Target’s CEO John Mulligan Discusses Q1 2014 Financial Results

We’re pleased with this progress and continuing to take steps that reinforce our commitment to earn back the trust of our guests.

We recently announced that we’ve hired Bob DeRodes as our new Chief Information Officer and I’m confident that Bob is the right person to lead our technology transformation and data security remediation efforts.

That same day, we also announced the important decision to move all of our REDcards under MasterCard’s industry leading chip-and-PIN technology. This decision, along with our accelerated rollout of chip-enabled card readers to all of our stores by this September, are among many crucial steps we’re taking to restore confidence among our guests, that it’s safe to shop at Target.

First quarter Canadian segment results were also largely in line with our expectations. Sales were just below the expected range, driven by softness early in the quarter. While losses were meaningfully lower in the fourth quarter, we’re still far from where we need to be. We continued to roll out enhanced tools and technology. We’ve increased the intensity of our volume messaging, and we’ve made several important changes to the Target Canada leadership team during the quarter.

As a result, we’re beginning to see improved guest satisfaction measures regarding in-stocks and price perception. While these early signs of progress indicate that we’re moving in the right direction, we’re committed to moving faster.

As we look ahead to the second quarter and beyond, the board and our team are aligned on three priorities. The first is growing traffic and sales in our U.S. segment. While the environment is challenging, we can do better. We need to improve on something we’ve historically done well, delivering unique products and services at great prices. As a result, we’re working quickly to drive more newness in our merchandising and presentation, helping to keep Target top of mind with guests by continually reminding them why they fell in love with Target in the first place.

Second, we must improve our Canadian segment performance. Canada is a great market and Target is a great retailer, but so far, we have not lived up to our potential or our expectations. Improving operations is key, but we need to think broadly about all aspects of our business and whether other changes are needed. We’ve made changes to the Target Canada leadership team so they could take a hard look at our current performance and apply fresh thinking about how to improve.

Finally, we need to accelerate our digital transformation and become a leading Omni-channel retailer. To do this, we’ll move more quickly to become more flexible in how we serve our guests, eliminating barriers that prevent them from shopping with us, where and when they want. This includes delivering products and services more flexibly in our stores or anywhere else the guest wants to receive them.

Our common theme across all of these priorities is a continued focus on our guests, not just the ones we currently have, but the potential guests who aren’t shopping with us today. We need to listen intently to all of them, how they’re feeling, what they want and how well we’re serving them. With that knowledge, we need to make decisions based on what will inspire them, deepening their love for Target by making their lives easier and apply all of our energy to make that happen.

Finally, we know we can’t accomplish any of this unless we unleash the talents of our great team. So we are focused on prioritizing and aligning our efforts to provide greater clarity and removing roadblocks that have been slowing our team down. We will empower them to take smart risks and hold ourselves accountable for learning quickly from the results.

We have been on this journey for some time, but the board believes and we agree that we can accelerate our progress. Given the recent announcements of leadership changes, many of you asked what is going to change. While that is certainly important, I want to make sure we discuss what is and is not going to change.

What clearly will change includes our emphasis on speed throughout the organization, our commitment to more rapid improvement in Canada, our focus on digital and becoming a leading Omni-channel retailer, and the level of investment in newness and innovation and what we offer to our guests. While we work toward those goals, we’ll continue to develop smaller, more flexible store formats to allow us to serve guests in markets that can accommodate our larger store layouts. We’ll continue our expense optimization efforts. Our goal is not to cut our way to prosperity, but to free up resources we can leverage and support a faster growth.

Finally, our point of view on capital deployment remains the same. This has always been a board level discussion and we continue to be aligned with them on the following priorities: invest everything appropriate in our core business on projects that will support Target’s growth and generate superior returns; support the dividend and build on our record of more than 40 years of annual dividend increases. And beyond those first two uses, return cash through share repurchase when we have room within our middle A credit ratings.

The board has made it clear that they agree with these priorities and that our leadership team has their full support. Our mission from the board is clear: provide focus, remove roadblocks and unleash the team to move faster. As Jeff Jones, our Chief Marketing Officer likes to say, interim will not mean idle. We’re committed to making real changes now, accelerating our transformation during this transition period, while the board conducts its search for a permanent CEO.

As Kathee mentioned, our first quarter results were markedly better than our fourth quarter performance, specifically compared with the trends we were seeing late in the fourth quarter following the announcement of the data beach.

In the U.S. segment, our comparable sales decline of 0.3% was near the high end of our guidance and flat to down 2%. Comparable traffic declined 2.3%, dramatically better than our late fourth quarter trends, but well below where we should perform over time. Consistent with broader trends in the U.S. market, traffic in our stores has been declining, while transactions in our digital channels have been growing rapidly, particularly in mobile.

However, given the relative size of these two channels at Target today, the mix effect of these opposing trends is driving a decline in overall transactions. The key to reversing this decline is clear: accelerate our digital capabilities and leverage assets across both our physical and digital channels to lead guests to choose us more often than they are today.

The distinction between channels is increasingly unimportant because single transactions are already straddling both the physical and digital channels. Ultimately, we should be agnostic about which channels guests choose and enable them to interact with us where and when they want to: in our stores, digitally, or preferably both.

First quarter penetration on our REDcards was 20.4%, up 3.3 percentage points from last year. This is very healthy growth, but a couple of percentage points below rates we were seeing prior to the data breach.

In the first quarter, as research showed that most consumers are putting the breach behind them, we ramped up REDcard offers to guests in our stores, and by the end of the quarter, we were making those offers with the same frequency as before the breach.

When we make an offer, the application rate for our credit card has largely recovered to pre-breach levels, but the rate for the debit card is responding less quickly. As a result, we expect slower U.S. REDcard penetration growth in the second quarter, up between 200 and 300 basis points from last year.

Looking ahead as part of our broader effort to rebuild traffic and sales, we will work hard to reaccelerate REDcard growth, particularly the debit product through our marketing and an enhanced focus on the role our store team members play in generating REDcard applications.

Our first quarter U.S. segment EBITDA margin rate was 9.5%, down nearly a percentage point from last year, driven by a gross margin rate decline of more than a percentage point.

As Kathee mentioned, we ramped up the intensity of our deals in the first quarter to get guests back into our stores and this decision was reflected both in better sales and traffic and a lower gross margin rate.

Our SG&A rate improved about 30 basis points from last year, reflecting outstanding discipline across the company, including the benefit of our expense optimization efforts as well as the timing of some expenses compared to last year.

In our Canadian segment, first quarter sales were below expectations in February and March, but were better than expected in April. Our first quarter gross margin rate was 18.7%, much better than the fourth quarter, but still below our full year expectation as we worked to clear excess inventory on long lead time receipts.

Expense rates were much better than a year ago, reflecting scale benefits and the comparison to last year’s preopening costs.

First quarter REDcard penetration was 3.9%, was nearly double last year’s rate, but still well below where we believe it will be over time.

Consistent with last quarter beyond operating results, our first quarter GAAP earnings reflected several items that reduced EPS by approximately $0.04. These items included data breach related costs net of an insurance receivable, continued reduction in the beneficial interest asset and a charge related to our decision to move from Visa to MasterCard for our co-branded REDcard credit product.

Turning to consolidated metrics, our first quarter interest expense of $170 million was down more than $450 million from a year ago, as we annualized the first quarter 2013 charge for the early retirement of high coupon debt.

We returned $272 million in dividends this quarter, up from $232 million last year as our $0.43 per share quarterly dividend was more than 19% higher than a year ago. We plan to recommend that our board authorize another similar increase this summer.

We did not repurchase any shares in the first quarter. While we expect to generate cash well beyond our expected uses over the next several years, our current metrics are beyond typical boundaries of our middle A credit rating. As a result, we do not expect to repurchase shares in the second quarter and may resume repurchases in the back half of the year at the earliest.

To resume this activity, we need to see continued improvement in our U.S. and Canadian operations, moving our credit metrics back to acceptable levels, relative to our single A rating. In addition, we believe it’s prudent to hold off on any repurchases until we have more visibility into our potential liability for third party card networks fraud and administrative costs related to the data breach. Based on what we know today, we do not expect to have visibility into those claims until the third quarter or later.

I’ll turn now to our outlook for both the second quarter and our updated expectations for the full year. Given our current trends and challenges in both the U.S. and Canada, we believe it’s appropriate to maintain a cautious outlook for sales in both segments. This allows us to plan inventory and hours effectively, while building contingency plans to allow us to flex higher as sales grow more rapidly than expected. We’ve updated our full year expectations for profitability in both segments, taking a more cautious view in light of the environment and the additional steps we’re taking to grow U.S traffic and sales, accelerate improvement in our Canadian operations and step up the development of our digital capabilities.

While we don’t expect these additional efforts to change our 2014 capital expenditures in a meaningful way, we are planning for lower operating margins in both segments as we dedicate additional resources to make progress.

Specifically, we expect to invest more in gross margin for newness, product innovation and promotions in both the U.S. and Canada to enhance our value proposition across both sides of the Expect More, Pay Less brand promise, and incur incremental expenses as we devote more resources to improve operations in Canada and speed up the development of digital and flexible fulfillment capabilities in the U.S. Longer term, we believe these investments will be paid back in the form of faster, profitable growth and increasing market share in both segments.

One note. Consistent with guidance last quarter, our outlook does not include potential additional costs related to the data breach beyond what we’ve already recognized as they’re still not estimable. As I mentioned, we continue to believe we have the financial strength to move beyond these near-term impacts once they are known even as we continue to invest to grow in both of our segments.

So with that context, let’s turn first to our expectations for the second quarter. In the U.S, we expect a slower improvement in sales trends, meaning, second quarter comparable sales should be flat to slightly positive.

We expect U.S. segment EBITDA margin rate will be below last year’s 10.8% rate, but we expect a smaller year-over-year decline than we experienced in the first quarter. Both gross margin and SG&A expenses will be pressured by our efforts to grow traffic and expand our digital capabilities, but we also expect an offsetting benefit of both gross margin and SG&A expense lines from our expense optimization efforts.

In Canada, we expect sales measured in U.S. dollars to be up about 75% from last year’s second quarter and about 25% higher than the first quarter. We will report Canadian segment comparable sales for the first time in the second quarter, but this measure will be highly volatile in the near-term as we’ll be measuring in our small set of stores.

Specifically, we expect to report a single-digit decline in second quarter Canadian segment comparable sales as we’ll be comparing against the very large grand opening surges we experienced a year ago, combined with the impact of our market densification later in 2013, which redistributed sales from our initial openers.

We expect the Canadian segment gross margin rate will improve beyond 20% in the second quarter, but will continue to reflect pressures from promotions and efforts to eliminate excess inventory. Expense rates in this segment should show modest improvement from our first quarter rates, but will remain elevated far beyond what they’ll be in the long run. Altogether, second quarter Canadian segment EBITDA losses measured in U.S dollars are expected to be approximately flat to last year.

We expect second quarter consolidated interest expense to be approximately flat to last year and tax expenses to be somewhat lower. Altogether, our expectations would generate adjusted EPS reflecting results from both our U.S. and Canadian operations of $0.85 to $1, excluding $0.02 related to the reduction in the beneficial interest asset and any potential cost related to the data breach.

For the full year, we continue to expect U.S. comparable sales in a range of flat to up 2% and we still expect an SG&A expense rate of about 20%. However, we’ve taken our gross margin rate expectations down below 30% to make room to invest more in products and promotion.

In our Canadian segment, in light of recent trends we’ve taken down our full-year sales expectations closer to $2 billion and with that new view of sales, we expect lower gross margin rate and higher expense rates than before. Specifically, we now expect our full-year Canadian segment EBITDA margin rate will be closer to minus 20% compared with our prior expectation closer to minus 10%. Altogether, these updated expectations will put our full-year adjusted EPS in a range of $3.60 to $3.90, $0.25 lower than the range we provided a quarter ago.

While these are our current expectations based on where we are today, I don’t want to create the impression that we’re satisfied. Recent management changes, including yesterday’s announcements, demonstrate that we believe meaningful change is needed to put us on a different long run trajectory.

In Canada, we need much more urgency to improve our operations, so our systems and supply team can enable the rapid growth in sales we’ll be driving to achieve scale. And in the U.S., even though we’re seeing industry leading growth in the digital channels, we need to grow even faster to catch up with others who have been on the journey for a much longer time. And we need to become much more willing to deliver more newness and differentiation to our guests.

Given that we’re already known for it, we need to continually raise the bar on what newness means. Providing our guests with a sense of inspiration and discovery that makes them want to visit us more often in whatever channel they choose.

 

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