Target and Best Buy are unexpected underdogs this critical holiday season

Target and Best Buy find themselves in an unusual spot this holiday season: fighting to retain market share during a season they usually dominate.

The last months of the year are especially critical to Target, which has lost customers to Walmart and other stores this year.

Both of the Minnesota-based national retailers already tamped down any expectations that they will have a blockbuster holiday season — a period that produces an outsize percentage of their profits.

"I think everyone is cautious about the holiday. ... Whether it's about market share or just the consumer not spending on discretionary, I guess we'll see," said Diya Iyer, S&P Global Ratings retail director. "Even the ones who have gained market share aren't guiding to a very positive holiday."

What's more, the season this year will test the resilience of a modern retail business model that Target and Best Buy for the most part built and that allowed them to surge during the pandemic.

The holidays come as households are feeling the full effects of two years of inflation, student loan payments have resumed and many still have credit card debt from last year's holidays, according to national surveys.

Shoppers told NerdWallet they were cutting back on the number of people receiving gifts this year. The National Retail Federation said spending will increase, but not as much as last year.

The first indication of what retailers are facing this holiday will come over the next two weeks. Target announces its third-quarter earnings Wednesday. Walmart also reports its financial results this week, and Best Buy follows on Nov. 21.

Executives at Target and Best Buy are expected to report sales dips from last year as spending on non-necessities has been on a downward spiral for months. Costco, on the other hand, said sales in September and October were up 5.3%.

"We are seeing signs of caution," Target CEO Brian Cornell said, during a CNBC virtual summit earlier this month. "I think the most prevalent term we hear from consumers is they're looking at their budgets really carefully right now."

Both Target and Best Buy are fighting to prove to investors that their long-term strategies — and the way they both led in reshaping the industry — to focus on improving in-store experience at the same time as building stronger pick-up and delivery operations — makes them a good bet on the investment end.

But now they are the underdogs. Within the last few days, Target's stock has been down more than 25% year to date. Best Buy's has been down about 17%, while Walmart's stock is up about 14% and Costco's up about 25%.

And Target and Best Buy are coming into the season with weaker results. Target posted this summer its first comparable sales dip since the spring of 2017 and Best Buy had its seventh consecutive quarter of sales declines.

"Our business, discretionary consumer electronics, you have to go all the way down the funnel, is very challenged right now," Best Buy CEO Corie Barry said in September at an Economic Club of Minnesota fireside chat with Minneapolis Federal Reserve President Neel Kashkari. "By the way, we also haven't had innovation in electronics for the better part of three and a half years really. Everyone has just been making as much as possible or pulling back as hard as possible."

That's not to say that consumers aren't spending money, Barry said. People are spending more on experiences like Taylor Swift and Beyoncé concerts — a phenomenon she called "funflation."

But with tightened budgets, that leaves retailers in unenviable positions to compete for limited dollars.

Consumers told consulting company Accenture in a holiday shopping survey that they are cutting back on giving gifts and putting up holiday lights, and are even planning to cook less elaborate meals.

While all retailers are dealing with economic trends, both Target and Best Buy are especially vulnerable during this season.

For the past five years, on average, Best Buy made 40% of its profits during the fourth quarter, said Mike Baker, a senior research analyst with D.A. Davidson Cos. Target made a smaller percentage, about 27% of its profits. However, January is traditionally a very slow sales month, meaning a lion's share of Target's sales occur in November and December, Baker said.

"It's the most important quarter with respect to their profitability for the year," he said.

Baker and other analysts have noted Target's recent loss of market share to competitors. The best hope, for Target as well as Best Buy, is to advertise great products and try to find ways to excite the consumer while at the same time stocking conservatively, he said.

"It's not the right environment for [Target]," Baker said, during a recent online roundtable. "Their mix is too discretionary versus Walmart. ... They do seem to be losing share in some of the non-discretionary categories. It's not a great environment there, but they seem to be doing worse than others. So they need to get the holiday right."

Not only have other major retailers like Costco and Walmart become more formidable using their low price points as leverage and Amazon with its convenience, there is also possible competition in the near future from resurrected retailers such as RadioShack, Toys 'R' Us and Bed Bath & Beyond.

As retailers compete for tightened budgets, factors such as store efficiency and shrink — which are retail losses attributed mostly to theft — matter more to the bottom line.

Target and Best Buy both were Wall Street and consumer favorites during the pandemic, as people stayed home, spending disposable income on electronics and home furnishing upgrades. Target said it gained nearly $9 billion in market share in 2020 as it grew its revenue by $15 billion. Best Buy's sales grew during the pandemic with comparable sales jumping considerably in 2020.

Target executives have said they expect comparable sales around a mid-single digit decline for the remainder of the year including in the third quarter. Best Buy leaders do expect comparable sales declines to be similar to or a little less than the more than 6% drop the retailer saw in the second quarter.

For Best Buy, back-to-school sales were better than executives had anticipated, and people are spreading out holiday purchases, starting in the fall.

For the fourth quarter, Best Buy executives said sales will likely be down even less possibly in the 3% range — or they could even be better than last year with the company expecting growth in home theater and further market stabilization.

Target and Best Buy also have positioned their inventories well to serve customers who still plan to spend this holiday, said Joe Feldman, senior managing director at Telsey Advisory Group.

"I think they are set up to have a pretty solid season," he said. "I think they just need to do some good merchandising and be on trend with product. [Despite competition,] they are the leaders in the space and they do a good job."

In the meantime, the companies are already adjusting strategies for the future. Best Buy, for example, is putting more resources into growing its health care products — and the Geek Squad services to install and troubleshoot them. The company announced another contract last week to build the business, this one with Mass General Brigham's home health division.

With the likely growth of health tech and connected devices, Barry has argued technology is slowly becoming more of a must-have than some people realize.

"We live in a really misunderstood industry," she said, at the Fortune Most Powerful Women Summit last month. "There's this idea that it's discretionary — but who here will go today without using some kind of electronics? This is a need."