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Target's big beat means it could be a winner this holiday

Customer with two-year-old shop in the toy section of a Super Target store in Littleton, Colorado.
Matthew Staver | Bloomberg | Getty Image
Customer with two-year-old shop in the toy section of a Super Target store in Littleton, Colorado.

Target made meaningful progress in bringing traffic and comparable sales back into positive territory last quarter. Perhaps most important were the areas powering that improvement, as their increased importance during the holidays put Target in position to win.

Growth in the discounter's so-called signature categories — baby, style, kids and wellness — accelerated during the recently ended period, and outpaced the company average by more than 3 percentage points.

These products will help differentiate Target's merchandise during the holiday season, and should allow it to maintain pricing power in a highly promotional environment. Not only that, but because these private label items cut out the middle man, additional sales of these custom-made products should push Target's gross margin higher.

In a similar vein, after logging 2½ years of growth in its toy business, Target is beefing up its assortment of exclusive items by 15 percent. That decision comes at a critical time for the toy industry, which is expected to record another solid year of sales gains.

And with Target's online sales growth accelerating 10 percentage points during the quarter, improvements to its in-store pickup and ship-from-store capabilities put the company in position to capitalize on the expected uptick in online sales.

Target shares leaped 6.4 percent in afternoon trading Wednesday, as the discounter beat Wall Street's earnings per share and sales estimates, and raised its full-year guidance. That's even as it continued to feel pressure from fewer shoppers visiting its stores, and a second-straight quarterly decline in comparable store sales.

"All in all, Target seems well-positioned for a successful holiday season," Moody's analyst Charlie O'Shea told investors.

Leaning into what's working

Style, kids, baby and wellness have been CEO Brian Cornell's key initiatives since arriving at Target two years ago. They were part of his plan to bring back the pizzazz the Target brand had been known for, after it shifted too heavily toward its role as a discounter.

These categories have consistently outperformed the company average, and have helped Target grab market share in apparel and home — two key categories during the holiday season.

Target has also seen "exceptional growth" in its two newest kids' brands, Pillowfort and Cat & Jack. The retailer will play into this strength by bringing in 1,000 new Cat & Jack items between October and December.

"Millennials like what they're doing in the kids and baby departments," Telsey Advisory Group retail analyst Joe Feldman told CNBC.

Target is also playing into its consistent execution in toys, upping the number of exclusive items in its stores to 1,800. The holiday quarter is critical for Target's toy business, as it accounts for half its annual sales in that category.

Industrywide toy sales are expected to pick up in the fourth quarter, and grow 6.5 percent over 2015, according to The NPD Group.

And while it remains behind competitor Wal-Mart on a digital front, Target is in position to continue narrowing the gap. After growing its digital sales 26 percent in the fiscal third quarter, Target will once again eliminate the minimum spending threshold shoppers have to meet to receive free shipping. That promotion helped lift its online sales 34 percent last year.

Target will also be able to ship online orders from 1,000 stores during the fourth quarter. That should help the company fill online orders faster and more cost effectively.

The company has also shifted more of its store employees toward filling online orders, assuming demand for in-store pickup will increase 50 percent from last season. Given that one-third of these shoppers add extra items to their carts when they come to pick up those orders, that could lead to incremental sales.

"It's one of the reasons we've been so focused on building out this capability," Cornell said.

Where troubles remain

Still, several lingering challenges weigh on Target's results.

The electronics category once again dragged down sales, while the ongoing transition of its pharmacy business to CVS put a dent in its traffic. While improving, Target still needs to boost the number of shoppers making repeat visits to Target stores items.

And food, which accounts for 20 percent of Target's annual revenue, once again posted a small decline. That's despite Target pumping up the value messaging around its grocery products, upping the quality of its produce and leaning into local offerings such as craft beer and wine.

Though the category was pressured by deflation, uncertainty in food has been one of analysts' biggest knocks on Target, as it's another category that drives repeat customer visits. Senior vice president of grocery Anne Dament is on her way out the door, and a replacement has not been named. Cornell said the company will detail its grocery plans — including which elements of its L.A. test stores it will roll out in remodels — come February.

"We have more work to do there, but we feel like we're making very good progress," Cornell said.

Fellow discounter Wal-Mart is scheduled to report its latest results Thursday.