Yesterday, Target announced Q3 financial results. The retailer posted one of its highest sales comps for the year (5.1%), claimed its largest-ever quarter for digital growth (49%), and said earnings were 20% higher than last year, thanks in part to strong sales and the benefit of a revised tax rate. But the stock dropped by 8.1%.

What happened?

Target posted a very healthy comp sales growth of 5.1%. In comparison, the retailer’s nearest competitor, Walmart, saw sales grow by just 3.4% in Q3. Even more compellingly, 3.4% of Target’s sales growth was driven by stores. Compare that to Q3 2017, where nearly all of the growth came only from digital properties, and you can see that fears of “the death of the store” were greatly exaggerated. In fact, Target and Walmart’s return to growth from their stores is happening right as Amazon’s 1P online sales growth slows to its lowest rate.

However, that growth has come at a considerable cost, particularly for Target, which spent over $1 billion in CapEx in Q3 alone. According to CEO Brian Cornell, the retailer has made significant capital investments in remodeling stores (over 300 so far this year) as well as major investments in new fulfillment methods allowing customers to order items directly from stores or to buy online and pick up in-store.

Amazon, notorious for being willing to funnel almost every dollar it earns back into growing its business, used to vastly outspend Target and Walmart when measured by CapEx as a percentage of revenue. Target finally realized it was bringing a knife to a gun fight and significantly ramped up its investments.

The big question has been: what do those additional investments get Target?

Analysts on the call spent a considerable amount of time asking about Target’s gross margins, which continued to decline. The retailer cited increased supply chain costs, largely driven by increasing share of its business being driven by digital and the higher cost to fulfill those orders. Notably, Amazon has seen considerable gross margin rate growth over the last four years. In the last quarter, the e-tailer posted its second-highest gross margin rate ever, and is now generating margin rates that are more like a Department Store than a traditional “big box” or “discount” retailer.

So how has Amazon been able to see gross margin expansion while Target faces contraction?

Amazon

An increasing share of Amazon’s revenue comes from high-margin services businesses, including third-party seller fees, AWS, Prime subscriptions, and the company’s highly profitable advertising business, which grew 122% this last quarter.

There is an old Winston Churchill quote, “Generals are always fighting the last war.” Too often, when faced with an incoming threat, generals (and in this case, retailers) will try to double down and meet the enemy on the field in a direct battle. Amazon, however, is already fighting the next war. Having made the expensive but necessary investments in a digital supply chain, the giant is now shifting its attention towards building out high-margin services businesses, while the rest of the retail industry is burning gasoline just trying to keep the businesses they almost lost.

Who will win the long-term retail battle? The company that can win the hearts and minds of consumers…without running out of money first.

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