that retailers constantly tread but the smarter businesses find ways to circumvent the problem. One such initiative is a 5% discount for shoppers that use credit and debit cards under a new rewards program to be introduced in the fourth quarter this year. That will provide an enticement to customers to not only enter Target stores but to spend more money. Target has been testing the scheme in Kansas City with the initial results very encouraging, according to the company. The national rollout could add 1% to Q4 sales and possibly 1-2% across all of FY11.

Another significant strategic move has been the PFresh program that is introducing more fresh product into Target’s general merchandise mix. Only 300 stores so far have the PFresh initiative installed but the potential is for another 1,400 stores to roll out the concept.

As per the quarterly sales release, Target said food and healthcare sales had been good with women’s apparel and shoes registering high single-digit increases. Electronics, video games music and movie sales had been slow.

The back-to-school season has been typical with sales trends in line with expectations.

The momentum that is building in Target has provided management with sufficient optimism to guide the market to expect comparable store sales growth of 1-3% in the third quarter this year. That momentum should carry through to the fourth quarter, hopefully even enhanced by the PFresh and 5% discount offers.

The most encouraging signal to date has been the steady increase in foot traffic. If this can be sustained into the crucial holiday season, Target will be in good shape for the full year.

Target’s store program is also signalling confidence in the near term future. With 1,743 stores today, it is continually remodelling the portfolio. Traditionally this is done over a 13-week period where the store remains open during the process, suffering reduced turnover during the disruption. As a trial, one store due for remodelling was closed completely over a 5-day period before re-opening. The results were not made public but we suspect it will not become the modus operandi as Target said there were limited opportunities to perform this ‘extreme makeover’.

The store count is growing robustly. A further 24 stores have been opened over the last 12 months, contributing to a 1.8% increase in retail square footage to 232.5 million square feet. Management plans to open 10 more stores in Q3 with a similar number in the final quarter of the year. Across 2011, a further 20 new locations are due to open followed by 30 more stores in 2012.

In addition, Target is still working on a new urban store format. These smaller stores are likely to be in-fill opportunities. The concept could be launched within the next few years.

Target is tightening its credit card standards to mitigate the risk of bad debts and an undesirable lift in receivables. Late fee income has been about one third lower than last year and net write-offs are expected to stabilise around $200 million per annum.

Management noted that the company is generating “far more cash than we believe is prudent to reinvest in our business at this time”. A 47% increase in the dividend has raised the annual payout to $1.00 per share although the payout ratio remains low at 25%. In addition, however, Target bought back $907 million in shares in the second quarter (17.5 million shares at an average price of $51.72). Since the share repurchase scheme began in the fourth quarter of 2007, the company has repurchased 128.6 million shares worth $6,620 million at an average price of $51.46.

The weekly chart of Target shows the share price has broken its uptrend that has been tracking the price rise since March 2009. The price action is currently consolidating sideways in a tight range bouncing above and below both the 39 week and 200 week moving averages. The weekly MACD which had given a bearish signal earlier in the year has now crossed back into positive territory above the zero signal line which suggests the moving average support may hold.

The recent daily price action is now trading in a tight range between $53 and $48. Of some concern is the recent cross of the 50 day below the 200 day but this signal is not confirmed until we see a clean break of the price below these moving averages.

Summary

Target’s confident store sales forecasts have given the market a boost. In combination with its traffic and store initiatives, it should be enough to sustain the positive earnings momentum through the financial year.

The recent macro-economic data is suggesting consumers are still not spending in the same manner as they have previously, but the new reality for retailers may simply be a lower rate of sales growth. In that sense, retailers that can generate solid earnings growth through good cost management and clever marketing will provide investors with a reasonable return.

We will continue to hold Target in the Fat Prophets Portfolio for these reasons.