$1.65 of Target's $4.11 Quarterly Profit Came From Tariff Refunds

Target (NYSE:TGT) reported second-quarter results Wednesday morning, and the headline numbers were solid. Earnings per share doubled year over year to $4.11, net sales grew 5.3% to $26.5 billion, and management raised its full-year outlook.

Shares climbed about 4% on the news, closing at about $159 -- within about $3 of their 52-week high.

But there is an asterisk on that doubled profit, and it is a big one. The quarter included $994 million of pre-tax tariff refund benefits, money returned to Target after the Supreme Court struck down a set of import tariffs in February. Those refunds contributed $752 million to net earnings, or $1.65 of the quarter's $4.11 in earnings per share.

That is one-time money. So the honest test of the quarter is what remains after subtracting it -- and the answer, to me, is a pretty good retail business. Excluding the refunds, earnings per share still grew 20%. And the raised outlook still stands without them.

A refund worth $1.65 per share

The refunds trace back to tariffs imposed under the International Emergency Economic Powers Act, which the Supreme Court ruled unlawful in February. Target received the money during its fiscal second quarter, and it arrived in size.

The company recognized the $994 million as a reduction of its cost of sales, which means the benefit sits inside gross margin and operating income. It flattered both. The quarter's gross margin rate of 33.7% included 3.7 percentage points of refund benefit, and the operating income margin rate of 9.6% (versus 5.2% a year ago) included the same 3.7-point boost.

Management's new guidance assumes no future refunds arrive. Whatever comes next has to come from the business itself.

The quarter holds up without it

Strip the refund out, and the underlying business kept the momentum it found earlier this year. Comparable sales grew 3.8% in the second quarter, and the composition matters: comparable traffic rose 3.6%, meaning nearly all of that growth came from more shopping trips rather than bigger receipts.

Store comparable sales rose 2.7%, digital comparable sales rose 8.7%, and same-day delivery grew more than 25%. Net sales in all six of Target's core merchandising categories grew year over year.

The margin story holds too. Excluding refunds, the gross margin rate expanded about 100 basis points from last year's 29%, helped by the comparison against a year-ago quarter loaded with markdowns and purchase-order cancellation costs. And non-merchandise revenue (advertising, membership, and Target's third-party marketplace) grew more than 20%.

Indeed, this was not a one-quarter pop. First-half net sales rose 6% year over year, the two-year growth rate accelerated from the first quarter, and after-tax return on invested capital reached 15.4% for the trailing 12 months, up from 14.3% a year earlier. The company also paid $518 million of dividends in the quarter while repurchasing no stock, leaving about $8.3 billion of buyback authorization in reserve.

CEO Michael Fiddelke said in the earnings release that the results give management "increasing confidence that our strategy is resonating with our guests."

Time to buy?

The updated outlook is where the refunds matter most, and the raise survives the subtraction. Target now expects full-year sales growth in a range around 5%, a percentage point higher than its prior guidance.

The new earnings-per-share range of $9.90 to $10.90 includes the $1.65 of refunds. But excluding them, the range is $8.25 to $9.25, and that midpoint sits $0.75 above the previous guidance of $7.50 to $8.50. So while the refund inflates the headline range, the underlying outlook rose too.

The market, however, has already rewarded the recovery. Shares have nearly doubled from their 52-week low of about $83, and at about $160 they cost about 17 times earnings -- and about 18 times the midpoint of the new guidance with refunds excluded.

At the low, the same earnings cost about 9 times. That discount is gone, and what remains is arguably a fair valuation for a retailer growing sales in the mid-single digits.

The headline number overstates the quarter, but not by as much as I expected going in. The refunds are a one-time $1.65.

The 20% underlying earnings growth, the traffic-driven comparable sales, and the guidance raise are Target's own doing. The stock price simply no longer treats any of that as a surprise.

Daniel Sparks and his clients do not have positions in any of the stocks mentioned. The Motley Fool has positions in and recommends Target. The Motley Fool has a disclosure policy.