目標百貨 (TGT) 2004 Q2 法說會逐字稿

Hello, and welcome to the Target Corporation second quarter earnings release conference call.

During the presentation, all participants will be in a listen-only mode.

Afterwards, you will be invited to participate in a question-and-answer session.

At that time, if you have a question, you will need to press star, 1 on your telephone.

As a reminder, this conference is being recorded Thursday, August 12th, 2004.

I would now like to turn the conference over to Mr. Bob Ulrich, Chairman and Chief Executive Officer.

Sir, you may begin.

Good morning.

Welcome to our 2004 second quarter earnings conference call.

On the line with me today are Jerry Storch, Vice Chairman;

Doug Scovanner, Executive Vice President and Chief Financial Officer; and Gregg Steinhafel, President of Target.

This morning, Doug will review our results for the second quarter of 2004 and describe our outlook for the third quarter.

Then Gregg will provide an update on Target's recent business and current initiatives.

Jerry will update you on the growth and performance of our credit card operations and Target.com, as well as developments in our supply chain.

Then I will wrap up our remarks, and we will open the phone lines for a question-and-answer session.

Now, Doug will review our results, which were released earlier this morning.

Thanks, Bob.

As a reminder, we're joined on this conference call by investors and others who are listening to our comments today live, via webcast.

Also, please note that any forward-looking statements we make in our remarks this morning should be considered in conjunction with the cautionary statements contained in our SEC filings.

As usual, today's call will be limited to 60 minutes, including our Q&A session.

If any of you still have questions when the call has ended, please feel free to follow up with Susan Kahn or me, directly.

This morning Target Corporation announced results for the second quarter of 2004.

For the period, net income was $1.4 billion or $1.54 per share and included earnings from continuing operations of $366 million, or 40 cents per share; earnings from discontinued operations of $31 million, or 3 cents per share; and a gain of $1 billion, or $1.11 per share, related to the sale of Marshall Field's to The May Department Store Company.

Earnings from continued operations -- from continuing operations include a pre-tax loss of $74 million, or 5 cents per share, related to the repurchase of $455 million of debt at a premium, primarily associated with the application of a portion of the proceeds from the sale of Marshall Field's.

Discontinued operations include results of both Mervyn's and Marshall Field's for the entire quarter.

Let me spend a few minutes and discuss results from our continuing operations in a bit more detail.

Total revenue in the quarter grew 10% to $10.6 billion, reflecting a 10.2% increase in merchandise sales and a 3.1% increase in net credit revenues.

Gross margin rates improved 99 basis points due to meaningful improvements in both markup and markdown rates, while SG&A rate was unfavorable to the prior year by 63 basis points due to three approximately equal factors.

Approximately 1/3 of this unfavorable variance resulted from higher worker's compensation expense in the quarter.

Approximately 1/3 was related to a year-over-year change in the timing of expense incurrence that will work itself out in our total-year results.

And 1/3 is caused by activities, such as our efforts to increase direct imports, that result in higher SG&A rate in exchange for a higher gross margin rate.

Depreciation and amortization expense grew $25 million, or 9.3%, from a year ago, due to our ongoing capital investment related to new store and supply chain growth.

Interest expense rose $53 million in the quarter to $207 million, from $154 million a year ago.

This growth is attributable to a year-over-year pre-tax increase of $60 million in loss on debt repurchase, reflecting a $74 million loss in the current quarter, compared to a $14 million loss in the second quarter of 2003.

This increase was partially offset in the quarter by the effect of lower average funded balances.

Our effective income tax rate for the quarter was 37.8%, compared with 38.0% in the second quarter of 2003.

Now let me turn to the balance sheet.

Our second quarter balance sheet presentation segregates assets and liabilities for our discontinued operations from our presentation of continuing operations.

The prior year presentation of assets and liabilities for discontinued operations includes both Mervyn's and Marshall Field's, while the current year amounts on these lines reflect Mervyn's only.

This is because we sold Marshall Field's just before quarter-end, so our balance sheet as of July 31st, 2004, reflects the receipt of $3.2 billion in proceeds from the sale.

Approximately 2.0 billion of the proceeds were applied to debt reduction.

And the remaining $1.2 billion were invested in short-term securities at year-end -- at quarter-end, rather, shown on the cash and cash equivalents line.

Net accounts receivable at the end of the second quarter reflect balances for the Target Guest Card and the Target Visa.

Net of the allowance of $351 million on these receivables, balances at quarter-end were 4.4 billion, in line with our expectations.

Our balance sheet inventory position grew by 20% year-over-year, and I think this merits a careful review.

Somewhat more than half of this growth is the natural increase required to support additional square footage and same-store sales.

The rest is directly, or indirectly, associated with our strategy to aggressively develop our direct imports capabilities.

In particular, we have refined our measurement of the point in the supply chain at which effective ownership occurs, causing a parallel and ongoing increase in our inventory and payables accounts.

On balance, our inventory is in typical, excellent condition as we enter the fall season.

In early June, our Board of Directors authorized a $3 billion share repurchase program that is expected to be completed over the next 2 to 3 years.

We began execution under this program during the second quarter, and we invested $472 million to buy approximately 11 million shares of our common stock at a weighted average price of $42.79 per share.

Because this activity was concentrated at the end of the second quarter, it had little impact on weighted average share count in the current period.

As you know, late last month we announced that Target Corporation had reached a definitive agreement to sell our Mervyn's retail subsidiary to an investment group comprised of Sun Capital, Cerberus Capital Management and Lubert-Adler/Klaff and Partners.

And to sell all of Mervyn's credit card receivables to GE Consumer Finance, a unit of GE Capital, all for an aggregate purchase price of approximately $1.65 billion.

The transaction is subject to the standard regulatory approval for this type of transaction, and is expected to close during our third quarter.

We expect this transaction will result in a pre-tax gain of approximately $270 million, or about 18 cents per share.

Separately, while the transaction related to the sale of Marshall Field's to The May Department Store Company was completed in the second quarter, the transaction to sell 9 Minnesota Mervyn's stores to The May Department Store Company is expected to close in the third quarter, and is not expected to result in a gain or loss at that time.

Finally, let me turn to our outlook for the third quarter and the remainder of the year.

As you know at the beginning of 2004, we communicated an expectation of our financial performance that envisions strong results in the first half of this year, followed by more modest growth in the second half.

I believe the results we have delivered in the first 6 months reflect the strong performance we planned, our year-to-date income from continuing operations before interest and taxes has increased more than 17%.

As we look to this year's third and fourth quarters, our base of performance from last year is more challenging, yet our momentum remains strong.

In last year's third quarter, we earned 33 cents per share, comprised of 30 cents per share from continuing operations, and about 3 cents per share from Mervyn's and Marshall Field's, combined.

Today, the median First Call estimate for our current year third quarter is 37 cents.

And while the dynamics behind most of the financial models that stand behind this median estimate have changed as a result of our actions regarding Mervyn's and Marshall Field's, I believe this estimate represents a reasonable expectation of earnings from continuing operations in the third quarter.

This discussion, of course, is before accounting for the approximate 18-cent gain we expect to record in the quarter on the sale of Mervyn's.

Our historical quarterly earnings detail restated to reflect current accounting classifications for continuing and discontinued operations will be included in an 8-K we intend to file next month.

Our third quarter ends on October 30th, and we currently expect to report our results on November 11th.

One final forward-looking comment.

Many of you have asked us about the overhead expense that might remain at Target Corporation which would hypothetically reduce our future profitability somewhat after our transactions are complete.

While there are some nuances to discuss, this possibility is substantially mitigated by the fact that we will continue to perform services for and collect fees from the buyers of Marshall Field's and Mervyn's consistent with our prior charge-out practices.

This transition period extends through next spring for Marshall's Field's and for up to 2 years, or more, for Mervyn's.

Now Gregg will review Target's results and current business trends and highlight several key initiatives at Target this fall.

Gregg?

Thanks, Doug.

Target delivered strong financial results during the second quarter, and we are very pleased with our performance.

Our total revenues in the second quarter, including sales from Target Stores, target.com and AMC, combined with our net credit revenues, increased 10% to $10.6 billion, primarily due to a 3.9% increase in comparable store sales, and the contribution from new store growth.

The increase in average transaction amount outpaced growth in guest traffic.

We again managed our inventory levels well and content well throughout the quarter, and we believe that our inventories are well-positioned as we move into the second half of the year.

Earnings before interest and taxes or EBIT rose 16.4% to $795 million, while EBIT margin grew by 41 basis points to 7.53%.

As Doug mentioned, this improvement is due to significant gross margin rate favorability in the quarter, partially offset by an unfavorable SG&A rate.

During the second quarter, Target opened a total of 27 new stores, including 7 SuperTarget Stores and 16 net new discount stores.

At quarter end, we opened -- we operated 1,272 stores in 47 states, including 126 SuperTarget locations.

As we move into the second half of 2004, we remain steadfastly committed to delivering both differentiation and value to our guests for unique, [Inaudible -- microphone inaccessible] merchandise, exceptional prices, fast, convenient service, in a pleasant shopping environment.

Our sharp focus on our "expect more, pay less" strategy, and on every detail of our operation, helps us sustain Target's competitive advantage and remain relevant to our guests over time.

To maintain the freshness of our offerings, we routinely introduce new merchandise and exclusive new brands.

In July, we launched C9 athletic wear by Champion, and we are pleased with our guests' initial response to our assortment.

The collection includes: performance apparel; functional basics, such as fleece, T-shirts, and socks for the entire family, as well as a line of athletic shoes; and delivers the style, comfort and authenticity of other well-known performance brands, but at half the price.

This partnership between Target and Champion reinforces our commitment to make great design available at affordable prices and positions us to substantially increase our market share in this popular category.

Another initiative that is building excitement among our guests and driving them -- and giving them more reasons to shop at Target Stores is The One Spot.

This concept allows us to capitalize on the value pricing trend that has contributed to the rapid growth of dollar stores, and offers our guests a treasure hunt experience they can't find anywhere else.

Our assortment includes a wide range of quality, gift-oriented, impulse merchandise such as: kitchen items, infant essentials, stationary, and toys, and changes frequently, encouraging our guests to visit our stores more often.

Based on stronger-than-expected results in our 125 test stores, we expect to complete our roll-out of The One Spot to all Target Stores next month.

Our seasonal businesses are another great example of how we excite our guests with products they want and need, and how we showcase the innovation that is central to Target's brand.

Importantly, these businesses also drive significant sales and traffic.

For example, our back-to-school assortment for younger children and high school teens feature denim and the latest apparel fashions, such as this year's layered looks, as well as basic essentials, like school supplies and lunchtime snacks.

Our back-to-college selection is directed toward guests in their late teens and early 20s, who are focused on decorating their living spaces and outfitting themselves in their own personal style.

To assist with this process, Target has created a back-to-college catalog for the first time this fall, which is being mailed and distributed to students on college campuses.

The catalog presents a variety of well-designed, colorful dorm room items at great prices, offers helpful decorating ideas, and includes information about the reloadable back-to-college gift card that was a great hit with our guests last year.

While it is still early in the back-to-school/back-to-college season, both businesses are delighting our guests, and are on power -- and are on par with our initial expectations.

Our P-2004 store prototype which we introduced in earnest in March of this year is also delivering guest satisfaction.

Provide this shopping experience to more of our guests, capture the benefit this format produces, we are fully remodeling about 70 existing Target Stores this year, and retrofitting an additional 130 stores with some of the most important P-2004 elements.

In October, we plan to open a total of 46 new stores, all of which will reflect our new prototype design.

Net of closings and relocations, 31 will be general merchandise stores and 10 will be SuperTarget Stores.

At SuperTarget, we remain focused on delivering our Target brand experience and driving increased shopping frequency, more effective communication of our value message, to make sure our guests understand what we already know that SuperTarget has great prices on groceries.

We are introducing new signing and graphics that affirm our "eat well, pay less" promise, and we are building awareness around the quality and exceptional value of our own brands in food.

Our Market Pantry brand represents basic staples throughout our dry, dairy, and frozen assortment and includes key items, such as flavored and bottled water, cheese, and cereal.

Market Pantry has the same quality as the national brands, but is priced much lower.

In fact, many of the national brands, such as Pillsbury, Kemps, and Kraft actually make our products.

Earlier this year, we introduced totally new packaging for Market Pantry, and by year-end we will have more than doubled the SKU count of this brand to about 1,000 items.

We are undertaking a similar effort related to Archer Farms, our premium owned brand.

Specifically, this month we are introducing a whole new look to the packaging, and for the year overall, we expect to increase the number of SKUs by nearly 50%, to about 1,900.

Other initiatives at SuperTarget to reinforce our brand image and drive trip frequency include: offering more tailored food assortments to reflect local preferences and ethnic favorites; a prominently signed and displayed assortment of the latest dietary trends, such as low-carb products; a broader assortment of pre-packaged items and convenient meal solutions; a renewed focus on freshness; and an expanded offering of wine.

Today we have wine in approximately 80 Super-Target Stores as well as more than 100 general merchandise stores.

Over the next year, we plan to add wine to all new and remodeled stores where it is legal, which will effectively double the number of stores that carry wine.

We remain very committed to SuperTarget.

We are pleased, both with our results and with the progress we are making in the minds of our guests.

We continue to view SuperTarget as an important component of Target's overall strategy, and expect that SuperTarget will continue to represent approximately 1/3 of our annual net, new square footage for many years.

Our commitment at Target to delight our guests remains as firm as ever.

We have confidence in the agility and the experience of our organization, and believe Target's strategy is sound.

Because the strength of last year's comparable store sales in the second half of the year present a difficult hurdle, we are planning our sales growth in this year's third and fourth quarters more modestly.

This is evident in our 0 to 2% guidance for August, which is comparing against last year's 8.3% performance.

However, we remain confident in Target's long-term growth, and believe that we are well-positioned to sustain our competitive advantage.

Now, Jerry Storch will give you an update on our credit card business, Target.com and Target supply chain efforts.

Jerry?

Thanks, Gregg.

Target's commitment to continue its improvement throughout our organization is a critical element in our ability to maintain our competitive advantage and continue to grow our market share profitably.

Whether in our credit card operations, our supply chain, at Target.com, or many other areas of the Company, we remain focused on innovations and initiatives that increase the speed and efficiency of our operations, and enhance our guest shopping experience to drive incremental sales to our stores.

During the second quarter, our credit card operations continued to contribute to our overall profitability and the credit quality of our Target portfolio continued to improve.

With the sale of Marshall Field's and the pending sale of Mervyn's, our balance sheet at the end of the quarter reflected net accounts receivable from the Target Visa and the Target Guest Card of approximately $4.4 billion, in line with our expectations.

Pre-tax profits from our credit card operations rose nearly 13%, due to lower bad debt expense, resulting from favorable trends in net write-offs and delinquencies.

Net write-offs in the quarter were $103 million, reflecting improvement in both aid and bankruptcy write-off trends.

Delinquencies, a leading indicator of future write-offs, also improved in the quarter to 3.8%, .4 percentage points better than last year.

Our allowance per doubtful accounts as a percent of second quarter-end -- end receivables was 7.4%, and our annualized net portfolio yield was 10.3% in the quarter, an impressive performance in light of having removed the high-yield Mervyn's and Marshall Field's proprietary cards.

Overall, we are quite pleased with the performance of our credit card operations.

From a financial perspective, these operations continue to be stable, predictable and appropriately profitable.

They're an important contributor to our objective of strengthening our guest relationships.

Specifically, through loyalty programs and 10%-off savings certificates, our credit cards provide meaningful sales-building opportunities, and these opportunities are further enhanced when combined with our guest relationship management initiatives.

Target.com continues to be an integral component of our strategy, providing another avenue for us to deepen relationships with our guests and to drive sales, both online and in our stores.

While many of our guests access Target.com to make online purchases, others use the site to view our gift registries or weekly circular, pay their Target Visa bill, learn about Target's community involvement, access company news and financial information, apply for a job, and much, much more.

And in our quest for continuous improvement, we are working intensively to further enhance Target.com.

Over the past year we have nearly tripled our online offering from approximately 13,000 SKUs to about 37,000 SKUs, broadening our assortment in key categories such as furniture, baby, and soft home.

We are increasing our efforts to understand our guests as individuals and develop more personalized marketing and merchandising efforts.

Last week, Target.com launched Target to a "T," a custom clothing shop that allows guests to order apparel items customized to fit their specific body.

Items includes Mossimo jeans for women and Merona shirts and Cherokee chinos for men.

Guests can choose everything from color to fit to pocket style, and the site is complete with photo examples for each choice.

Using these guest preferences and detailed data about the guest's size and shape, a unique pattern is created for each garment and sent electronically to the factory.

Once the custom garment is assembled and finished, it is shipped directly to the guest.

The whole process takes less than a month.

This fall, Target will also roll out a customized mailing program called Target Mail.

Communications to guests will be uniquely tailored to reflect individual shopping patterns and attributes.

And, therefore, the program will enable us to wrap many existing direct mail pieces into one monthly mailing with content that is significantly more relevant to each guest.

By understanding our guests, we can more effectively satisfy their wants and needs and capture increased market share.

Our year-to-date results at Target.com confirm that we are on the right track and that our efforts are being recognized.

Compared with the first 6 months of 2003, our sales in 2004 have doubled.

And over the past 18 months, our number of unique visitors has grown faster than all but 3 major sites on the entire Internet.

With almost 13 million unique visitors to our site each month, we now rank 39th among the nearly 50 million websites on the Internet and the top handful of retailing sites.

Finally, I'd like to provide a brief update on the continuous improvement we are making in our supply chain.

Maintaining sufficient distribution capacity and excellent in-stock levels remain 2 of our top priorities.

As a result, earlier this summer we opened three new regional distribution facilities, 1 each in Kansas, Texas, and Ohio.

This brings our current distribution networks to 22 regional distribution centers and 3 import warehouses, resulting in an improved level of service to all our stores and increased guest satisfaction.

Our efforts to convert indirect purchases to direct are moving forward as planned, with continued increases in import penetration.

This growth is resulting in increased utilization of our 3 import warehouses, as well as better integration of these facilities into our supply chain.

Trapping, which involves holding merchandise related to a specific event or store set in our distribution centers, produces early product flow to our stores and improves our seasonal transitions.

By trapping product, rather than just letting it flow, we lower handling expense and use backroom space more efficiently in the stores.

This fall, we plan to trap more than 3 times the number of events we trapped a year ago.

With our online, real-time, global product design and development network, we now have one of the fastest product pipelines in the retail industry.

Lead sourcing allows us to be first with new fashions, colors, and styles and to instantaneously change course in response to hot new trends, dynamic production opportunities and capabilities, or fluid political and economic conditions around the globe.

Lead sourcing is a key factor in helping our guests expect more and pay less, as we simultaneously reduce our merchandise lead time and cost of goods.

These are only a few examples of strategic investments we are making in our supply chain.

To support our new store growth, to increase our productivity and to improve our store service levels.

We believe that continuous improvement throughout our organization is imperative to sustain our competitive advantage and we are working diligently to achieve world class performance.

We are not standing still in our credit card operations, on the Internet, in our supply chain, or anywhere else.

And we are confident that our efforts will contribute to continued profitable growth at Target Corporation for many years.

Now, Bob has a few final comments.

As you've just heard in detail, we are pleased with our overall results in the second quarter.

We are excited about Target's opportunities for growth, and remain confident that we are on track to deliver another year of outstanding performance in 2004.

With the sale of Marshall Field's and the pending sale of Mervyn's, the strategic direction of Target Corporation is clear and our long-term outlook is bright.

As always, we remain committed to delivering superior value to our shareholders over time.

That concludes our prepared remarks.

Now Doug, Gregg, Jerry, and I will be happy to respond to your questions.

Thank you, sir.

Once again, if you would like to ask a question, you may press star, 1 on your telephone.

And our first question comes from Emme Kozloff of Sanford Bernstein.

Hi, thanks.

Doug, are you anticipating any early retirement of debt in Q3?

And if so, is your guidance on Q3 before or after this charge?

And then just as a follow-up, is there any updated guidance on full-year?

I mean, now -- you know, you said there is so much uncertainty surrounding Mervyn's and Marshall Field's before, but now that the sales have been announced for both, is there anything directionally there we can know?

Because, it's obviously 3 times the size of Q3, so it's going to be far more significant for the second half.

Thanks.

Certainly.

As always when we make forward-looking statements regarding earnings, we are ignoring the potential impact of future debt retirements that give rise to these charges.

We are always in the market for attractive opportunities, attractive economic opportunities, to retire debt that's outstanding.

And so, it comes and goes based on the availability of those securities.

So, very specifically, our EPS expectations do not envision debt repurchase at this point at a loss, although that, clearly, always remains a possibility.

Looking forward, we've tried to be as clear as we can about our third quarter outlook.

Let me walk through some of the elements that play through our fourth quarter as a result of the strategic repositioning, the Mervyn's and Field's transactions, that is, and our share repurchase.

As you know, we've disclosed at the time of the Field's transaction, that we expected that transaction to be slightly accretive in the second quarter -- in the third quarter, rather, but probably about 2 cents dilutive in the fourth quarter.

Mervyn's, assuming it were to happen earlier in the third quarter, would be a bit dilutive in the third quarter, and we've already disclosed that we expect it to be 4 to 5 cents dilutive in the fourth quarter.

Share repurchase tends to offset some of those trends in the fourth quarter.

Share repurchase would be mildly accretive in the fourth quarter.

It certainly would not be enough to offset the 6 to 7 cents of dilution combined between the sales of Mervyn's and Marshall Field's.

Great, just one follow-up.

I just want to make sure I understand your comment on SG&A.

You're basically saying that, you know, whether it's the unallocated corporate expense or the allocated expenses to Mervyn's and Marshall Field's, you are going to get paid enough from the outsiders to basically offset this entirely?

Certainly for the short-term, and it's incumbent upon us as we look into '05 and beyond to manage our business effectively.

Let's all remember that the size of Mervyn's and Field's combined is about the size of 1 year of growth at Target.

So, I feel very comfortable over time that we'll be able to manage this without this becoming a meaningful discussion point quarter after quarter.

I mentioned in my earlier remarks, yes, there are some nuances.

So is there a penny that shifts from one quarter to another quarter?

Of course, but I think that's micro-managing at this point, and as we get closer to '05 and beyond, we'll be very careful to talk about those effects.

On balance, that's not an issue from my standpoint.

Great, thanks.

Thank you.

Our next question comes from George Strachan of Goldman Sachs.

Thank you.

With the repurchase of debt in the quarter, does that do anything to the 2 to 3-year time frame for the $3 billion stock repurchase?

In other words, could it conceivably be accelerated to the shorter end of that range?

The repurchase of debt in the quarter is totally unrelated to the future timing of the execution of our share repurchase program.

Let's talk about the share repurchase program itself.

When we announced it in June, we said we would intend to invest 3 billion buying back our shares, with the expected timing to be over the next 2 to 3 years.

We got a good, strong launch in the quarter, repurchasing nearly a half a billion shares of our stock, with our stock at its current trading levels.

I personally find it to be a great value, and I think, therefore, that we would intend to continue to be quite aggressive in the marketplace for acquiring our shares at current levels in the short run.

Also, just a question for Doug, you know, we've been out to the Brooklyn terminal store, and every time I've gone there it's been -- it's been packed.

I'm wondering how you're viewing these urban locations, and your future strategies for Target?

This is Jerry.

They are -- you know, a key part of our growth plans, but they remain a small part because, of course, compared to the vast number of locations we have in suburban and ex-urban areas, they're still pretty small.

We're very happy with it.

Thank you.

Thank you.

Our next question comes from Daniel Barry of Merrill Lynch.

Good morning, two questions on your expenses.

First, your workman's comp.

What percentage of workman's comp is in California?

And do you think the recent legislation there is going to benefit you going forward?

We don't disclose that figure with a precise number, but certainly a much larger than pro rata share of our worker's compensation expense is in California.

As you know, California is responsible, contributes 15 to 20% of our sales, and it certainly is larger than that in terms of contribution to work comp expense.

There've been several pieces of legislation over time in California.

Most of them, across the years, have not been good from our perspective.

The most recent piece of legislation went in the other direction.

Okay, another question on your direct imports.

I guess it hurt your SG&A and helps your gross.

Is that a wash?

I mean is it a net benefit to operating profit --

We expect to generate a net benefit.

In other words, we can measure with precision the extra SG&A costs of engaging in that activity, and we engage in it because it is a net positive.

And, therefore, we certainly expect and certainly have been generating -- expect to generate, and have been generating, more gross margin dollars than we're incurring in expense dollars along the way.

And if roughly a third of the increase, or about 21 basis points in this quarter was -- was just an accounting effect on the SG&A, what is -- what happens going forward?

Does that continue at 20 basis points several more quarters?

Or does it ever even out?

I'm -- what I intended to say in my comments is the thought that that evens out during the current year.

In other words, on a net basis, looking at all of the various kinds of timing issues in SG&A expense versus last year, on a continuing operations basis only, about a third of our increase in this quarter was due to timing issues that were adverse in the quarter and will be net neutral for the year.

I wasn't talking about that, I meant the direct import effect.

The direct import effect is an ongoing effect.

We continue to grow our direct imports business year after year.

And we continue to incur incremental expenses to support all of the activities that surround that.

It's not a new issue this year.

This quarter the net effect of all of that was a bit larger than it has been.

Generally speaking, it's kind of a 10-basis point annualized item in the background.

This quarter, for a variety of reasons -- issues, including direct imports, that represent a switch between SG&A and gross margin rate were more like 20 basis points, give or take.

So, going forward you're saying it may be roughly in the 10 basis point area?

That is what I expect it to be for a long time to come, on an annualized basis.

Gotcha.

Thank you.

Thank you.

Our next question comes from Jeff Klinefelter of Piper Jaffray.

Yes, congratulations on a great first half of the year.

Two quick questions.

One on SuperTarget.

Wondering if you could talk a little bit more, I know you've given us a lot of feedback on it being approximately equal to the returns, Doug, of the traditional discount store.

You know, there are a lot of questions surrounding this division, whether or not it can exceed those returns over time, at what point it would exceed those.

You know, do you have to do perishable distribution at some point to get there?

Could you talk a little bit more about, you know, specifically what the leverage points are for that division, at what point in the scale you could get there?

And then just a clarification on Q4, just curious if we're going to get any sort of visibility on, you know, including the dilution, is there an EPS number, a consensus number, that you actually feel comfortable with at this point?

First on SuperTarget, to clarify, SuperTarget is not a division.

SuperTarget is a prototype, and represents about 14% of our current Target stores' square footage, and is not managed separately as any kind of separate division.

The core reason that causes our returns, age-adjusted for like discount stores, to be virtually the same at SuperTarget compared to our general merchandise stores, is that implicit in our whole decision process to build these stores, we generally choose site-by-site the prototype that delivers the highest net present value, and that generally means that SuperTarget, give or take, earns about the same return on invested capital as the other stores that we're building at the same time.

Obviously, if we were to find some way to improve the overall profit formula of SuperTarget, then SuperTarget's historic store base would continue to outperform.

But I think it's very, very important to understand that that's not -- while it's something we always seek, it is not something that is required to enjoy the kinds of financial benefits that we expect to enjoy by continued investment in SuperTarget.

Thank you, our next question comes from Shari Eberts of J.P. Morgan.

Actually, I'd like to interrupt for just a moment before we take that question.

Your fourth quarter question, we're not, at this point, giving any precise guidance surrounding fourth quarter.

Obviously, it was a very strong quarter last year.

Obviously, we expect growth this year.

What we've tried to do is lay out the factors that would be unrelated to Target's ongoing business that effect the quarterly EPS, specifically the Mervyn's and Field's dilution effect, and the accretion effect from our share repurchase program.

Yes, Operator.

Thank you.

Our next question is from Shari Eberts of J.P. Morgan.

Thank you.

And good morning, everybody.

A question, either for Doug or Gregg.

Just hoping you could put the growth margin improvement, as well as the SG&A rate increase, in a bit of historical context for us?

Is this -- you know, sort of, a typical quarterly performance, if you're looking at the results on just a continued basis?

Is this better than average, just some history or context there would be helpful.

Certainly.

From a gross margin rate expansion standpoint, gross margin rate expansion in the range of 100 basis points would be at the very high end of our historical experience, and would be sharply higher than anything we would expect in the future.

So, this was, from my standpoint, a terrific quarter from a gross margin rate standpoint.

Even after you adjust for these SG&A versus gross margin rate issues, there's still 80 basis points, give or take, of gross margin rate improvement.

A great performance.

On the SG&A side, again, if you'll allow me the luxury of ignoring the 20 basis points associated with the flip-flop between SG&A and gross margin rate, we're left with 40 basis points.

That's a bit higher, a bit more adverse than what we have seen lately, a piece of that gross margin -- pardon me, a piece of the SG&A rate deterioration that I spoke of related to worker's compensation, is related to adjustments of historical reserves or claims prior to 2004.

That's not something we expect to do every quarter.

So there's a much larger year-over-year increase in work comp this quarter than I would expect to incur in the third or fourth quarter.

And separately, the timing issues speak for themselves.

Okay.

Is there any, you know, information you can provide in terms of what an average ongoing growth margin rate improvement would look like going forward to help us in our modeling?

And the same for the SG&A?

Well, certainly one component in isolation, is a 10-basis point, give or take, annual increase -- annualized increase in SG&A that has a benefit in gross margin rate.

There are a lot of other factors that affect gross margin rates.

Some of them go up, some of them go down.

Over time, as we look into our future plans that support our objective to grow earnings per share, we do not envision substantial gross margin rate expansion.

There are a lot of issues in gross margin rate that go the other way.

Food products, certainly, generally speaking, are at a lower margin rate than our average.

Pharmacy, which has been growing at double-digit same-store sales growth year after year after year is sharply lower than our overall store-wide average.

We intend to balance all of these factors across time to achieve our earnings growth objectives, but net-net we do not expect long-term continued expansion of gross margin rate.

Okay.

And then just one separate question, just on the -- the third quarter, same-store sales plan, I know August is planned a little bit conservatively.

Would you expect that to improve in September as some of the comparisons against the stimulus last year go away?

The expectation we have for the full quarter for same-store sales is plus 2 to plus 4.

So, certainly we expect September and October, combined, to be better than August this year as a direct result of last year's base of comparison.

Great.

Thanks so much.

Mm-hmm.

Thank you.

Our next question comes from Deborah Weinswig of Smith Barney.

Good morning, in terms of the inventory position, can you help us, I guess on, you know, for modeling purposes going forward, should we continue to expect to see growth in the 20% or so, range?

Whether it's fully 20% or not, for a period of time next couple of quarters, you should expect to see meaningful year-over-year growth in inventories ahead of our growth in sales.

Again, this is not a risk factor, it's simply -- it isn't even that we have more inventory in the pipeline, it simply is that we're recognizing ownership farther back in the pipeline, and you'll see a parallel dollar increase in inventories and in payables as a result of this refinement of our accounting practices.

Okay, and then on the, kind of, inflation/deflation side, can you quantify the impact in the current quarter?

And what's your view going forward?

As you know, we can't quantify that quarter-by-quarter.

We get a precise view of year-over-year inflation or deflation once a year, as of October 31st.

So, in a couple of months we'll be able to talk about what's happened over the last 12 months.

As you know, last year we had overall store-wide deflation in our sales line of about 4%, give or take.

We think that the middle of the road expectation this year is more or less neutral.

We think we have about an equal number of SKUs that are inflationary versus deflationary, could tilt a little bit toward the deflationary side, but it would be easy to be off by a point or two in predicting that kind of figure.

Okay, and then one last question.

Gregg had mentioned during his comments that The One Spot, you know, The One Spot offering had encouraged guests to visit stores more often.

Is there anything, in terms of what you can quantify, that you've seen in terms of frequency of visit in those locations that had The One Spot?

We can't specifically attribute a change in the frequency of visits to just The One Spot, but it -- it -- it helps complete the overall -- overall offerings in those stores that have them, and the guest feedback has been very, very positive.

And the vast majority of those sales are -- are incremental in nature, so, over the long-term, this is just another successful element of our merchandising strategy that's going to help drive trip frequency and total.

Okay, so, basically, would it be in, maybe, focus groups that guests have mentioned that this has led them to increase their frequency of visit?

It's just basically -- it doesn't say that specifically, but it, basically, what the guest says is that they really love The One Spot shop that we have in the store, and they think it's -- they think the merchandise is a great value, it's cool, and it's neat, and overall adds to the positive shopping experience they're already experiencing at Target.

Okay.

Great.

Thanks, so much.

Thank you.

And our next question comes from Mark Miller of William Blair.

Hi.

Good morning.

I have 2 questions on your gross margins.

The first is: How much of the mark-down improvement in this quarter was a result of developments that are specific to this quarter or year-on-year comparisons?

And how much of it is due to the utilization of the import warehouses?

And then how far along are you in the integration of those import warehouses?

Well, I would just tell you that during the second quarter, we managed our -- we managed our business very, very well, as we typically do.

And so, in spite of sales softening slightly in the second quarter, we had strong markdown performance.

And so that was a contributing factor.

Certainly the import warehouses are a contributing factor as we -- as we utilize them more effectively, and we hold more of our seasonal merchandise upstream and distribute that merchandise closer to need.

That is a contributing factor, as well.

But it's really hard to separate out how much is due to one versus the other.

Overall it's been, as you know, was very positive for us from a markdown perspective.

I can tell you that we were starting to bump up against our full effective capacity of import warehouses, so they're very heavily utilized.

Okay.

Great.

And, then, on the mark-up, I know there's a lot of factors that are driving that.

I guess, any qualitative perspective on the relative importance of those?

I mean, how much do you think is coming from the direct imports versus reverse options versus other initiatives you have?

Thank you very much.

Well, as you know, the markup has, as Doug has said, has both pluses and minuses.

We have negative mix influences as we grow our food and consumables and pharmacy businesses at a faster rate than the Company overall.

And the positives are from -- we are getting positive growth in margin from e-sourcing throughout the entire Company, and through our global sourcing initiatives, which impact our direct imports.

And in total, we're able to offset the negative mix implications with the positive growth in these other businesses, and that's what we expect to continue to do going forward, is to be able to maintain the appropriate balance of both, so that we can maintain or slightly increase our margin over a long period of time.

Let me try, actually, one other question, as well.

The rollout of the private label products.

Can you comment on the consumer off-take to-date?

Has that met or exceeded your expectations?

Thanks.

It's been very, very positive, and it's met our expectations.

We have grown our SKU count in private-branded foods and our share of store's purchases in private branded foods.

And we are now into the low double-digits in terms of penetration of the combination of Market Pantry and Archer Farms, as well as our Target brand in the general merchandise side.

All of our private branded categories are performing very, very well, and we continue to emphasize them, and build great quality, deliver exceptional value, and we are looking at continuing to expand those lines.

Thank you.

Our next question comes from Christine Augustine of Bear Stearns.

Thank you.

Do you anticipate that you might look to accelerate your square footage growth over the next several years now that you have disposed of under-performing assets?

And then my second question is: Where -- what is your current view on acquisitions internationally, to expand there?

Thank you.

Target has never been capital constrained, and we think that we are growing at an appropriate rate.

It allows to us develop strong team members and strong managers to give a true Target brand experience.

It allows us to acquire attractive real estate sites without overpaying, so we think it's appropriate and it will deliver the kind of earnings performance that we have in the past, over time.

In terms of the international question, Jerry, would you like to comment on that?

Sure, we all believe at some point, I don't know if that's, you know, 5 years, 10 years or who knows when, Target will be international as a retailer, but we will do that only when we find the appropriate vehicle for accomplishing that.

Meanwhile, we have tremendous growth prospects right here in the United States for a very long time to come.

Thank you.

Thank you.

Our next question comes from Robert Drbul of Lehman Brothers.

Hi.

Good morning.

I know you can't give us guidance for the fourth quarter in terms of the EPS, but can you tell us, you know, share with us what the comp plan would be for the Target Stores division for the fourth quarter?

We clarify our comp plans by quarter when we get to the beginning of the quarter.

So we'd like to get into the third quarter, here, and see how our business develops, and then we will be very precise about our outlook for the fourth quarter.

Generally speaking, our outlook is consistent with what we've laid out before.

That comps were much stronger in the back half of last year than they were in the front half, and, therefore, generally speaking, we don't expect comps in the fourth quarter to mirror the kind of strength that we saw, especially in the first quarter of this year, to a lesser extent, the quarter just ended at about a 4.

Okay, thank you.

Thank you.

Our next question comes from Gregory Melick [ph] of Morgan Stanley.

Hi, thanks.

Just want to follow up a bit on the trapping and the growth of that.

Jerry, I think you mentioned that you plan on trapping 3 times the number of items versus a year ago.

And I was wondering, is that still predominantly all seasonal items?

Or are you finding new areas where that makes sense and sort of helps merchandise flexibility?

You know, seasonal is certainly one of the major focuses, but it's not the only one.

Anytime when we have a large amount of products that are related, then we can do it.

Okay.

So that -- and that increase in the 3 times of the items, is that now -- is that why we're hitting capacity on the import warehouses?

No.

Sometimes you're trapped in the regional distribution centers.

Okay, so that has no impact on the import distribution?

Not directly, no.

And, then, the second question on credit growth.

It used to be quite a bit more than sales, and now the receivables are growing a little bit less.

Where -- where should we be expecting those -- what are you guys benchmarking for growth in the credit receivables next 12 months?

We don't have a specific objective of growing the, you know, the receivables at a set pace.

As you know, from our many prior discussions, we grow the receivables based upon the credit quality of the applications, of the, you know, use of the card in the store.

It's not a gold number, it's a derived number.

Having said that, I would think that over time, the credit card receivables growth would asymptote towards the growth of the revenues in the Company as a whole.

Okay.

Great.

Thanks.

Thank you.

Our next question comes from Aram Rubinson of Banc of America.

Hey, thanks.

Question on the toy category, it looks like there could be some consolidation or concentration in that arena.

And I am just curious in terms of your approach to that business, both in the store and in the online world?

And how that might change going forward?

Well, our approach to the toy business, going forward, is not likely to change.

We are -- we have planned our -- our toy business, it's a very important category for us and regardless of what happens externally with Toys R Us or anyone else, we are -- we're going to manage our business the way we have in the past, we've got our own strategy, content, and pricing, and we're going to continue to do what we've done in the past to grow our market share.

But to do so profitably and so we're laying out our fall plans right now, very consistent compared to what we've done in the past.

In the online world, the objectives are quite similar.

There are sometimes opportunities to extend a product line offer [Inaudible] much larger than what we sell in the store in the online world.

But, generally speaking, it's exactly what Gregg said for the store-based world.

And just to clarify, on a housekeeping front, a shift in the timing of when you've taken ownership of the inventory.

Just tell me what triggered that.

And, thanks, for your time.

Well, certainly we're being a lot more careful about our accounting for imports given the burgeoning growth in imports, and as we carefully reviewed the supply chain, we've realized that we likely took technical ownership of products earlier than the point in time at the supply chain at which we have very detailed, precise information.

And, therefore, we have estimated the amount of inventory that we own for which we don't have precise information.

Thank you.

Thank you.

Our next question is from Wayne Hood of Prudential.

Yes, Doug, I have 2 questions for you, and 1 for Gregg.

The -- your leverage ratios, in light of the sale and just groping the equity alone, is dropping fairly dramatically.

I'm just wondering, could you revisit, now that those 2 divisions are gone, what your target of leverage ratios look like?

Because it looks like it's getting to a point where you can buy back or announce a buy-back beyond what you've already announced with the sale of those divisions to get those ratios back up.

Well, of course at this instant in time, we have received the 3.2 billion in proceeds from May Company, and of that -- or against that comparison, we have invested only $0.5 billion in share repurchase.

So, compared to the balance sheet here at the end of July, obviously, we have some work to do to catch up, to get some balance.

We don't have specific balance sheet targeted ratios, and have not had for years and years.

What we choose to do is to maintain substantial financial flexibility, and in addition, to maintain financial attributes, mainly, you can think of this as an interest coverage ratio, in order to maintain, to stand behind our strong "A" category, long-term debt ratings and our number 1 ratings on our commercial paper.

So, it's driven out a dual objective to remain flexible for future investments, and to retain ratings consistent with our current categories of ratings.

Well, when you look at those in the future, would you be able to maintain those ratings and also buy back stock beyond what the proceeds have been that you received?

When we look into the next 2 to 3 years, it translates to the share repurchase program we've announced, which we have every intent to execute against.

Looking beyond the next 2 to 3 years, certainly, we would either have an ongoing ability to continue to buy back shares, or we would invest in something productive in lieu of share repurchase, or some combination.

But, clearly, as we look forward, we have the capability, in our opinion, to fully execute the share repurchase program, maintain our current credit rating categories, and retain sufficient dry powder to invest in something if it came along and met our criteria.

Okay.

And then the recurring service revenues for Mervyn's and Marshall Field's, can you be be a little bit more specific about the dollar magnitude around that, where they're going to fall, is it going to be in the revenue line or offset the SG&A?

And is there anything in those agreements that would, if receivables began to slow or there was a charge-off, it would come back to lower those service revenues?

No, the receive -- we've sold the receivables for Marshall Field's, those are now owned by May Company.

Essentially the -- the key categories where we -- you can think of the service revenues, and I'll come back and talk about the accounting in a minute, I'm using the word revenue a bit loosely here.

The service revenues that we will enjoy, essentially, reimburse us for the costs that we incur in our IT world, and, separately, reimburse us for a wide variety of headquarters costs, including the cost to service, in the very short run, the credit card portfolio that now belongs to May, and soon for a very short time, to service Mervyn's credit card portfolio on a parallel basis.

We will account for what we're calling revenue here in this discussion, as an offset to the cost that we incur.

In other words, this will be a contra-expense item that simply lies alongside, or will lie alongside, the incurrence of the expense, so that our SG&A rates won't be changed by this activity.

Okay.

And Gregg, I just have 1 question for you.

The trip frequency in those P-2004 stores, where you've already had those up and running, what was the frequency -- what did that frequency look like versus the chain average or your expectations?

Thank you.

Well, these are new stores that we've introduced P-2001 concept in.

And so, there's no relative basis of comparison in terms of what the trip frequency might have been had they been a different format.

We can -- we can just tell you, though, that based on comments from guests, and the behavior in those stores right now, is that we are -- we are seeing and feeling a pattern that -- that will result in these guests visiting our stores more often because of the commitment we've made to categories that drive trip frequency.

So, we know over time, that we will get continued trip frequency, or greater trip frequency, in these formats versus our prior formats.

Operator, as we approach 11:30 eastern, I think we probably have time for one more question.

Thank you.

Our final question is from Charles Siegel [ph] of LSR Advisors.

Hey, guys.

Congratulations.

Just as a, you know, a point of clarity for the fourth quarter, I guess you're not giving guidance.

I didn't know if you would be able to say if, on an operational basis, you were expecting growth or a decline, maybe, you know, ex-the -- ex-the dilution.

Let's talk about continuing operations, earnings before interest and income taxes.

We had a very -- we had a spectacular year in the fourth quarter last year at Target Stores, and so the base is challenging.

Yet, against that base, we clearly expect to achieve appropriate growth in EBIT during the fourth quarter this year.

The rest of those issues I talked about, simply, are issues of translating our expected EBIT growth to the bottom line in the form of EPS.

Again, to the extent that we have left any questions unanswered, or if there's further clarification, please feel free to follow up with Susan Kahn or myself.

Bob?

Thank you all for your participation.

That concludes Target's second quarter 2004 earnings conference call.

This concludes today's conference.

We thank you for your participation.