Still O (No) Canada for Target?

Target had an extremely slow start north of the border last year. Fortunately, traffic and sales are improving, but what about profits?

Jul 10, 2014 at 10:05AM
Target Canada

Target (NYSE:TGT) is relying on Canada as a future growth channel. In its first year, Target Canada generated sales of $1.3 billion, but it also suffered a $941 million loss. Not many retailers are capable of delivering extraordinary results after just one year in a new country, especially in Canada, where consumers are known for being loyal to local retailers. Despite the poor start and difficult terrain, Target is sticking around for a fight. However, don't expect a clear winner any time soon. This one could go the distance.

Bad gets better
The fourth quarter of last year wasn't a memorable one for Target. The primary focus was on the data breach in the United States, but it didn't perform well in Canada, either. In fact, gross margin came in at a miserable 4.4% due to heavy markdowns in order to clear excess inventory. Gross margin improved to 18.7% in the first quarter, but this is still far from impressive. Once again, Target was forced to clear excess inventory.

Due to the poor reception in Canada, Target has relied on promotions to drive sales and traffic, but promotions mean lower prices, which then means smaller margins. Going forward, Target expects to slowly yet surely clear its excess inventory. According to Target's first-quarter conference call, Target has seen a positive trend in its Canada stores.

This trend is simple. The longer a store has been opened, the better it's performing now. According to Target, this pattern is almost exact to when a store opened. This pattern indicates that local consumers might slowly be adjusting to the Target brand. This likely has a lot to do with Target tailoring its pricing and merchandise mix to better fit local consumers' wants and needs after an atrocious start, but promotions also play a major role. 

Another positive here is that -- unlike last year -- Target can now forecast better. Last year, Target had no experience selling merchandise in Canada, which put it at a great disadvantage to local competitors as well as Wal-Mart Stores (NYSE:WMT). Now that Target has a better idea of what to expect from Canadian consumers, it can better plan its pricing and merchandising. Over the long haul, this should lead to reduced inventories and improved margins. However, this story isn't all roses.

Living with Wal-Mart
To Target, Wal-Mart is like that older brother who wins at everything and is always limiting Target's potential. The situation is no different in Canada, where Wal-Mart has a 19-year head start. But let's take a look at the big picture.

If you're potentially interested in investing in Target, then Canada is only one part of the story. If you're going to invest in Target or Wal-Mart, then you need to look at the entire operations of both companies. 

While both companies have delivered top-line growth over the past five years, operating margins have suffered:

WMT Operating Margin (Annual) Chart

Wal-Mart Operating Margin (Annual) data by YCharts

Target has increased its promotions in order to drive more traffic, and Wal-Mart must contend with a hesitant low-income consumer, partially due to reduced government benefits. Fortunately, Wal-Mart has other growth channels that have proven to be effective (i.e. small-box stores and e-commerce).

In order to improve margins, a retailer needs capital to invest in new initiatives, and that capital can be found in free cash flow. This then ties into return on invested capital: How good is that retailer at delivering results with its investments? Consider the chart below with those thoughts in mind:

WMT Free Cash Flow (Annual) Chart

Wal-Mart Free Cash Flow (Annual) data by YCharts

Wal-Mart generates more free cash flow, which is expected. Bigger isn't always better, but the difference in return on invested capital is still significant. 

The bottom line
Target might see improvements in Canada over the long haul, but this is far from a guarantee. If Target is forced to rely on promotions to drive traffic and sales, then profits will never materialize. Nobody knows if Target stores in Canada can deliver profits without promotions. Time will tell. In the meantime, Wal-Mart offers stronger growth avenues, more cash flow to invest in those growth avenues, and a higher return on invested capital.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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