Target (TGT) has been one of the retail winners in an otherwise dismal environment due to the advent of the coronavirus. The company’s digital sales in particular, have exploded even as store-based sales showed weakness. Target leveraged a suite of delivery options developed over the last few years to successfully navigate the challenging environment.

There is no question Target has executed well on expanding delivery options. The same-day pick-up and delivery services were experiencing rapid customer adoption and growth well before social distancing entered consumers’ vocabulary. The popularity of store-based fulfillment of digital sales, especially through the company’s same-day delivery service, has driven up the share of online orders fulfilled through stores, benefiting expenses. The growth in same-day delivery has been especially surprising to us as our expectations were more tempered versus actual results. Target’s aggressive focus on expanding delivery options has been a key factor in the company representing one of the largest positions in our portfolios.

However, the influx of online orders has exposed persistent weaknesses in the company’s fulfillment operations which will require solutions if digital sales are to drive future performance. Anecdotal reports and survey results as well as direct experience of clients and employees suggests the company still has a fair amount of work to do to maximize efficiency of online fulfillment. The rush to meet demand – and ship products quickly in a competitive and inventory constrained environment – has resulted in an increasing rate of order splitting in fulfillment, creating costly inefficiencies in the distribution and delivery of orders.

Examples are not difficult to find, including instances where a single can of corn – retail price $0.54 – was delivered in its own box. In another instance, an order for small bottles of children’s paint, at $0.99 per bottle, arrived in multiple boxes with only one or two bottles in each package. In each of these cases, even though the products were attached to larger orders with minimum order sizes for free shipping, the company certainly lost money on the sales. In other instances, poor packaging has resulted in an increasing rate of lost and replacement goods as indicated by reviews on the company’s own website. A search of reviews increasingly indicate low ratings for, among other things, boxed cereals and canned products having little to do with the actual product and more to do with the condition in which those products were received due to poor packaging.

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It’s difficult to estimate how much the inefficiencies are costing the company since a number of factors would go into such a calculation. However, we can estimate a rough potential order of magnitude by making a few general assumptions about the nature of the company’s online business simplified so as not to overstate precision.

The company’s annual digital sales for 2019 amounted to $6.8 billion. The figure will certainly rise materially for the current year, but since we have known data for the prior year, we will proceed with that information while acknowledging that the expense increases with greater digital sales – something the company itself acknowledged in its most recent quarterly report.

In the event we assume an average transaction size of about $80.00, based on data from 2016, the company processed about 85 million orders last year. Target doesn’t specifically provide fulfillment method breakdowns within its reports though we know from company statements that about 80% of digital orders are fulfilled from stores (including shipping from stores) while about 15% of digital orders are fulfilled from distribution centers. The balance is fulfilled through direct shipping from the vendor. Delivery and pick-up have been growing as a proportion of store fulfilled sales, though we don’t know the exact breakdown, so let’s assume for a moment that only 15% of digital sales are fulfilled from stores should shipment versus pickup, delivery, etc. In this case, shipping represents 30% of the company’s annual digital transactions, or 25.5 million transactions annually.

It’s more difficult to assess how many of these orders are broken into separate shipments since a given order may consist of one or two large items (diapers or formula, for example) or a number of smaller items as would more typically be the case with groceries, crafts, and similar goods. Again, for the sake of argument, let’s base a calculation on an average of 2.5 shipments per order, for a total of 63.75 million annual shipments. In the event 25% of shipments represent unnecessary redundancy in an efficient distribution system, whether through excessive division or orders or damage to the orders which is replaced, that comes to approximately 15.9 million unnecessary shipments. The average blended cost of a shipment alone probably being about $3.00, depending on the specific items, that’s roughly $50 million a year in additional expense – about $0.08 per share after tax with 515 million shares outstanding.

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In reality, we believe the actual incremental cost to be at least an order of magnitude larger or more – a minimum of around $100 million to $150 million when including product replacement costs – or close to $0.15 to $0.22 in earnings per share.

A $100 million or $150 million incremental expense on the company’s $3.3 billion of net income last year isn’t all that significant at about 3% to 5%. However, growth in digital sales will amplify these costs barring improvement in the fulfillment operations. The doubling of digital sales in the face of coronavirus concerns is a prime example – a proportional increase in the incremental expense (which may even then be an underestimate given the distribution and inventory supply chain pressures associated with coronavirus) would push the figure to as much as $300 million or more, quickly becoming a meaningful proportion of the company’s net income even as revenues rise. In the long term, this is an unsustainable expense despite the success of the delivery models to date.

Target did introduce a discount of $1.00 for consolidating orders just over a year ago which begs the question of why these types of fulfillment issues are arising in the network. The explanation likely has something to do with coronavirus related disruptions, but the greater issue is that the discount does not appear to be a very frequent option for customers. In testing availability of the discount, we found across hundreds of order combinations consisting of various items, including clothing, groceries, hard goods, home goods, media, etc., that the discount for consolidating orders was often not offered as an option at checkout even when delivery dates varied significantly among the items comprising the order. The discount appeared most often when orders consisted of largely similar items, for example, groceries or hard goods, but more infrequently when orders consisted of mixed good types. However, a clear pattern was not discernible in the tests.

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Granted, no company is immune to such issues, especially during challenging times when inventory distribution is interrupted and order volumes surge. Nonetheless, the vaunted efficiency of established competitors such as Amazon (AMZN) requires a dedicated focus on matching that efficiency in digital fulfillment in order to be competitive in the long term. Target can sustain a measure of elevated expense in periods of unusual demand but the costs will quickly overwhelm the operation under more normal circumstances.

Target has passed the initial test of getting online customers through the virtual doors. The second test, which will ultimately determine how valuable those customers end up becoming, remains daunting in the face of fulfillment challenges.

Conclusion

Target is an excellent company that has effectively scaled its delivery options – including store pick-up, drive-up, and same-day delivery, to provide a platform that can compete effectively with online retailers. The rapid adoption has certainly benefited the company and shareholders by setting the company apart from competitors. However, this does not absolve Target of maximizing its fulfillment operation’s efficiency as making these delivery options work for both consumers and shareholders requires a focus on efficiency and speed.

The digital sales fulfillment issue is one of several the company needs to address to further improve overall operating performance. Target still suffers from store out-of-stock positions which hamper sales growth which was problematic well before coronavirus related shortages. In order to remain a first-class retailer, Target will need to more proactively address these matters and gain a better grip on the efficiency of its entire distribution and fulfillment network.

In the meantime, we’ve trimmed our portfolio position, much like Mr. Brian Cornell, based on a combination of operating expense pressures and our assessment of overall forward appreciation potential based on current valuation.

Disclosure: I am/we are long TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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