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How Much Did Supply Chain Expense Impact Margins at Target?

Rising costs are taking a toll at Target Corp.

As the retailer reported strong Q3 earnings and anticipated a robust holiday season, it noted declining gross margin due to supply chain expense could be a recurring issue.

In a Nutshell: Target focused on growth and made investments in the quarter, including pulling orders forward, to ensure sufficient supply in time for the holiday season. In turn, it also saw higher supply chain expenses, such as shipping costs.

The company said third-quarter gross margin rate was 28 percent for the quarter, compared with 30.6 percent in 2020. Target attributed that decline to higher merchandise and freight costs, increased inventory shrink, and increased supply chain costs from compensation and headcount in the company’s distribution centers.

“We continue to see some periodic outages across different items and categories. We‘re in the holidays with a very healthy inventory position overall. Specifically, at the end of the third quarter inventory on the balance sheet was more than $2 billion higher than last year, representing growth of about 18 percent from a year ago,” John Mulligan, chief operating officer, told analysts on a Wednesday morning conference call.

Mulligan said a “sizable amount” of the inventory will continue to flow into Target stores over the next few weeks, and that the company has “clear visibility” to where the goods are located and when they will arrive. To meet the discounter’s goal of being ready for the holidays, the company has “secured the necessary capacity across both rail and over-the-road trucking to accommodate anticipated shipments throughout the fourth quarter,” he said, adding that the company is working around the port delays by diverting shipments to less congested entry points and relying on air freight when needed.

“We took specific actions to ensure we have a healthy inventory position going into the holidays, even though those actions involved some incremental cost,” Michael Fiddelke, CFO, said. 

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As for the added costs, Feddelke said it was worth it: “We’ve already seen the benefit of this year’s inventory investments, given that they helped to power our third-quarter traffic and sales growth that exceeded our expectations.”

Brian Cornell, chairman and CEO, told analysts that traffic was the primary driver of growth, “consistent with recent quarters.” And while he noted that supply chain pressures intensified in the third quarter, Cornell also focused on emphasizing that customers were responding to Target’s holiday promotions, low-price guarantees and ongoing efforts to take the pain points out of the shopping experience.

Investors had a different take, focusing less on customer response and showing that they weren’t thrilled with the possible margin outlook going forward. They sent shares of Target down about 5 percent following the company’s earnings report.

Analysts on the conference call were hoping to get some clarity on whether the gross margin hit was limited to the third quarter, particularly since the discounter was flowing goods in sooner for the holidays. Executives only said they expect supply chain issues to continue into 2022. As for the supply chain challenges, the expectation is that they would dissipate over time.

One other point analysts were hoping for some insight into was whether Target might pass on some of the cost pressures to consumers to offset the margin hits. Company executives said Target is facing product cost increases from some vendors, driven by higher costs in their businesses, but remained mum on whether they had any plans for price hikes.

While the general theme of the call was on the emphasis that Target was investing in growth to maintain and continue to build its market share, it appeared that analysts were hoping for more under-the-hood details so they could extrapolate what fourth-quarter earnings might look like, as well as better estimate their profitability projections for fiscal 2022.

Net Sales: For the quarter ended Oct. 30, total revenue rose 13.3 percent to $25.65 billion from $22.63 billion, which included a 13.2 percent increase in net sales to $25.29 billion from $22.33 billion. Target said comparable sales grew 12.7 percent in the quarter on top of a 21 percent spike a year ago, with comparable-store sales up 9.7 percent and comparable digital sales spiking 29 percent.

Feddelke noted that within digital fulfillment, sales on orders shipped to homes rose slightly over last year, while same-day services grew 60 percent on top of a more than 200 percent spike last year. Among the same-day options, both in-store pickup and Shipt grew more than 30 percent in the quarter, while drive-up grew more than 80 percent.

For the quarter, Target’s apparel business saw comp sales grow in the low double digits, according to Christina Hennington, executive vice president and chief growth officer. “Performance was strongest in swim, young contemporary, intimates and hosiery,” she said. In home, low double digit growth was led by seasonal categories and reflectedrecord-setting performance in the back-to-school, back-to-college and Halloween season,” Hennington said.

For the nine months, total revenue rose 15 percent to $75.01 billion from $65.22 billion. Net sales for the period rose 14.9 percent to $74 billion from $64.4 billion.

Earnings: Net earnings rose 46.8 percent to $1.48 billion, or $3.04 a diluted share, from $1.01 billion or $2.01, a year ago. On an adjusted basis, diluted earnings per share (EPS) was $3.03.

Wall Street was expecting adjusted diluted EPS of $2.83 on revenues of $24.78 billion.

For the fourth quarter, the company said it expects high-single digit to low-double digit growth in comparable sales, versus the previous guidance for a high-single digit increase.

For the full year, Target said it continues to expect its operating income margin rate at 8 percent or higher.

For the nine months, net earnings rose 80.8 percent to $5.4 billion, or $10.87 a diluted share, from $2.99 billion, or $5.91, in the year-ago period.

CEO’s Take: “Following comp growth of nearly 21 percent a year ago, our third-quarter comp increase of 12.7 percent was driven entirely by traffic, and reflects continued strength in our store sales, same-day digital fulfillment services and double-digit growth in all five of our core merchandising categories,” Cornell said.