The largest retailers in the U.S. took center stage this week, with 3Q22 updates painting a more bifurcated outlook than many had anticipated. Target’s traffic and sales results were in-line for its October-end quarter; however, "trends softened meaningfully" late in the quarter and continued into November, which resulted in management lowering their 4Q22 sales and profit outlook (which now includes a low-single-digit comp decline and margins of around 3%, versus its prior plan of around 6%). In light of management’s lowered outlook for the business and economy, Target announced a $2B-3B expense restructuring program. In contrast to Target’s revised outlook, both Walmart and Sam’s Club came in well above plan for sales and profit results on both an absolute and relative basis. Sales at Walmart’s physical stores were up substantially as more consumers sought out Walmart’s value during this highly inflationary environment.
After again reviewing 2Q22 results for these chains, we would say that the Q3 trends were more of a continuation of the summer and not a new and sharp downshift. That trend is a consumer unwind of demand for goods, especially soft-home, cozy/comfy apparel, and consumer electronics. In addition, we are mindful that curbing consumer demand for goods to stem goods-price inflation is the Federal Reserve’s objective.
Why the difference between Target’s and Walmart’s results and outlooks? Three reasons. First, only 20% of Target’s business is grocery compared to 50% at Walmart. As we have been writing about recently, discount grocers have been experiencing substantial trade-in, whereas more conventional grocers have been suffering disengagement. Target is not getting that trade-in. Walmart stated that two-thirds of its market share gains in grocery were in households with >$100K in income, which squares with our consolidated trade area demographic data (below).
Second, Target’s discretionary business is running on a far higher level to the 2019 baseline than Walmart’s. Target’s 2H21 apparel, home, and hardlines business was 34% above its 2H19 level. In contrast, Walmart’s general merchandise was only 9% above. These categories represent 60% of Target’s sales mix compared to 30% of Walmart's, or 2X. As such, the normalization of consumer spending in these categories is going to have a far harsher impact on Target given that it has 3X higher exposure versus Walmart and 2X the sales mix (leaving it 6X more exposed). These dynamics also hurt Target in other ways. For instance, Target's inventory turns slowed further, leaving it with still too many goods. Too many goods results in greater clearance activity, depressing margins, and leaving less ability to flow in new goods that "surprise and delight" guests. Retailers work best when they are in chase-mode and less well when in clearance-mode.
Third, the consumer perceives (falsely) that Walmart has meaningfully lower prices than Target. Target’s comments during its 3Q22 reinforce the deal-driven mindset that we have discussed in recent weeks, with management noting that the consumer is now moved (traffic and conversion rate) by lower prices. During the past two years, the consumer has been more focused on "value" with value being measured by quality/make with less consideration put on actual price. As such, Target needs to move its merchandise mix more towards opening price points and Target private brands, which takes time. On the other hand, Walmart doesn’t have to make such an adjustment because they are the price setter for the lowest price, and as such, they are where shoppers flock for today’s best expression of "value."
In our updated Holiday 2022 outlook in last week’s Anchor, we argued that the physical store would stand out more prominently this season as consumers more carefully scrutinize each purchase to assure "the perfect gift" (interestingly, we saw dwell times increase across a number of retail categories in October, which some management teams have attributed to increased instances of "price shopping"). We also argued that omnichannel retailers had the opportunity to build upon their recent gains as digital-only retailers were suffering commingling, concentrating, and compounding headwinds; and as such recent disruptors to physical retail were unlikely to grow this holiday and "rob the room of its oxygen." As a consequence, omnichannel retailers would find it easier to increase their rates of customer acquisition and engagement. This week’s updates from Walmart, Target, and other larger retailers strongly support those arguments as well as our recommendations for physical retailers to further invest in products and services that "surprise, thrill, and delight" as that is where physical retail has a competitive advantage. All of these factors will be in more force after the holiday season and during 1Q23.
Other callouts from our updated Holiday 2022 Outlook that were on display in Target’s and Walmart’s updates include: (1) food & beverage is to be an outperforming category as consumers want to festively celebrate the holidays with loved ones (and to show off new homes purchased amid migration trends); and (2) value, club, discount, and off-price retailers are going to be the retail channels of consumer choice this season. We've provided some additional commentary from Target and Walmart's updates below.
Key Target Metrics
- Target’s comparable store-sales increased +2.7%, which was evenly split between average ticket (+1.3%) and transactions (+1.4%). Sales were led by beauty, food & beverage, and household essentials. CEO Brian Cornell shared, "Through the first two months of the quarter we had seen comp growth of well over 3% and then saw a deceleration to just under 1% in October. Even within the month of October, results in the back half of the month were much softer than in the first half and the mix of our sales tilted much more heavily towards promotions. This rapid change in trend is consistent with what we're seeing in syndicated data on broader industry trends and the feedback we're hearing from our guests. More specifically, consumers are feeling increasing levels of stress, driven by persistently high inflation, rapidly rising interest rates and an elevated sense of uncertainty about their economic prospects. With high rates of inflation continuing to erode their purchasing power, many consumers this year have relied on borrowing or dipping into their savings to manage their weekly budgets but for many consumers those options are starting to run out. As a result, our guests are exhibiting increasing price-sensitivity, becoming more focused on and responsive to promotions and more hesitant to purchase at full price."
- Target Chief Merchant Christina Hennington said, "When they shop our frequency categories, some guests are trading into smaller pack sizes, opening price-point options or own brands to reduce their spending on a single trip…these trends only became more pronounced towards the end of the third quarter when spending patterns changed dramatically. With inflationary food prices absorbing more of their spending, those costs are crowding out other categories, including spending on discretionary items and in some cases, even household essentials. However, we also note both from our recent performance and from guest surveys that despite the pressures they are facing, our guests want to celebrate the holidays in person with loved ones…As we turn our focus to 4Q22, we'll do what we always do: work tirelessly to deliver value and solutions to our guests while also delivering …, we're focused on providing our guests with affordability…[and) one of the signature ways we plan to stand out this holiday season is through our focus on the combination of newness and value, which cut across all our core categories. Given that the gift-giving season is underway, and our guests are turning to Target more and more for their food and beverage needs."
- Placer data (below) confirms the downshift in trend articulated by Cornell; however, when looked at on a three-year basis, November only shows about a 350-basis point downshift.
- Target's Trailing-twelve-month (TTM) sales per square foot increased $7 QoQ to $443, and this metric is likely to increase by a low-single-digit rate over the next year. Four new locations were opened during the quarter, and the company remains on track for 23 for the year. Chief Operating Officer John Mulligan noted that "we’re finding more and more opportunities to open larger locations… [and] we plan to lean into [the new larger 150,000 square foot prototype unveiled outside of Houston]."
- Profitability substantially declined and profits halved. While Target increased its revenue and units sold, they sold each unit on average for 5% less than last year. Target's gross profits fell by 9% and its gross margin rate declined by 335 bps. Assuming Targets’s average unit retail (AUR) was $20.00 in 3Q22 last year, its retail margin per unit sold declined from $1.30 to $0.46.
- Gross margin rate is down due to clearance activity, liquidating inventory through salvage, and theft. CFO Michael Fiddelke shared, "The primary driver was a higher-than-expected markdown impact from promotions as our guests became increasingly price-sensitive and concentrated their discretionary spending on items on promotion, most notably in the latter weeks of the quarter. While we anticipated a highly promotional environment this fall, given the excess inventory we've been seeing across retail, this enhanced focus on promotions reflects an increasing level of stress on consumers, as they navigate through multiple headwinds including persistent inflation and rapidly rising interest rates."
- Shrink is a growing problem facing all retailers. Fiddelke noted that at Target, "year-to-date, incremental [shrink]…will reduce our gross margin by more than $600 million for the full year…[This] is an industry-wide problem that's often driven by criminal networks, and we are collaborating with multiple stakeholders to find industry-wide solutions." Assuming that the stolen merchandise had a COGS of 60%, this is $1B in retail value, or over $500K per store Assuming that the merchandise has an average retail price of $40, that’s around 13K items per store stolen from Target’s stores and network for the year. Moreover, Target expects the shrink/theft problem to intensify as the economy worsens and in response more product is going to go behind glass and under lock & key, which is sub-optimal from a shopper experience perspective.
- TTM EBITDA and free cash flow deteriorated QoQ from $8.5B and $477M, respectively, to $7.6B and -$1.8B. Both figures are most likely to climb higher over the next year. However, reflecting the deterioration, buybacks are on hold until a solid recovery in the figures.
- As mentioned above, Target announced a $2B-3B expense reduction program that is to take up to three years to implement. This is a big number relative to our estimate of central costs at $6.8B (excluding marketing) and it involves task simplifications and re-building processes to remove waste. It’s also important to keep in context that $2B-3B also includes savings from new hires and wage increases that were previously planned and budgeted for, including at the stores, distribution centers, sortation centers, and last-mile delivery costs. (which echoes Amazon’s shutdown and canceling of fulfillment centers). In light of this reduction program and the one at Amazon, as well as the softer revenue outlook from the two, we suspect that future announced "wage investments" by the two will be far less frequent (perhaps even absent) than they have over the past four years. Beginning in 2018, competition for store, distribution center, and fulfillment center workers rapidly intensified both because workers were growing scarcer and because Target and Amazon wanted to increase the competitive pace and pressure on less well-positioned and -capitalized competitors. Given the size and prominence of the two, they moved the labor market’s wage higher. That strategy, or challenge, looks to have run its course. For the remainder of this year and into 2023, we will be listening closely to see if that is in fact the case, as well as to carefully scrutinizing the BLS Employment Situation report (the unemployment report). Should this truly be the inflection point in retail labor cost escalation, that will be a major win for the Federal Reserve in its fight against inflation.
Key Walmart Metrics
- Walmart's U.S. comparable-store sales increased +8.2%, with grocery comps growing by a mid-teens pace. The comp composition was +5.6% in average ticket for physical, +1.7% in transactions for physical, and +0.8% from digital. Placer data shows that conversion rate improved YoY, indicating that when a visitor came into the store, they liked what they discovered and purchased. Walmart U.S. health & wellness category also posted very strong results with +high-single-digit growth despite lapping last year’s vaccine lift. General merchandise categories like lawn & garden, automotive, and back-to-school were higher YoY; whereas, apparel, electronics, and home were down as expected. Compared to its plan, management noted that upside came from share gains with households with incomes above $100K (as noted above), curbside, and delivery. Management stated that Walmart U.S. sales were strong each month of the quarter and into November, with 4Q22-to-date sales meeting their plan for 4Q22 (comps of +3%). We believe that the more likely range is mid- to high-single digits given their market share gains.
- Walmart's trailing-twelve-month sales per square foot increased by $14 to $593 QoQ and will likely increase by a mid-single-digit-plus rate over the next year due to persistent inflation, ongoing market share capture of households and household budgets, and the advantages from omnichannel. If one assumes an average ticket size of $41, each Walmart U.S. location has added about 1K transactions per week which is more than 3X the rate of last quarter and validating the point above about omnichannel increasing its rate of new households. Placer data shows unique visitors were roughly flat YoY during October for Walmart; whereas, visitors declined 1.5% for Target. The chart below shows that visitation surged for Walmart going into Halloween; whereas the lift at Target was more muted.
- Walmart's inventory levels were appreciably brought down intra-quarter and should be a non-issue by year-end, leaving the company in a strong position to drive profitability higher in 2023. That is a welcome development for Walmart’s competitors (that are also trying to clean up their inventories and restore their own profitability).
- Profitability (adjusted for one-time and extraordinary items) moved down modestly to 4.9% from 5.3% due to the increased clearance activity to reduce the remaining excess inventory of general merchandise (that was present exiting 2Q22) and higher wage costs. Walmart increased prices to fully cover supplier price increases. For example, Nielsen data for the 4-week period ending November 5th shows General Mill’s brands up +23.5%! In response to the high inflation for food items, CEO Doug McMillion stated, "inflation in dry grocery is too high, we want to bring prices down." That statement follows an article this past week in the WSJ titled, "Walmart Is Flexing Its Muscle Again: The largest U.S. retailer and other industry giants are taking an increasingly aggressive stance with suppliers as the economy slows. The world has turned." We believe this means that further price increases by national packaged food brands are over and that retailer brands’ price points are soon to run lower as the retailers seek to further differentiate themselves on value.
- Assuming inflation comes under better control--which we would define as a 10% monthly decay in the rate of inflation over the forthcoming months through monetary and fiscal policy, lower commodity costs, retailer push-back on suppliers, and consumer curtailment of demand (both switching to private label and cutting calories)--that would still put food-at-home prices 30% higher than they were at the start of the breakout (below). That’s a stunning increase for those households of more limited means and it implies longer-term adjustments for the grocery industry; that stark 30% figure should also be considered when thinking about the proposed Kroger/Albertsons merger. Kroger’s arguments for the merger include being able to offer the best sourcing for produce (freshness and quality) at the best price, more retailer brands, and more pushback on suppliers (shelf stable product). We suspect that Albertsons and Kroger are extra incented to "flex their muscles" as well
Key Sam's Club Metrics
- Sam’s Club comparable-store sales (excluding gas) increased +10%, which keeps the 2- and 3-year CAGRs consistent. The comp was evenly split between ticket and transaction. The only declining merchandise category was consumer electronics. Home and apparel were up high-single-digits. As shown in the table below comparing Sam’s to Costco, both are producing very stable 2- and 3-year CAGRs, with Sam’s moving higher as its sales growth was less dynamic in 2020 creating an easier comparison base.
- Sam's trailing-twelve-month (TTM) sales per square foot increased $30 QoQ to $1,023. It seems highly likely that this figure moves up high-single-digits over the next year.
Membership count was at a record level; of note, Sam’s increased its membership fee in October; Costco chose not to follow.
- Profitability improved YoY as Sam’s has increased confidence about the value of its offering after two+ years of enhancements. When asked about Sam’s ongoing momentum, Sam’s President and CEO Kathryn McLay explained, "I think we have a pretty simple flywheel that's been sitting at the heart of driving the growth over the last 3 years. And it all starts with creating a member-obsessed culture. If you do that, you can't help but create items and services that members love. If you create items members love, you can buy deep and get cost advantages that you pass on to the member. And if you have great items at disruptive prices and you open up the channels of access…then you can't help but drive membership income. As we've driven that, we've been able to take some of the funds back and invest it in our associates who then help create this member-obsessed culture. And that is the flywheel that's just been fueling the 11 quarters of double-digit comps."