After a Data-Breach-Related Sell-Off, Is Target a Good Bet?

Target's data breach caused significant damage, including tarnishing the company's image as a strong operator, as evidenced by its sharply reduced market capitalization since the event occurred. Is it a good bet at its reduced price?

Feb 24, 2014 at 4:45PM

The costs have been continuing to rise for Target's (NYSE:TGT) holiday season data breach, an unfortunate event that led to the theft of payment card and personal data for up to 110 million customers.  Among those indirectly affected are the nation's credit unions, which are estimated to have incurred $30 million in costs to date, according to the Credit Union National Association. 

As for Target itself, the costs are indeterminable at this point, although customer defections have led to a recent decline in comparable-store sales and a sagging stock price. However, with a solid brand position in the discount-retail space and an improving financial profile, is Target a good bet at its current price?

What's the value?
Despite being a fraction of the size of the discount sector's elephant, Wal-Mart Stores (NYSE:WMT), Target has built a loyal following of customers coming to its bright, clean stores, many of whom are no doubt attracted by exclusive apparel lines, like C9 by Champion and Genuine Kids by Oshkosh. 

After getting customers through the door with exclusive brands, Target then uses a friendly selling environment to encourage the purchase of a wide variety of essential goods, led by pharmacy, beauty, and personal-care products. The company has also been incorporating food-retailing operations into the vast majority of its stores in order to fulfill its goal of being a one-stop shopping destination for its customers.

In fiscal year 2013, Target has reported very mixed results, with a marginal top-line increase offset by a steep drop in operating income, due to the negative effects of greater inventory markdowns and losses from its nascent Canadian operation. The company has also been hurt by an aggressive marketing push for its loyalty program, which offers cardholders a 5% discount on purchases and free shipping from its website. 

On the upside, though, Target's sale of its credit card operations to TD Bank Group in May raised nearly $6 billion and meaningfully lowered its debt load, freeing up funds for growth initiatives, including the development of its small-format CityTarget stores.

A losing proposition
Much of Target's value seems to come from its image of being a quality operator. It's an image that the company has successfully peddled to the populace with its various programs, including distributing a portion of its profits to community nonprofit organizations. Unfortunately, that value likely took a hit with its recent security-system breakdown, as customers may question whether they can trust the safety of their personal data when they shop at Target. 

More ominously, a tarnished image would likely mean that Target would have to compete more on price in the future, a losing proposition when your competition is the likes of Wal-Mart Stores and Costco Wholesale (NASDAQ:COST).

Despite having its own operating troubles, including government investigations into its foreign business dealings and general labor practices, Wal-Mart reported a slight top-line gain in FY 2013. This performance was thanks to a further expansion of its international store base, which ended the period with roughly 11,000 stores. Like Target, though, the company's profitability was hurt by an aggressive pricing environment, a data point that management blamed on the expiration of government-support programs that help its large low-income customer base.

Of course, Wal-Mart was built for a cutthroat competitive environment, with an unmatched logistics operation that is constantly beating on its suppliers for cost savings. The company's operating prowess is evidenced by its generation of more than $23 billion in operating cash flow in FY 2013, which allowed it to further invest in its growth initiatives, including its small-format Neighborhood Market stores. 

Looking ahead, Wal-Mart is planning to use its efficiency edge to engage in further price-cutting, a strategy that should benefit its customers but likely puts additional pressure on its competitors' operating margins.

Costco was also built for a low-margin operating environment, averaging a 10.7% gross margin over the past five years compared to a 31.8% average at Target. The company continues to employ its low-margin strategy to perfection, using enormous buying power to maintain low prices and happy customers, as evidenced by a continuation of strong customer volumes and comparable-store sales results in its latest fiscal year. 

More important, Costco's strategy continues to lead to solid operating cash flow, allowing it to further invest in its distribution and supply chain initiatives, with the goal of creating even larger efficiencies down the road.

The bottom line
Target will undoubtedly recover from its data-breach misstep, though the ultimate cost tally of the event remains up in the air. However, a likely consequence for the company is lower near-term profitability, as Target will likely have to increase its security protocols and system oversight, resulting in higher costs and potentially lower profits for shareholders. Therefore, until the dust settles on this event, investors would be wise to steer clear of Target.

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Robert Hanley has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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