Why Target Received a Frigid Response North of the Border and What It Can Learn From Costco and Wal-Mart

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Target (NYSE: TGT  ) has had to deal with a lot of negative news of late, the most obvious being the data breach. However, while the data breach is likely to negatively impact Target for the short-to-medium term, it will eventually fade away. That being the case, let's take a look at a more important factor for Target when it comes to the company's growth potential.

Target is relying heavily on Canada for growth. It opened its first 24 stores in March 2013, upped its Canadian store count to 82 by September 2013, and would like to open another 124 locations. This is very ambitious, but Target is going to need more than ambition to navigate the Canadian consumer landscape. Based on early reports, many Canadian consumers are disappointed with what they have experienced thus far. 

Unexpected challenges
When Target first entered Canada, everyone was optimistic. I admit to being one of them. After reading a Huffington Post article about Target in Canada, I read the comments below the article. Many of these consumers lived in Canada and had visited a Target store. While there were some positive remarks, these were rare. Most consumers stated their displeasure with Target, primarily due to Target stores running out of products and prices being too high. The former is completely fixable. The latter might be fixable as well, but that wouldn't necessarily be a positive for investors because it would shrink margins, which would then negatively impact the bottom line.

Target stated that customers can save more by using its REDcard, which will lead to discounts. But Canadian consumers are loyal to their local brands -- or Wal-Mart Stores (NYSE: WMT  )  and they don't have much interest in signing up for a loyalty program, especially after witnessing the data breach situation in the United States.

One of the comments left by a Canadian consumer hit me. This particular consumer commented that Target fails to realize that "Canadians aren't the same as Americans." Americans aren't the most loved people in the world. And it's pretty safe to say that we probably like Canadians more than they like us. The point here is that Target infringed on Canadian territory, buying the once-popular Zellers and turning these locations into Target stores. So, not only did Target replace a Canadian brand, but most Canadian consumers were probably expecting something closer to Zellers and have been disappointed.  

Back in August 2013, Forum Research conducted a study on how satisfied Canadian consumers were with Target. The answer: 27%. An even bigger negative is that the consumer-satisfaction rating was 32% in April 2013, indicating that Target had been heading in the wrong direction.

Comparatively, Costco Wholesale's (NASDAQ: COST  ) customer satisfaction rating in Canada: 62%. Costco generates 70% of its income through membership fees, which allows Costco to offer low prices on items in its stores. This approach has seemed to work well everywhere Costco has gone. And Costco is aiming for balanced international growth, with plans to open 36 new stores in FY 2014. In the first quarter alone, it will open 15 stores, 10 of which will be in the United States.

Target's strategy to improve its reputation in Canada is to grow its share of frequency categories, including food, cosmetics, and health products. This has potential, but food products have lower margins than most other store items, so Target is banking on consumers adjusting to the one-stop shopping destination.

Getting back to Costco, it's not just better situated for today's consumer in Canada but everywhere else in the world. And it doesn't have a recent data breach to contend with. But what about Wal-Mart's presence and potential in Canada? How will it affect Target?

Wal-Mart in Canada
Many people hate Wal-Mart because of its business practices. While some of these practices are clearly immoral, the majority of them are just business. Any company that can maximize its potential by limiting the growth potential of its competitor is a well-managed company and should be considered by investors. 

For example, Wal-Mart plans to aggressively grow its food category in Canada. Why? We'll, there's more than one reason, but consider the information above about how Target wants to grow share in its food category in order to generate more traffic. Wal-Mart is capable of limiting Target's growth potential in this area, and Wal-Mart is already working from a 100-basis-point gain in food and consumables in last year's third quarter on a year-over-year basis. Wal-Mart currently has 227 Supercenters with groceries in Canada versus 153 discount stores.   

That said, Wal-Mart is also looking to improve in Canada on its own merits. While net sales increased 3.8% in the third quarter, this was primarily due to square-footage increases. Comps declined 1.3%, and traffic slid 1.5%. Therefore, Wal-Mart won't just grow its food category to block Target but to generate more traffic. Regardless of the reason for this initiative, it's a potential negative for Target.

The cold north
Many analysts believe that Target will be a long-term winner in Canada. This is entirely possible. However, why rely on potential when you can invest in actual results? Of the three companies mentioned above, Costco appears to be the best performer north of the border.

While Wal-Mart continues to generate significant cash flow for its shareholders, Costco offers more top-line potential. A potential investment depends on your investing style. One thing is for sure: Target is currently facing more headwinds than both of these peers. 

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Dan Moskowitz

Dan Moskowitz spends the majority of his time researching stocks. He believes that fundamentals, and logic pertaining to industry trends, win out over the long haul.

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8/28/2015 4:00 PM
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