Target: The Good News, the Bad News, and Its Top 3 Priorities

Target’s data breach came as a massive hit to the company, but the company's story goes much deeper. Here's what investors should know.

Jul 3, 2014 at 1:15PM
Target Canada

Source: Target.

Target's (NYSE:TGT) interim CEO, President, and CFO John Mulligan described the company's first quarter as "unusually challenging" on the conference call. The difficulty stemmed from the data breach, after which Target lost the trust of its customers. This led to declining foot traffic and sales. While Target still has to contend with many challenges, notable positives for the company exist as well.

Good news
According to Mulligan, foot traffic and sales have improved substantially since the data breach. Apparently, Target has surveyed customers, who said they have put the data breach behind them. Target has also moved all of its REDcards onto MasterCard's chip and PIN technology. This is in addition to Target's accelerated roll-out of chip-enabled card readers for all stores by September of this year. This, in turn, should greatly increase customer trust over time. Ironically, because of this, Target will likely become one of the safest retail shopping destinations in the United States in the future.

Now for the bad news.

Bad news
Target's first-quarter comp sales declined 0.3% year over year, but that's an easy number to overcome, and it's far from news to worry about. The biggest negative is gross margin.

Domestically, gross margin came in at 29.5% versus 30.7% in the year-ago quarter, which related to increased promotions. These promotions are a good way to increase traffic and sales, but promotions mean lower prices, which contract margins. This then negatively impacts the bottom line, which is what we don't want to see as long-term investors. Here's the bigger picture of Target's gross margin performance over the past several years:

TGT Gross Profit Margin (Annual) Chart

TGT Gross Profit Margin (Annual) data by YCharts.

 In Canada, gross margin came in at 18.7% due to excessive inventory. It's too early for a comparative measure on this front, but this is not a good number whatsoever. Below is a sample of gross margins for big-box retailers Wal-Mart Stores (NYSE:WMT) and Best Buy, and Target's overall operations:

TGT Gross Profit Margin (Annual) Chart

TGT Gross Profit Margin (Annual) data by YCharts.

Target plans on increasing the intensity of its value message (offering more value to consumers) in order to increase foot traffic in Canada, but that's easier said than done considering Canadian consumers are so loyal to local retailers. And even if foot traffic improves, it will likely result from lower pricing, which won't have a positive impact on margins. 

Target has announced three priorities for improving overall operations. Let's take a look at them. 

Target's three priorities
Target's No. 1 priority is to grow traffic and sales in the United States. The reason for this is obvious. Target has 1,789 retail units in the U.S. versus just 127 in Canada. In order to drive this growth, Target will aim to deliver unique products and services. 

Target plans to place a primary focus on great prices and "more newness in our merchandising and presentation." This might be good for sales growth, but it doesn't sound as though it will drive profitable growth, which is what we want to see for long-term investor rewards.

Improving the Canadian segment comes in as the second priority. The real key here is a recent change in leadership, which will supposedly lead to a fresh look into improving operations. All we can do here is wait and see.

The third priority is "to accelerate our digital transformation and become a leading omnichannel retailer." Target has a long way to go. For instance, its biggest competitor, Wal-Mart, is now ranked the No. 4 e-commerce retailer in the United States by Internet Retailer, and Wal-Mart's e-commerce sales increased 30% last year, which even surpassed Amazon's sales growth at 20%. Target doesn't report full-year e-commerce sales, but it did deliver a 20% gain in a tumultuous fourth quarter. Therefore, hope exists. 

Target will aim to offer more flexibility to customers in regard to when and where they can shop. The problem is that Wal-Mart has the same goal, and it has a lot more ammunition to put toward this goal. Consider a free cash flow comparison between them over the past decade:

TGT Free Cash Flow (Annual) Chart

TGT Free Cash Flow (Annual) data by YCharts.

However, Target is moving in the right direction.

The bottom line
In order for Target to achieve its three priorities as a whole, it will listen to feedback from its guests and implement what they want most. Target is also very focused on speed. It wants to accelerate growth in Canada, digital, omnichannel, newness, and innovation. Additionally, it will open smaller stores in urban areas -- probably because Wal-Mart is seeing success with its small-box stores.

In the meantime, Wal-Mart will continue to plod along, delivering significant free cash flow generation, profitable growth, and generous returns to shareholders. Currently, Wal-Mart's dividend yield of 2.5% isn't as generous as Target's at 3.6%, but that's not enough to offset the stronger operational performance and future potential you will find with Wal-Mart.  

Weighing everything together, Wal-Mart remains a better investment option at this point in time. 

This stock has almost unlimited potential
Imagine the multibillion-dollar sales potential behind a product that can revolutionize the way the world shops and interacts with its favorite brands every day. Now picture one small, under-the-radar company at the epicenter of this revolution that makes this all possible. And its stock price has nearly an unlimited runway ahead for early, in-the-know investors. To be one of them and hop aboard this stock before it takes off, just click here.

Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Amazon.com and MasterCard. 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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