Motley Fool Hidden Gems Investing - Tight Budgets Come for Target

Episode Date: May 22, 2024

Just how resilient is resilient? (00:21) Jason Moser and Mary Long take a look at Target earnings, the “resilient consumer,” and new rules for the Buy Now, Pay Later industry. Then, at (14:47), Matt Frankel joins for some David-versus-Goliath stock matchups. Companies discussed: TGT, WMT, COST, AFRM, PYPL, FICO, UPST, DKNG, CHDN Host: Mary Long Guests: Jason Moser, Matt Frankel Producer: Ricky Mulvey Engineers: Dan Boyd, Dez Jones Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Target misses the mark, but you're listening to Motley Fool Money. I'm Mary Long, joined today by Jason Moser. Jason, thanks for being here. Hey, Mary. Thanks for having me. Of course. So today, Target reported earnings. Here's what I've got. Comparable sales down 3.7%. That's the fourth straight quarter of declines there. Total sales down 3.2%. Traffic down 1.9%. Average transaction also down 1.9%. Sounds like a lot of bad news. What's behind this?

Yeah. I mean, it does sound like bad news. It's kind of par for the course, I guess, for most retailers, it feels like, with the exception of maybe a few. But I think with Target, they're coming off of some challenges here recently. When you look through the release, when you look through the call, management was very quick to focus on the consumer and the normalization. That's a word they used in the call that I think accounted for a lot of what's been going on. It's this normalization and spending patterns that they saw really emerging a couple of years ago, as we got back to normal, where consumers are focusing a little bit more on services and entertainment stuff outside of the home, which makes a lot of sense. We were

all sequestered for a while in what they say curtailing those activities during the pandemic. And I think what we saw, or what we're seeing at least with Target's results, Obviously, inflation and higher consumer prices are still playing a role in their results. They're seeing some soft trends in the discretionary categories. They noted in the call, it was most prevalent in the home and hard lines part of their business. That makes a lot of sense, but it's something they're going to have to overcome. It also makes me think of restaurants when they're dealing with difficult comps. They go through a stretch where they're really performing well, they keep on chalking up

all these great numbers, then they go through a little bit of a lull where things hit a little bit of a reset, and then they get back to growth beyond that. That could be where we are with Target right now, but there's no question, they're dealing with what has been a challenging consumer environment. I think you're right. When you say this is par for the course, management seems to have the same outlook, they didn't seem too worried. Guidance for the full year, unchanged. Wall Street seems to feel differently. Last I checked, the stock was down 7% this morning. But management doesn't seem to be too

troubled by that. No, and they shouldn't be. I mean, I think, again, it's sort of taking the longer view. It could be a little bit of a taking sort of some short-term pain for some long-term gain there. I mean, there are some things to smile about in the results, in the call. I mean, They've seen improvement in many of the drivers of the business over the last several quarters. We hear this a lot here, this resilient consumer. They talk about the U.S. consumer remains resilient in the face of multiple challenges. It's a little bit confounding at times. We know that consumers are really feeling the pinch of higher prices, and it's becoming

a little bit more difficult to access capital in that way. But it does feel like with Target, I mean, inventory is down 7% from a year ago. Gross margin expanding a little bit, thanks to cost controls. They're resorting to less discounting. That's always a good thing to see. And I don't know if you remember, Mary, several quarters back, the word shrink was really, that was the word du jour for many of these companies. And they're seeing a lot of improvements in their efforts to control that shrink as well. So it wasn't the greatest quarter in the world, but it does feel like they're on the path to recovery here.

Yeah, I want to zoom in on the consumer for a second because Brian Cornell in talking about all this kind of put some of the blame on the macro. Basically, hey, sales are down, budgets are tight. We expect that. In response, Target's already slashed prices on already 1,500 everyday items. I think they've said that they're going to slash prices

on up to 5,000 items. And what are these items there? Milk, bread, back-to-school stuff, summer party supplies. What do those discounts actually look like, though? Because of the press release where Target announced this, plain bagels are $0.30 off, frozen pizza, $0.20 off, laundry detergent, $0.70 off. Are those lowered prices enough to get consumers back at Target and spending more again? I mean, as prices and inflation persist, I mean, it certainly can't hurt, right? I mean, I think all consumers appreciate lower prices, and Target is trying to do what they can to participate in that. It does feel like they're making a lot of progress in regard to their

loyalty program. They relit the fire on that Target Circle loyalty program. They relaunched it back in April. They have over 100 million members now. They added more than one million new members to that Target Circle program in the quarter. I'm glad you focused in on key items there. They're grocery items, right? I think where Target is concerned, that's a place where they could stand to improve. With Target, grocery still only represents basically a fifth to a quarter of the overall business. Whereas, when you look to competitors in the space like Walmart, for example, Walmart is a leader in the grocery space. You're talking about 50% in that neighborhood. So, it does make a lot of sense for them to really focus

on cutting prices where consumers see it most day in and day out. It remains to be seen whether it ultimately will have a great impact on bringing consumers into the stores on a more regular basis. But again, going back to that Target Circle relaunch, there's a lot to be said for that. I think that's an important thing they did there. We've seen, Obviously, throughout the last several years and decades, I guess, really, we could say there's just a lot of power in that loyalty program and that membership model, right? And if Target can continue to focus on creating reasons for customers to come back, and loyalty programs, membership programs are usually one of the best ways to do that, then they

should benefit from that. So, Target's got this not great quarter. Meanwhile, Walmart and Costco have boasted pretty strong results. So Target has seen comparable sales slip. Walmart, on the other hand, saw them climb this past quarter. Traffic dipped for Target. It rose for Walmart. Is it, you know, you hit on the grocery comparison between Walmart and Target and how Walmart

does a better job there. And it's easy, I think, to see these two companies as selling a lot of the same things. But do you think it's fair to make an apples to apples comparison between Target and Walmart or Costco, for that matter? Yeah, I think it's fair. Certainly, it's fair. I mean, they all play in the same sandbox. And I think one of the things, a theme we saw on the call for this most recent quarter for Target, something they really focused in on was being able to fulfill orders, being able to make sure they had what consumers wanted. And that's something that a lot of these companies,

and Target certainly fell in this, they ran into shortages. Supply chains really ran into some headwinds here over the last several years. I think that's where scale comes into play here. You think about Walmart vs. Target, what's the big difference there? Well, Walmart really is just a lot bigger. They have the scale that Target doesn't necessarily have. When consumers know that they can go somewhere and they can get what they want, then they're probably likely to go back. Those are good customer experiences. Whereas, if you go to a store and you don't find what you're looking for, and if that happens on a repeated basis, that becomes a problem. Customers start to defect and they go other places like a Walmart,

for example. Being able to see that Target was able to fulfill these orders more and really give customers everything that they want, I think that can really play a big role in helping bring Target back up to that level where a Walmart and a Costco is. I say Costco here. Costco, to me, they're on a completely different level. They've been at this for a long time. They know what they do. They do that one thing, and they do it really well. With Target, they're not quite in that same ballpark, but it seems like they're working to get there. The loyalty program, making sure that they have an inventory on hand that consumers want, being able to fulfill those orders, I think makes a big difference and could certainly be a positive driver in the coming quarters.

I want to pivot to one other story because I am, after all, here with the one, the only, Jason Warren Cash Moser. The CFPB, the Consumer Financial Protection Bureau, announced this morning that it views buy now, pay later companies, so that's Affirm, Klarna, PayPal, as essentially the same as credit card providers under the Truth in Lending Act. So, what that means in practice is that BNPL companies will now have to refund customers for returned products or canceled services. They'll have to look into merchant disputes and provide bills with fee disclosures. Is this rule really anything new?

Are BNPL companies already doing this? Well, I don't know that it's really anything new. I mean, if you look at the BNPL space, I mean, right now, it's not even really clear as to who all of the providers are and ultimately which ones comply with things like refunds and disputes versus the ones that don't. But I do feel like in regard to BNPL, it's such a new space still. We've talked about it for a little while, but it's still a very new space. And I think this is one of those headlines that ultimately is a positive in that it's codifying what has been more or less a wild west of a new offering, right? And we've seen a lot of big sort of

incumbents in the space, companies like PayPal and whatnot jumping in there, but also a lot of new companies that are founded on this one simple offering of buy now, pay later. It's just not been very clear what the rules of the game are. And so this news, I think, helps ultimately codify what has been a bit of a sort of a nebulous offering. And that, I think, is good for consumers. I think it's good for investors in that it at least gives us some clarity, some understanding as to how this offering may move forward and how companies can ultimately benefit from it.

Yeah, Buy Now, Pay Later is a $309 billion industry. And I hear these rules and they sound positive to me. I wonder, might these protections drive even more consumers to BNPL that were maybe skeptical of it before? Yeah, it certainly could. I think that probably would be a good thing for those running it, as long as they're running it well. More purchases means more money flowing through those networks. That's always a good thing. You get benefits from take rates. That's ultimately what these companies participating in the space want. They want more money flowing through those networks. But by the same token, there are plenty of risks that come with it.

At the end of the day, BNPL is still essentially like a credit card. You're just purchasing something with debt. Whether it's a credit card or whether it's BNPL, you're still purchasing something with money that you may not necessarily have to spend at that point in time. What BNPL has done so well is, they're able to offer these types of purchases with maybe interest-free or fee-free types of purchases, and that's great, but that's not something that lasts forever, and that's also not something that necessarily applies to everybody that's out there. It creates a little bit more risk for the companies doing this, much like lenders. You're going to be writing off loan losses and stuff like that. Ultimately, they will adjust,

they will charge more to consumers who don't pay their bills on time, which then means, that interest-free thing has just flown out the window. There's going to be some cost to you spending someone else's money, which is totally understandable. I go back to a target data point that I saw in their call, where they call out one in three Americans today has maxed out or is close to maxing out the limit on at least one of their credit cards. We also know that, based on the data, consumer credit card debt is at all-time highs. While we talk about this consumer that's still resilient, it's clearly a consumer that is under threat. For the BNPL industry to be able to bring these rules into play and make

it a little bit more clear so that we as consumers understand at least what we're doing, what we're getting in exchange for the service that we're using, I think that makes a lot of sense. I think it could absolutely result in more folks using BNPL. It absolutely could also result in more consumers trying to figure out more ways to get more credit cards. when you're spending, when you're spending money, you don't have, that's just, that's not always the greatest option. Jason Moser, lovely to talk with you today. Thanks so much for the time and for the insight into these two new stories. Thank you. You just found out that your sales team is at risk of missing quota. Don't panic. Just ask

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rippling.ai slash fool. It's fun to root for the underdog, but that doesn't mean that the underdog always wins. Up next, Matt Frankel joins me for a look at some David versus Goliath stock matchups. We're playing this conversation in two parts across today and tomorrow. Today, we pit Upstart against FICO and DraftKings against Churchill Downs. Everybody loves an underdog story, but if you're an investor, is it better to bet on David or Goliath? Today, I'm talking to Fool contributor, Matt Frankel, and we're taking a look at a number of

newer, sometimes smaller companies that are going up against more established players in the same space. Matt, thanks for being here today. Yeah, always good to be here. We're going to take a look at four different matchups that each kind of tackle a different angle of this general David versus Goliath theme. Our first fight is going to take place in the arena of credit reporting, where we've got an upstart, upstart holdings, going up against a more seasoned player, FICO, or the Fair Isaac Corporation. So, Upstart, for those that don't know, is a fintech company that wants to look beyond credit scores when it comes to determining loan risk. FICO is the credit score. So, let's start with

this. Is the world wide enough for both of these companies to exist? Well, yeah, a couple of points. For anybody who's checked their own FICO score, I'm sure you have at some point, knows that it's not perfect. We have three different FICO scores, for one thing. I personally don't have three different credit ratings. My risk profile is what it is. There's a lot of room to consolidate that. It's not just the three different credit bureaus. There's, I think, 28 different versions of the FICO score. There's an auto version. There's a mortgage version. Which one's the real number? There's a lot of room for improvement there. Number two, Upstart actually uses FICO scores in its model. Its goal is to be better than Upstart.

it. But if a consumer has a FICO score, it will use it. FICO kind of overlooks a lot of consumers. For one, if you haven't had a monthly payment reported to credit in the past six months, you don't have a FICO score. And not everyone who doesn't have outstanding debt is a bad risk. So, there needs to be a way to evaluate that. People who maybe have poor credit scores but have more than enough income to justify a certain purchase would be declined by the traditional FICO model, but could be approved through upstarts because they look at things like education, employment, factors that are legally not included in the FICO model. Yes, there is a lot of room for both of them. Upstarts trying to take the FICO model and make it into a better action plan

for lenders. When I line these two companies up against each other, it's pretty clear to me who the Goliath might be. FICO has a market cap of nearly $35 billion. Upstart, on the other hand, is closer to $2 billion today. FICO has been around since 1956. Upstart came onto the scene in 2012. FICO is the older, more established, larger company here. That said, do you see any weaknesses that stick out to you in FICO's current business that maybe its mammoth size and longer lifespan might disguise? Well, I mean, the weakness is the same as its strength. FICO's strength is that it can describe me with one number, or describe any consumer in just one number or not a number, saying, don't lend to them, they don't have a credit score.

That's also their weakness, is that you are more than your credit score. And that's actually Upstart's slogan. You're more than your credit score. There's other things that come into play when it comes to the likelihood you're going to pay back a debt. A lot of people don't know, statistically, this has been proven, people with college degrees are more likely to pay back debts than those who don't, regardless of credit score. That's something that is included in Upstart's model that isn't included in the traditional FICO model. You are more than just one number. Your credit rating depends on what you're trying to buy. Upstart considers that, and FICO doesn't. Like I said, their weakness is the same thing as their strength. If a company has a hard cutoff,

we want someone with a 700 FICO score, it's really nice to be able to get it down to one number so they can quickly screen applicants. But you're also excluding a lot of people who should be creditworthy, and that represents potential business that you're ignoring. Even as we're talking about this and laying out the differences between these two companies, I can't help but wonder, like, okay, FICO knows this, knows everything that you're saying. It's not like this is secretive information about what Upstart's including in their model or what they're trying to do. So, what is stopping FICO from saying, oh, Upstart's including more people and expanding credit access to more people. We should just do the same. I mean, the short answer is because no

one's dropping the FICO score. FICO is still used in 90% of lending decisions, including those made using Upstart's model. They don't want to take the risk. It seems like an unnecessary risk when you already dominate your industry. It'd be like Google trying to start a new search engine. Why? You don't really need to, you're already dominant. I think that's why. It's really two different businesses, and more so than people give it credit for. Upstart was a pandemic darling that's now down almost 93% from its all-time high. In 2020 and 2021, it was generating income, but since then, it's only seen net losses. One of the reasons for that is that interest rates have hit this company pretty hard.

That said, is there a secret weapon that's hiding in Upstart's slingshot? Well, I think at one point during the pandemic, Upstart was actually the Goliath here by market cap. To be fair, it never should have been a $400 stock at the time, if we're being totally honest. But you're right, it wasn't a profitable business. It was growing rapidly. But that's because everybody in the world was borrowing money because it was so cheap to do it. Loan volumes have just fallen off a cliff over the past two years or so as interest rates have risen. People aren't as convinced that the economy is doing well and is going to continue to do well. People are more hesitant to borrow money. So, all of that has really dried up the lending business.

That's why Upstart's unprofitable. It's not that they necessarily did anything wrong. It's that loan volume is one quarter or whatever it is of what it was in the pandemic years. They need volume to make money. If we see interest rates start to normalize, which I think everyone hopes that they do, you should see Upstart become profitable, because it is a high-margin model. For now, that's why they're unprofitable. That's not the only reason the stock is down 93%. That has a lot to do with it should never have been that high in the first place. I could name you a list of 50 stocks from that era that are in the same bucket, but that's really why. Given a choice between these two companies,

and understanding, as you said, that both, but Upstart especially, are operating on cycles here that are dependent on a lot of other factors, looking ahead long-term, taking that foolish view, between the two of these, Upstart and FICO, Matt, which would you say is the better buy? Well, I own Upstart, so that's kind of the easy answer. But it really depends on risk tolerance, because these are at totally opposite ends of the spectrum. So, our next battle pits online sports betting platform DraftKings against an older, more traditional company, Churchill Downs. So, Matt, when I first started looking into these companies, my inclination would have been to have labeled Churchill Downs as the Goliath.

And I think I would have attributed that largely to the fact that the company's been around for a lot. I think of sports betting as online sports betting and the phenomenon that it's become as something that's newer and more modern. And I know that Churchill Downs has been around far longer than that phenomenon has existed. They opened their first racetrack in 1875, for instance. That said, when you look at the market caps of these two companies today, it appears that DraftKings may actually be the Goliath here. They're valued at over $21 billion to Churchill Downs' $9.8 billion. They're both sizable companies, but lined up next to each other, DraftKings seemingly takes the cake. What do you say? When it comes to sports betting in

particular, who is the real underdog here and why? That's a tough question. They're both good companies, they're both really impressive. DraftKings was probably the most successful SPAC IPO of the entire SPAC era. A lot of people don't realize that that was one of the blank-check companies, and it's one of the few that actually did well. No, they've really been a big beneficiary of the widespread legalization of sports betting. It's a less capital-intensive business. That's why they get more credit from the market for the revenue they generate, because they're growing rapidly. As they grow, profitability should come. They should be able to get, eventually, right now they're in growth mode, but when they're

more of a mature business, should theoretically have higher margins than Churchill Downs just because they are an online presence. Same reason online banks tend to be more profitable than brick-and-mortar banks. But for the time being, Churchill Downs is an impressive business by itself. The gambling business, if you're a brick-and-mortar operator, is not easy to make money. It sounds like a really easy business. You're literally in a business where people give you their money. But it's a lot tougher than that when you realize just how much capital is involved in building and maintaining facilities. Churchill Downs is a big place. It's not cheap to maintain. They also own a bunch of brick-and-mortar casinos. They own off-track betting facilities.

they own a lot of physical assets that need to be maintained. And for them to generate a 14% net margin from those assets, that's not easily done in the casino business. Great casino operators, Caesars Entertainment has been bankrupt in the past. It's not a terribly easy business. But having said that, DraftKings has an advantage. They're actually the No. 2 online sports betting company next to FanDuel. Flutter Entertainment is theirs. But they're the domestic player. They're exclusively U.S.-focused. They're in 26 states. They expect 30% revenue growth this year. Very impressive company. And they're going to be cash flow positive this year. So, I think one way to kind of think about the difference between these two

companies, while they largely dabble in the same space, is exactly what you hit on, that DraftKings is digital, a digital offering. And Churchill Downs has far more of a physical brick-and-mortar presence. That said, are we seeing Churchill Downs start to dabble in that digital gambling space as well? They are. I wouldn't necessarily say it's been a focus. They've been making bolt-on acquisitions in the digital space. They have the brand recognition. They're probably not surprising. A lot of their focus on digital gaming has been in the horse racing and that kind of space, where I think they do have an advantage over DraftKings. Churchill Downs, I don't know if you can name a bigger brand, I'm not a horse racing guy, but if you can name a bigger brand

in horse racing, that's got to be it. So, they are kind of dabbling in that. I don't see them being, I don't see FanDuel, DraftKings, and Churchill Downs becoming the big three in online betting, but they have a pretty big moat in terms of their physical presence, and that's really their niche. Yeah. So, let's kind of talk about that physical presence a little bit, because you mentioned that Churchill Downs, in addition to owning the racetrack that hosts the Kentucky Derby, that's kind of what comes to mind when we hear Churchill Downs. They also have many other real estate properties. I believe it's 14, what they call live and historical racing properties, plus a number of gaming and casino properties. So, DraftKings, again, we said that they're a

mostly digital company. They do partner with some physical sportsbooks. But again, it's digital at its core. When we line these two companies up and we think about Churchill Downs' real estate footprint, is that footprint an asset, a liability? How do you think about that? The short answer is, it depends what the economy is doing and what the market is doing. Right now, live entertainment has never been a better business. If you've gone to a concert any time in the past year, you know you're paying so much more for your concert tickets than you were four or five years ago. Live entertainment is great right now. It depends on what consumer preferences are with live entertainment. A lot of people thought that

the live entertainment boom was a post-COVID pent-up demand thing like that. But no, concert tickets are still going for $500. How much would it cost you to see Taylor Swift right now? How much would it have cost you in 2019? It seems like it has some staying power, that live entertainment is a much better business than it was a few years ago. But at the same time, it is a capital-intensive business. If we hit a real recession or real economic trouble, you can see attendance at those places start to decline. Casinos have historically been surprisingly recession-resistant, but that's not a guarantee. Vegas revenues do dry up during really tough periods. But it can be a benefit or a burden, depending on what the economy is doing.

Let's pivot to DraftKings, because they're losing money and burning cash. What needs to happen for this company to turn a profit in, I'll say, a reasonable timeline, and then maybe let you define what reasonable is? First off, management said that they're going to be cash flow positive this year. That's why the stock is doing so well right now. It's very close to its 52-week high, and That's why. Cash flow positive 2024, they're saying. They say 30% revenue growth. Profitability, they're going to need really two things to happen. They need to engage the current users they have more, which they're doing. Their average revenue per user increased by 6% last year. They're building better relationships with their customers. They really need the

legalized gaming to continue to roll out. It takes a little while before their presence is really known in the market. For example, the state neighboring my North Carolina just recently legalized sports gaming. A lot of people don't really know it yet. A lot of people don't know how to bet on sports if they wanted to. It does take a little bit of ramp-up time to educate the consumer and really let them know the options out there. I mentioned earlier that they are in 26 states right now. They're not fully maximized in 26 states, in other words. They really need to build out that engagement. That's really what's going to lead them to profitability. As they get mature, their customer acquisition

cost comes down a lot. The amount of money they need to spend on growth, which is a lot right now, will start to come down. Long-term, they have the potential to have better profitability than Churchill Downs. Right now, they have a 39% gross margin. Churchill Downs is 33%. When you look at the gross margins of the business, even though they're a younger company, their gross margin is already way above where Churchill Downs is. As they grow, they have a lot of room to expand their margin. It sounds like you just answered this question, but I'm going to set it up for you just in case there was any questions. As we've addressed, these companies operate in overlapping sectors. There's a lot of overlap between the business

that these two companies do, but it doesn't sound like there has to be a winner, necessarily. If we take a foolish long-term time horizon of five to 10 years, which stock are you betting on in this matchup? I could make a solid case for both of them. I would have to go with DraftKings as far as long-term. If my time horizon is 20 years, I'm a DraftKings fan. As always, people on the program may have interests in the stocks they talk about. And The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Marian Long. Thanks for listening. We'll see you tomorrow.