Michael Fiddelke
Executive Vice President and Chief Financial Officer at Target
Thanks, John. I want to start where John just ended and reiterate how closely we're listening to our guests, ensuring we understand how they're feeling and how that is affecting their shopping behavior and moving quickly to serve their rapidly-changing needs. Obviously, if recent softening consumer trends continue through the fourth quarter, that will put some pressure on our near-term financial performance. But with a durable model and an agile team, we can navigate those challenges and emerge even stronger in the long term while continuing to deepen our relationship with guests and build long-term preference for Target.
Once again, this quarter, I'm going to begin my remarks by covering our inventory position, given that it continues to be an important area of focus. And like last quarter, I'm going to base my discussion on comparisons to 2019, given the highly volatile conditions that have affected inventory since the onset of the pandemic.
As you saw on our balance sheet this morning, we owned $17.1 billion of inventory at the end of the third quarter, which is $5.7 billion higher than the end of Q3 2019. In percentage terms, this year's number represents an approximate 50% increase from three years ago, a deceleration from three year growth of 68% as of the end of the second quarter. Of the dollar increase in our inventory since 2019, about two-thirds or $3.9 billion is aligned with our sales growth over that same three year period. The remaining one-third or about $1.8 billion is new inventory that's arrived early relative to when it would have been received in pre-pandemic years. This early inventory is being driven by two related factors. The first is our explicit decision to add cushion to our lead times this year in order to mitigate the risk we were facing a year ago when the bulk of our global shipments were arriving late. The second factor is the unexpectedly-rapid acceleration in the global supply chain that we saw in Q3, which caused us to receive shipments even earlier than scheduled.
It's also important to note that the composition of our inventory continues to evolve as we've leaned into frequency categories where we're seeing robust growth and taken an increasingly cautious position in discretionary categories. More specifically, the percent of our inventory units in discretionary categories was 8 percentage points lower than at the end of Q2 and lower than in 2019 as well.
With that context, I'll turn to our third quarter financial performance, beginning with the top line. Total sales grew 3.3% in the third quarter, the same as in Q2, driven by a 2.7% increase in comparable sales, combined with the benefit of new stores. Total revenue grew 3.4% in Q3, reflecting a 9.5% increase in other revenue, which was driven by the growth in our Roundel ad business. Traffic continues to be an important driver of our growth, having expanded 1.4% in Q3 on top of nearly 13% growth a year ago. In addition, this quarter, we benefited from a 1.3% increase in average ticket.
Among our sales channels, stores continue to drive our growth as we saw a 3.2% increase in store comparable sales in Q3 on top of nearly 10% growth a year ago. Comparable sales in our digital channel grew 0.3% in the quarter on top of nearly 30% last year. Same-day services led our digital growth, most notably through our drive-up service, which delivered high single-digit growth on top of more than 80% growth last year.
As Brian mentioned, while our overall Q3 comp increase was consistent with Q2, we saw a dramatic change in the pace and composition of our business toward the end of the third quarter. More specifically, within the quarter, comparable sales grew 2.8% in August, rose to 4% in September and decelerated to 0.9% in October. Also notable, even within the October period, there was a dramatic change in the pace of our sales. As you'll recall, the month began with an initial round of holiday promotions from Target and some of our competitors, and in that week, we saw a high single-digit increase in comp sales compared with last year. However, for the remainder of the month, we saw a low single-digit decline in comp sales over those last three weeks. Nearly all of the slowdown was driven by our discretionary categories, apparel, home and hardlines, as our guests became increasingly cautious in their spending in those categories at both Target and throughout the industry more broadly.
So far in the month of November, trends have been largely consistent with what we were seeing at the end of October, in terms of our comp trends, the mix of sales between frequency and discretionary businesses and the focus on promotions by our guests.
While our Q3 gross margin rate of 24.7% was more than 3 percentage points higher than in Q2, it came in far short of our expectations, driven by 3 factors. The primary driver was a higher-than-expected markdown impact from promotions as our guests became increasingly price-sensitive and concentrated their discretionary spending on items on promotion, most notably in the latter weeks of the quarter. While we anticipated a highly promotional environment this fall, given the excess inventory we have been seeing across retail, this enhanced focus on promotions reflects an increasing level of stress on consumers as they navigate through multiple headwinds, including persistent inflation and rapidly rising interest rates.
A second factor that's impacting our gross margin is inventory shortage, or shrink, which is a growing problem facing all retailers. At Target year-to-date, incremental shortage has already reduced our gross margin by more than $400 million versus last year, and we expect it will reduce our gross margin by more than $600 million for the full year.
As Brian mentioned, this is an industry-wide problem that is often driven by criminal networks, and we are collaborating with multiple stakeholders to find industry-wide solutions. For example, because stolen goods are often sold online, Target strongly supports the passage of legislation to increase accountability and prevent criminals from selling stolen goods through online marketplaces.
A third factor that affected our Q3 gross margin was the incremental cost of managing early inventory. In the near term, these pressures should begin to recede as we move through the fourth quarter and into next year as receipt flow naturally moderates following the holiday season and we'll begin to benefit from the reduction in order lead times John mentioned earlier.
And finally, regarding gross margin, category mix moved from being a slight headwind in Q2 to a small tailwind in Q3, contributing about 20 basis points of gross margin benefit in the quarter. This change in mix impact might seem counterintuitive given some of the category trends I highlighted earlier. However, underneath the surface of discretionary comps when compared to our second quarter results, comp sales in apparel, a high-margin discretionary category got stronger in Q3, while comps in hardlines, a lower-margin discretionary category saw a deceleration in the third quarter.
Moving down to the SG&A expense line. We saw a small amount of deleverage in Q3, even as we continue to benefit from disciplined cost management across the organization. In spite of that discipline, we're facing inflationary cost pressures across multiple expense lines in the P&L. Within compensation, expenses reflect ongoing investments in hourly team member pay and benefits, partially offset by a year-over-year rate benefit from lower incentive compensation expense.
Altogether, on the operating income line, on both a dollar and rate basis, we saw a year-over-year decline of about 50% in the third quarter. I want to emphasize that we're not happy with this performance and expect to deliver much stronger dollar and rate performance over time.
Now I want to turn to capital deployment. And as always, I'll start by reiterating our priorities, which have been consistent for decades. We first look to fully invest in our business in projects that meet our strategic and financial criteria. Then we look to support our dividend and build on our 50-year record of annual dividend increases. And finally, we devote any excess cash beyond these first two uses to repurchase our shares over time within the limits of our middle A credit ratings.
Beginning with our first priority, capital expenditures have come in at about $4.3 billion through the first three quarters of the year, and we're now expecting our full year capex will come in around $5.5 billion in light of continued inflationary pressures affecting the cost of this year's projects. We paid just under $500 million in dividends in the third quarter, up from $440 million a year ago, reflecting a 20% increase in the per share dividend, partially offset by a decline in our average share count.
And finally, we didn't repurchase any shares in the third quarter, given current financial performance and the working capital investments we've made to support in-stocks and early receipts. In the near term, we will continue to take a very cautious approach to share repurchase in light of the volatility of the environment and our commitment to maintaining our middle A credit ratings.
So now I want to close my Q3 review with a discussion of our after-tax return on invested capital. For the trailing 12 months of the third quarter of this year, our after-tax ROIC was 14.6% compared with 31.3% a year ago. While this is a disappointing decline, a mid-teens after-tax return on capital is still very healthy in absolute terms and a testament to the durability of our business. Importantly, we expect to see a significant recovery from this number over time as we move beyond the unusual headwinds that have been affecting our business this year.
Now let me turn briefly to our expectations for the fourth quarter. In the current environment, we're facing an even higher degree of uncertainty than a quarter ago given the volatility we've been seeing recently. And in light of the dramatic changes in shopping patterns we've seen both at Target and across the industry, we believe it's prudent to plan for a wide range of comparable sales outcomes in the fourth quarter that's centered around a low single-digit comp decline, consistent with recent trends.
Underlying the sales expectation, we're planning for softer discretionary category comps than we've seen in the last two quarters, partially offset by the benefit of continued strong growth in our frequency businesses. If these sales trends persist, we'd see far less of a benefit from leverage on fixed expenses than we've seen so far this year.
In addition, we'd expect greater markdown pressure from Q4 promotions given the increase in price sensitivity our guests have shown recently and our commitments to end the year with a clean inventory position, especially in those categories where trends have softened. And as I mentioned, we're planning for additional pressure from inventory shrink, given the worsening trends that have emerged so far this year.
Altogether, these expectations lead to a wide range for our expected Q4 operating margin rate centered around 3%. The single-most sensitive input to this profit projection is the level of demand for our discretionary businesses. If that demand improves from recent trends, we would expect fewer markdowns and would likely outperform our updated profit expectations. While if demand softened further, profit could see additional pressure.
As we look beyond the holiday season, we're planning for a continued challenging environment as we move into next year. And as John and Brian already pointed out, we are fortunate to have a durable model that is well positioned to continue serving our guests even in the toughest of times. In addition, we have a significant opportunity to harness efficiencies in support of our long-term growth and profit goals.
At the end of 2019, our operations had been built to support a business that delivered $77 billion in sales that year. And our long-term algorithm at the time was anticipating low single-digit top line growth in the years ahead. If things had played out that way, we might be looking at a total sales number in the low to mid-$80 billion range this year. Instead, even in the midst of a very challenging environment, we're positioned to deliver total sales of well over $100 million this year.
So today, we have a compelling opportunity to look across our operations with an eye to simplifying and optimizing those operations for a more than $100 billion business. And today, as we look at the operations we have and where we think they can be, we believe there's a $2 billion to $3 billion savings opportunity over the next three years. To be clear, this isn't about slashing resources. And in particular, we're focused on continuing to invest in our team, which is our most valuable asset. As Brian said, we are in the initial stages of scoping this opportunity, and we expect to share detail on our progress at our 2023 Financial Community Meeting.
In the meantime, I want to join Brian and wishing all of you a happy holiday season, and I want to pause and thank the entire Target team for making Target a great place to work and a store that's ready to bring joy to millions of our guests throughout this season and beyond.
With that, I'll turn the call back over to Brian.
