Ladies and gentlemen, thank you for standing by. Welcome to the Target Corporation Second Quarter Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded Wednesday, August 22, 2018. I would now like to turn the conference over to Mr. John Hulbert, Vice President, Investor Relations. Please go ahead, sir.

Good morning, everyone, and thank you for joining us on our second quarter 2018 earnings conference call. On the line with me today are Brian Cornell, Chairman and Chief Executive Officer; John Mulligan, Chief Operating Officer; Mark Tritton, Chief Merchandising Officer; and Cathy Smith, Chief Financial Officer. In a few moments, Brian, John, Mark and Cathy will provide their perspective on our second quarter performance, outlook for the full year and progress on our long-term strategic initiatives. Following their remarks, we'll open the phone lines for a question-and-answer session. As a reminder, we're joined on this conference call by investors and others who are listening to our comments via webcast. Following the call, Cathy and I will be available to answer your follow-up questions. As a reminder, any forward-looking statements that we make this morning are subject to risks and uncertainties, the most important of which are described in our SEC filings. Also in these remarks, we refer to non-GAAP financial measures, including adjusted earnings per share. Reconciliations of all non-GAAP numbers to the most directly comparable GAAP number are included in this morning's press release, which is posted on our Investor Relations website. With that, I'll turn it over to Brian for his thoughts on our second quarter performance and our outlook for the rest of the year and beyond. Brian?

Thanks, John, and good morning, everyone. We are really pleased with the second quarter financial results. Comparable sales grew 6.5% in the quarter, representing Target's strongest quarterly comp performance since 2005. This increase was driven by traffic growth of more than 6%, an unprecedented number and, by far, the strongest performance since we began reporting this metric in 2008. Total sales were up 7% from a year ago, reflecting 0.5 point of growth from our new and non-mature stores. Store comparable sales increased nearly 5%. And digital sales grew more than 40% in the second quarter as guests continue to respond to a growing menu of convenient fulfillment options, newness throughout our merchandising categories, freshly remodeled stores and a higher level of service across the chain. On top of the strong digital sales trend we've been seeing for many years, we saw a meaningful incremental lift from our 1-day sale in July, which came in far ahead of expectations. With very strong traffic, both in store and online, we saw accelerating comp sales trends in all 5 of our core merchandising categories. While there are healthy increases across the board, comp growth in our Home category was amazingly strong, up nearly 10%. Hardlines also saw high single-digit comp growth, driven by strength in both Toys and Electronics. And with stronger-than-expected sales, our business delivered stronger-than-expected profitability. Our second quarter adjusted EPS of $1.47 was near the high end of the guidance range of $1.30 to $1.50. This represents about 20% growth compared with a year ago despite the fact that our results continue to reflect significant investments in both capital and operating income to position Target for long-term success. These investments include our plan to perform wall-to-wall remodels of approximately 1,000 stores over a 3-year period; our work to completely…

Thanks, Brian, and good morning, everybody. As I've discussed with many of you, the operations team faces a fundamental challenge in delivering on our strategic initiatives. As we work to make changes to virtually every facet of our operations, modernizing our supply chain, delivering new fulfillment options and increasing efficiency in our stores, we need to simultaneously focus on maintaining everyday reliability in support of a $75 billion business. In the face of this challenge, I'm really proud of how our team is performing on both priorities, particularly in light of the rapid acceleration in sales we've seen in recent quarters. As you know, our strategic plan includes significant investments in the physical infrastructure of our stores. This is because our stores will continue to be the key fulfillment node for our guests, whether that's a traditional store trip, a Drive-Up order, an in-store pickup order, a trip by a Shipt shopper or a traditional e-commerce purchase shipped from a local Target store. Our goal for the year is to deliver well over 300 remodels, and we are on track to deliver that plan. We completed remodels of 113 stores in the second quarter on top of the 56 we completed in the first quarter and many more underway. In fact, in July, we had 258 locations undergoing a remodel during at least a portion of the month, the highest at any time in our history. While our remodel project creates an optimal platform for all of our fulfillment initiatives, it also provides our guests with a more inspiring environment that's easier to shop, and our guests continue to respond by shopping more often. Specifically, consistent with our plan, we continue to see traffic-driven incremental sales lifts of 2% to 4% in our remodeled stores following completion of the remodel.…

Thanks, John. As Brian and John have mentioned, the momentum we're seeing across our business is amazing and we can't point to any one single driver. Instead, the common denominator is our guest who is thinking of us and choosing to shop with us more often. As we benefit from this momentum, our goal is to maintain this focus on our guests and push ourselves to do more even more quickly in service to them. As we've said before at Target, we're at our best when we maintain a proper balance in our business with a focus on delivering "and," not "or." After all, we don't ask our guest to expect more or pay less, we work to consistently deliver on both sides of that brand promise. But it doesn't stop there. We feature a curated assortment that satisfies wants and needs, offers basic items and must-have style and highlights national brands and owned brands. We invest to ensure we're priced right daily and offering compelling deals, design our assortment to support both stock-up and fill-in trips, and we feature all of it in stores and online. Guest surveys give us confidence that we're achieving a proper balance in the current environment. For example, in the second quarter, our guest scores for convenience and everyday pricing increased, and our differentiation score increased as well. This is a testament to the efforts of our entire team over the last 18 months and their focus on delivering the right combination of everyday prices and compelling promotions with the right assortment of innovative national brands, alongside exciting new owned and exclusive brands. We're also seeing good balance in our category performance. Comp growth in all 5 of our core categories accelerated in the second quarter, and all of them grew faster than our…

Thanks, Mark. Our second quarter financial performance exceeded our expectations on both the top line and the bottom line, reflecting the benefit of our strategic initiative in a very strong consumer environment. As Brian mentioned, our second quarter comp sales increase of 6.5% is the strongest we've seen at Target in 13 years. This growth reflected a 4.9% increase in our store comparable sales combined with 41% growth in digital. These are both very healthy numbers in isolation, and they're even more powerful together. Traffic growth of 6.4% accounted for nearly all of our comparable sales growth in the second quarter. In addition, for the first time in nearly 2 years, our comp sales grew faster than comp traffic as we saw a small 0.1% increase in basket in the quarter. In our last quarterly call, when describing our first quarter traffic increase of 3.7%, we described it as the strongest result we had ever reported since we began reporting this metric in 2008. Obviously then, this quarter's traffic growth of more than 6% is well beyond anything we've reported before, and we are really encouraged to see continued momentum in such a key metric. Our second quarter gross margin rate of 30.3% was down about 10 basis points from last year and slightly better than our guidance. Among the drivers, we continue to see meaningful pressure from fulfillment costs as guest engagement with our digital channel continues to grow and we rapidly roll out new convenient fulfillment options across the country. However, in the second quarter, this headwind was almost completely offset by the benefit of our merchandising initiatives, including ongoing cost-saving efforts and the benefit of our work on pricing and promotions. The mix of our sales was a slight headwind in the second quarter as strong sales…

Thanks, Cathy. Before we move to your questions, I want to add to what Cathy was just saying. 18 months ago, when we were developing our plan to make additional investments in our business, so we could move faster, we considered all of our stakeholders as we evaluated our options. Obviously, we started with our guests since they are at the center of everything we do, but we also decided to increase our investments in our Target team, adding hours, training and wages to allow them to better serve our guests. We thought about our merchandise vendors and how we can change the way we work together to deliver quality, newness, differentiation and value to our guests. We looked at our community giving and corporate responsibility efforts, focusing on the issues most important to our guests and where Target can have the most impact. And we obviously considered you, our shareholders, because your capital supports all the investments we make. So as I mentioned at our Financial Community Meeting last spring, I am very grateful for the personal comments I received from many of you in support of the commitments we've made to our business, our team, our community and creating long-term shareholder value. I hope you're as excited as we are to begin seeing the benefit of the long-term decisions we made last year, which are already driving a higher level of engagement between our guests and our brand. With that, we'll move to your questions.

[Operator Instructions] Our first question comes from Seth Sigman with Crédit Suisse.

My question is about the guidance. So the guidance seems to imply, I guess, slightly better operating profit growth in the second half of the year. In the second quarter, it was up, and it was up for the first time in a very long time, which is nice to see. But it was down for the full first half on similar comps to what you're assuming for the second half. So can you just remind us of some of the drivers? And Cathy, we got the margin commentary, but just help us a little bit more with some of the levers as we move into the second half of the year, some of the cost savings and other opportunities that will help support that operating profit growth.

Yes, Seth. Thank you. As we did say, we're obviously very, very pleased with the quarter, so thank you for the comment. And as we think about updating our guidance for the remainder of the year, we expect consistent sales. So first, on the top line, we see the back half and we've got plans for consistent sales growth in that same range, which is obviously very strong, consistent with the traffic and sales we've been seeing. And then on profitability, we see a great opportunity to continue to take share and go after some categories, specifically Toys and Baby. So we baked that in into the back half of the year. So all of that said, we'll continue investing in both the fulfillment aspects, which are coming through in gross margin, and then the category mix. And then on the SG&A line, we'll continue to invest in our stores. All of that said, we expect the back half of the year for a slight deterioration in op income margin rates.

But Seth, we feel like we're very well positioned for the back half of the year. As I've mentioned with my prepared comments, we're seeing a very strong start to Back-to-School and Back-to-College. We continue to see very strong traffic trends. And we expect to monetize that in the back half of the year. So you should expect continued strong performance from Target throughout 2018, but it also sets us up for a very strong performance as we go into '19 and beyond. So I think we're well positioned to continue to build off of the current momentum. And you should expect us to begin to grow operating income from a dollar standpoint.

And as you've mentioned, op income dollars did grow in the second quarter.

That's great color. If I could just follow up, Brian, on your point. I mean, clearly, there's broad-based strength here, and you highlighted that you don't think it's any single initiative. But can you maybe speak to the biggest surprises relative to your expectations? Because, obviously, the quarter turned out better than expected as well as the outlook. So just any more color on, relative to your expectations, what is outperforming?

Seth, I'll start with each one of our key initiatives is ahead of the schedule that we had set 18 months ago. We continue to see really positive responses from our store remodels. And John mentioned that in the month of July alone, we had over 250 stores under construction. In each and every market, we're seeing really strong guest response to those reimaged stores. Our new small formats continue to impress and are driving productivity from a sales standpoint that are beyond our expectations. The reaction that the guest has had to our new brands has been spectacular in Home, in Apparel and now in electronics. And each one of the fulfillment capabilities continues to deliver a great response from the guests. John talked about the Net Promoter Scores we're getting for a service like Drive-Up that we'll bring to scale for the holiday season, the reaction we're getting in each and every market to Shipt and the quality of Shipt shoppers that are servicing their members. In urban markets like New York or Chicago, San Francisco, Boston, D.C., the ability to shop our urban small formats and then, hours later, have someone deliver that package to your doorstep for a $7 charge, very well received. And the investment that we've made in our store teams and putting more expertise in departments like Beauty and Apparel, in Food and Beverage, in technology, the reaction we're getting from our guests exceeded our expectation. So all of our key initiatives, as they're working together as one, are ahead of the schedule that we would have set 18 months ago. And now as we move into the holiday season, we'll have more of those at scale, and as we move in to '19, we'll be further ahead of the original plan that we had established back in February of 2017. So each one of the key elements is working ahead of the schedule that we had set back in February of 2017, and we expect that to continue to accelerate. And as you've heard me say numerous times, the traffic number to me is the most important measure that our strategy is connecting with the consumer both in our stores and online, and we continue to see very strong traffic as we go into the third quarter.

Our next question comes from Mike Lasser with UBS.

You mentioned that the remodels were -- some of that activity peaked out in July. Was there actually a drag from that, the traffic and same-store sales results would have been even better had it not been for some of the remodeling activity?

Yes. Mike, it's certainly disruptive when we're remodeling stores. And now we're doing it at scale. So we're very focused, John and his team, on shortening the construction cycle, less disruption, rapid recovery. But you can only imagine, with over 250 stores under a construction during an important month like July, there was significant disruption in those store sales. We're going to see the recovery as we go into the third quarter, and we certainly expect to have even better response in those stores in Q4. So when we remodel, there's significant disruption in sales, but we're seeing that return very quickly once we complete the remodel.

And is that also the case -- I mean, there was a shift with your same-store sales, and it seems like, based on your guidance, the shift has been really a meaningful story here in what either you saw in the third -- in the second quarter or what you expect for the next couple. And then I have one last follow-up.

Yes. Mike, while we're very pleased with the rollout, at this point, it's a very, very small impact to our overall sales. So we'd certainly expect over the next few years that shift will have a more meaningful impact on our overall performance, but at this point, it's still on a very nascent stage.

I'm sorry, Brian, that was my fault. I meant like a calendar shift rather than...

No.

I'm sorry, my fault, I should have spoken clearly.

We've seen no major impact to the calendar shift throughout the season.

Okay. And then the last question -- the follow-up is -- so it sounds like the gross margin is going to be impacted by the mix, which is a prudent strategy and totally reasonable for the back half. Is there also some effect from fulfillment costs as e-commerce becomes a bigger portion of the mix? And does that act as a continued drag beyond just the next couple of quarters?

We're certainly going to face some headwinds from the rapid growth that we've seen online. Our digital performance is up 41% on top of 32% last year. But I think Mark and our entire team have done a sensational job of managing gross margin rate. You look at the kind of growth we drove in the second quarter, up 6.5%. You look at digital growing by 41%. And we're able to basically maintain gross margin rates equal to last year. I mean, the erosion was 10 basis points. So with that kind of explosive growth, we're managing mix very effectively. And it's where -- and again, you've heard us talk about this before -- the continued performance of our owned brands plays a very prominent role in allowing us to manage our mix. To have a category like Home grow at almost 10%, driven by some great new brand launches, led by Made by Design during the quarter, that's how we're managing to mitigate some of the gross margin rate deterioration that others are experiencing right now. So I feel really good about the efforts of the team and our ability to continue to drive store growth at almost 5%, build our online business at a rate of 41%, but use our mix management and our owned brands to deliver very strong gross margin rate performance in the quarter.

The next question comes from Oliver Chen with Cowen.

Our question is about pricing and promotion. What are your thoughts on managing that in the context of what you've been doing in the consumer environment? You've done a really good job with that gross margin rate. I'm just curious about value and how you'll continue to communicate that. Also, we were curious about the loyalty program. You have a very loyal customer, but what's ahead in terms of what you're thinking there just to capture that and continue to engage [ that customer ]?

Oliver, why don't I start with loyalty, and then let Mark talk about our continued efforts to support our priced right daily positioning. I mean, the loyalty program is off to a very solid start in the Dallas market. We're watching that carefully. John Mulligan and I are actually going to be heading down there this week to assess the program, and our performance in the market, still in a very early stage. But as we think about 2019 and beyond, we certainly expect our Target loyalty program, Target Red, to play a very important role in building even greater engagement and loyalty with our guests. So lots more to come as we get into 2019 and think about loyalty. But Mark, why don't you talk about our efforts on the pricing and promo front and our continued support of being priced right daily.

Yes. Oliver, I think that the work that we did with priced right daily beginning in 2017 and our opening price point stance, which really spans how we're pricing every day both in national brand and owned brand, has been really key to part of the traffic generation and seeing consistent flow, whether it's in stock-up or, more importantly, in fill-in trips that are changing our frequency business, but also, across the board, make it very easy for the guests to shop in-store and online with great transparency and simplicity of pricing. So we've been able to exercise great pricing, communicate simply to the guest, and we're getting credit for that. And the data that we're seeing in share in each of the categories is really reinforcing that.

Oliver, I think one of the reasons we're so confident in our second half outlook is because we're seeing such a great response from our guests to the investments we've made in pricing to make sure that we're priced right daily on those key Food and Beverage and household essential items. Those are driving footsteps to our stores, visits to our site, and they've been a key driver behind the rapid acceleration in traffic.

That's really helpful. Our last question was about supply chain. You made a lot of really encouraging progress in supply chain. What are your thoughts about the state of speed and stock levels? And we saw a lot of the technology and thoughts you have ahead at your Investor Day at Target lab. What are you seeing in terms of how you'll manage the bricks-and-clicks story and also how you'll manage for the smaller pack sizes? Would love an update there.

Yes, another great question. I think I talked about this a little bit in my remarks. The challenge for us is balancing changing the business while we operate the business. And as you said, we showed you a lot of what we're doing to change the business. We'll start scaling a lot of that work in 2019, and that has the opportunity to significantly move our capabilities forward as we begin to scale that work. I think, right now, we've said as the sales accelerated particularly in Q2 -- from Q1 to Q2, there are some areas where we've been spotty on in-stocks, and we're not happy with that. And you see the response in our inventories. We've -- we're flowing goods in a little bit earlier for Q4 so that we can flow them into the stores appropriately. We've taken positions in things like A&A basics, things like denim, chinos, where last year, frankly, the new brands came out and we are almost immediately out of stock. We've made investments there. And then we're working hard on Food and Beverage. And as Mark said, we're gaining share for 6 quarters in a row, so we're learning how to operate that business both differently in the store and in the supply chain. So we feel good about the progress we've made, but we are not satisfied with our current in-stock position. There's more work to do there.

And, Oliver, I'll just build on that for you and others on the call. Well, this was a really strong quarter for the company and when we think about comps at 6.5%, the strong comps in-store, the acceleration in digital, there's a lot to be proud of, but we know we've got a lot of work to do. And we've got to make sure that we are now meeting the demand that's taking place within our system. So John is very focused on that to make sure that we improve our in-stock position. But we've seen obviously a step-function change in demand in our stores and online, accelerated growth. We're chasing some of that growth right now. And we've got to continue to make sure that we're doing a better job of replenishing our system as we go into the back half of the year and particularly as we get ready for continued strong growth in 2019.

The next question comes from Chris Horvers with JPMorgan.

I wanted to -- you focused a lot on scaling in terms of 2019, the different initiatives, but also in terms of the investment base. At the Analyst Day earlier this year, you called out '18 as an investment year, and you're reiterating your view of profitable growth in '19 and beyond. Can you frame out how you think of that in terms of the margin rates in the business, including gross margin and operating income rate? Could we see flat grosses in '19 and up OI rate? Or are you thinking about profitable growth in terms of a flow-through on a flat OI rate?

Chris, this won't to surprise you. We're not going to give 2019 guidance today.

I'm trying.

I know you are, and you're trying hard. But I would refer you back to Cathy's comments earlier. When we look at our second quarter progress, really strong gross margin rate for a company that grew at our level. And for the first time in a while, operating income is growing from a dollar standpoint. So we're seeing some improvement in our performance. We expect that to continue over time. But you'll have to stick with us for another day when we're ready to give 2019 guidance.

Understood. And then in terms of the e-commerce growth, you called out a big lift from the 1-day sale, but at the same time, you're scaling a lot of fulfillment options into the back half. So do you think you can maintain sort of that 40% online sales growth into the back half? And how much of that contributes to the updated comp outlook versus, say, share in Baby and Toys in these key seasons coming up?

Chris, I'll let John build on this, but we expect very strong digital growth in the back half. Obviously, we're guiding to comp sales that are going to be very consistent with our first half performance. You're going to continue to see us scale up Drive-Up and Shipt, same-day delivery in urban markets, so that's going to play a very meaningful role. But you should expect our stores to be a very important driver to our growth in the back half of the year and complemented by continued maturity in our fulfillment capabilities.

I'll just add real quickly, Chris. Stores did almost [ 5% ] comps by themselves. And obviously, our stores are fulfilling much of that 41% digital growth, and so well over 2/3 of that -- of the digital growth is being fulfilled out of our stores. And so we're blurring those lines every single day, making sure we have a great experience for our guests and letting them choose to shop how they want to engage with Target. And so we're going to start talking less and less at some point about an actual digital comp because it is truly our entire business fueled by those stores.

The next question comes from Matt McClintock with Barclays.

Brian, I was wondering if I could ask a macro question. So the broader retail industry has truly enjoyed a resurgence across the board this quarter. Target seems to standout because of the traffic, as you highlighted. But I was wondering if I could get your thoughts on what's driving this? Why did the consumer -- the American consumer all of a sudden just wake up and start going to retailers again? And then thinking forward, how should we think about Target's strength this quarter and the traffic trends this quarter, the strength everything that all throughout the year when we get to 2019 and you're up against that comparison in 2Q? Because I just want to say, in 2Q of next year, there's going to be a lot of skepticism that you can comp the comp at that point in time. So just your thoughts.

Let me start with the macro environment. And we've talked about this a lot over the last few years, and there's been a lot of questions about the role stores would play and was everything going to shift online. And I think the one voice that was missing from that conversation was the voice of the consumer, and consumers continue to vote with their footsteps. And as we sit here today, the numbers tend to vary from week-to-week, but on any given day, 90% of retail sales are done in physical stores. And I think what you're seeing right now from a macro basis is well-run retailers with strong balance sheets that generate cash that they can invest back in their business are winning right now. And there's obviously others right now that can't afford to invest in their store experience or build capabilities or drive differentiation, and they're giving up share. So there's clearly winners and losers. We certainly think we're migrating to the winners column. And we're driving not only traffic, but as Mark and Cathy and John have talked about, we're taking market share in all of our major merchandising categories. And the investments we're making to make sure that Target is a long-term winner are being rewarded right now by the consumer and our guests. So we've got to continue to make sure we focus on executing our strategy as we go into '19, continue to take advantage of the market share opportunities that are out there. And I'll go back to our February 2017 investor conference. And one of the things we talked about in our overall management thesis is there are going to be billions of dollars of retail market share up for grabs, and we're going to position ourselves to take more than our fair share of that. We're seeing it happen. As companies like Toys "R" Us and Babies "R" Us exit the market, as others close stores, we're picking up market share in those important categories and those key geographic catchments. And we'll expect to continue to do that in '19 and beyond, and it's what gives us confidence that we're going to be able to lap these strong numbers in 2018 with continued strength in '19 and beyond.

Our last question comes from Joe Feldman with Telsey Advisory Group.

I wanted to go back to something, I think, John was talking about with the labor and some of the changes maybe in the way you're hiring people and kind of the way you're allocating labor in the store and some of the transformation in the back room. Can you just give a little more detail on that and explore that issue?

Sure, Joe. I think, internally, you've probably heard us talk about the store modernization, and it's really Ken and the store team doing a great job just stepping back and saying what is it we're trying to accomplish in the store? And certainly, there's the work we have to do moving product out to the sales floor and checking people out and all the things that just happen because they have to happen in a store. And our goal there is to become more efficient and to become more efficient not just for efficiency's sake, but to provide the fuel so that we can invest in more talent and better expertise on the sales floor and in particular, in those areas where it matters the most. So think Beauty, Electronics, with our visual merchandising in both Home and Apparel and then in Food. Those are areas where we have gone out and actively hired for expertise, and that's where things like the wage investment are so critical. They've allowed us to differentiate in who and how we hire people. And so those team members, finding ways to bring that expertise in and then keep them on the floor, so that the Beauty team member is in Beauty all the time and they're able to help the guest and they also keep track of what's going on in that part of the store relative to in-stocks and inventory flow. And so rather having a team of generalists doing price change one day, checking out the next day and maybe moving freight on Wednesday, these individuals are accountable for their part of the store. They're out there, they get to know the guest and provide a very different level of experience. And then we've invested in tools and a significant amount of training to help them. And this has been a journey we've been on for a couple of years, and we will be on it for a couple of more years as the team continues to evolve and build capabilities. But we think it's something incredibly important to our long-term success.

John, thank you. And operator, thank you. That concludes our Q2 earnings call. I appreciate everyone joining us today, and we look forward to talking to you again when we talk about our Q3 results. So thank you.