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Is Target on Target with its Recent Initiatives?

Source: Target

Traditionally, discount retailer Target (NYSE: TGT  ) has relied on its unique merchandise assortment from partnerships with leading designers and brands to compete with other retail giants. However, the company seems to have fallen behind its peers in recent years, as evidenced by its inferior financial metrics relative to other retailers such as Costco (NASDAQ: COST  ) and Kroger (NYSE: KR  ) .

For the past five years, Target grew its top line by a CAGR of 2.3%, compared with annualized growth rates of 7.7% and 5.3% for Costco and Kroger, respectively. With respect to earnings growth, Costco and Kroger increased their net income by five-year CAGRs of 9.7% and 4%. Meanwhile, Target's fiscal 2014 earnings of approximately $2.0 billion is its lowest in 10 years.  

In light of this, Target has rolled out two new initiatives in recent years: REDcard and PFresh. Have these initiatives performed as expected, and did they improve Target's competitiveness against Costco and Kroger?

Source: Target

REDcard is Target's line of in-house credit and debit cards, started in 2013. The cards offer Target customers a 5% discount off all purchases, free shipping with no minimum purchase, and an extra 30-day period for returns.

On the surface, this seems like another strategy to be price competitive with other retailers and gain a larger wallet share of budget-conscious customers. In reality, a 5% discount isn't significant--it's the customer analytics behind such loyalty cards that make all the difference.

One notable example of retailers leveraging on the power of loyalty cards is the country's largest grocer, Kroger. Kroger has been a pioneer in the use of loyalty cards, having launched its "Kroger Plus Card" program in 2003. While Kroger doesn't disclose its membership statistics on a regular basis, past disclosures have revealed that about 50% of U.S. households were Kroger's loyalty card members in 2010. As many as 9 million quarterly mailings were sent to its members in 2012.

With this kind of scale, Kroger has worked closely with its customer-analytics vendor Dunnhumby to customize its SKUs and targeted discounts. The results speak for themselves, with Kroger having delivered 41 consecutive quarters of identical supermarket sales growth.

However, Target shot itself in the foot with a data breach involving 40 million credit and debit cards in December 2013. Consumer confidence is especially critical with respect to the use of such cards for payment. Target understands this well and has acted quickly to restore customer trust.

It has appointed Bob DeRodes as executive vice president and chief information officer, effective as of May 5 of this year. He will be in charge of ongoing data security enhancement efforts such as plans to incorporate MasterCard chip-and-PIN technology across its REDcard portfolio. Notwithstanding the results of such efforts, Target will have to incur additional costs.

In addition, Target's REDcard program is relatively new and of a much smaller scale that than of Kroger. The success of a customer analytics program is highly dependent on the collection of sufficient customer data over a period of time.

Since 2009, Target has tested a new store format called PFresh, which carries 50% to 200% more food products than its general merchandise stores. The company has since rolled out its PFresh concept nationwide over the course of a few years. While the original intention of PFresh was to draw more foot traffic and cross-sell other higher-margin products by using food products as loss leaders, results have been less than impressive.

Target saw its gross margins decline from 32% in fiscal 2009 to 29.4% in fiscal 2014. The main reason is that although customers have been snapping up the low-margin food products, they haven't been buying the other higher-margin stuff. In fact, Target has pushed its fresh food department toward the back of its stores, hoping to minimize the possibility of customers doing quick fill-in trips.

Costco's recent experience validates such concerns. Costco's net income fell by 15% in its recent quarter, with analysts pointing to its loss-leader fresh food strategy as the main culprit. One such example is Costco's $4.99 rotisserie chickens, which it sells about 60 million of each year.

However, Costco has the ability to continue with this strategy because of a differentiated business model. Costco is a membership warehouse club operator that collects significant annual fees from a 70 million-strong membership base. Without recurring income to subsidize fresh food discounts, Target is at a disadvantage competing for customers with Costco on the same fresh food loss-leader strategy.

Foolish final thoughts
Although it's encouraging that Target has taken proactive steps to enhance its competitiveness, it doesn't seem that either REDcard or PFresh will be the solution. In my opinion, Target's growth prospects aren't likely to be exciting in the near-term and I will advise investors to pass on it.

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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