Target's decision to remodel stores goes beyond gut instinct

Target Chief Operating Officer John Mulligan says he gets asked "all the time" why the company keeps investing in its stores.

It's a new digital world, after all. Amazon.com blew past the Minneapolis-based retailer in annual sales years ago and is now nearly out of sight. In response, Target is planning to invest more than $1.5 billion just in renovating existing stores, including more than two dozen in the Twin Cities.

It might look like the company is allocating that much money to stores out of a desire to simply stick to its roots, maybe because no better ideas have come along.

Yet that's not what's going on here. Target is using its stores in a way no one was talking about 10 or 15 years ago. And by investing in them, it is sticking to something that goes very deep in its DNA: running the business based on a return on investment.

The answer to the question Mulligan said he's asked all the time — why invest in stores — is those are the projects that still earn good returns.

Target, of course, is not the only company that runs its business this way, yet the company was known for doing that in retailing long before it was fashionable.

Nearly 40 years ago the New York Times quoted an analyst, in a glowing profile of a company then called Dayton Hudson, saying that "the emphasis on return on investment is unique in retailing. Usually merchants look at sales volume or profit margins."

The corporate manager's job was to wisely decide what to do with the shareholders' checkbook, and that took more than gut instinct.

The founding Dayton family left the scene, but the methodology stuck. Pick up an annual report from the late 1990s and you will find a section talking about a then fashionable concept called economic value added, which was mostly the same idea with a new label.

A return-on-investment update remains a staple of Target's annual financial meeting, and that's what had Mulligan on a ballroom stage alongside his boss, CEO Brian Cornell, and other Target executives last week in Minneapolis. Most of their presentation to stock analysts and investors was about Target's retail stores.

Paying a lot to remodel stores is one way to show a return on investment. The company is budgeting about 325 remodels this year. Depending on the store, a renovation might easily take $5 million or more in capital. But the makeover leads to a 2 percent to 4 percent increase in annual sales.

While that sales increase doesn't seem like a lot, the additional gross profit from those additional sales should be enough to make the back-of-the-envelope math work for a good return on the investment.

Using the stores, buildings that have generally been paid for already, beats having to sink capital into new distribution centers to process that online volume. That's a better utilization of the capital already spent, another way to think about return on investment.

This kind of use of a Target store is what gave rise last week to what CFO Cathy Smith suggested was a new business model. It's not exactly a profoundly different business model, but it's fair to say the lines are blurring between what we have come to understand as an online retailer and a traditional one.

The new model only really works if Target can meet the challenge of efficiently keeping thousands of products on the move, not in trucks or in cases but item by item.

Once it was common for Target to ship a pallet of laundry detergent bottles to a store, with store staff replenishing the shelves from the pallet full of stuff. Then Target shipped cases and now it has the capability to ship maybe a few items. That's quite an achievement, and it means a lot less stuff just sitting around, waiting to be put on a shelf.

Another past practice that was tossed overboard is ensuring that a delivery truck leaves a Target distribution center full. Sure that's the most efficient way to run a truck, but to wait for a full truckload you may have to be willing to let a couple of days go by before the next delivery arrives. That meant the store had to keep more stuff on hand to keep the shelves from going empty.

Target generated an after-tax return on invested capital last year of about 14 percent, and it expects to do better this year.

Target certainly has challenges aplenty to adapt to what the customer wants and to respond to tough competitors. But it's the companies that can't generate 14 percent or 15 percent after taxes in their core business that ought to be looking at other places to invest their money.