Will Target Continue to See a Cold Reception in Canada?

Target is relying on Canada as a future growth catalyst, but this is going to be much more challenging than anticipated.

Jul 16, 2014 at 10:00AM
Target Canada

Target.com

If you plan to invest in Target (NYSE: TGT), then you need to know what's going on with its Canadian operations since Target is relying on Canada as a future growth channel.

Will Target Canada's challenges eventually thaw out, or will it continue to receive an arctic-like reception from Canadian consumers? The answer could be the difference between significant growth and powerful headwinds for Target.  

Canadian reception
In fiscal-year 2013, Target Canada generated $1.3 billion in revenue, but that's not the whole story. While $1.3 billion in revenue is good for a retailer expanding into a new country, $941 million in losses is terrible.

Target expects its revenue in Canada to double in 2014, but that doesn't mean much without margin expansion and a road toward profitability. In the fourth quarter of last year, Target Canada reported a gross margin of 4.4%. This was due to heavy markdowns to clear excess inventory. Gross margin improved to 18.7% in the first quarter of this year, but that's still a poor number. Once again, this was due to excess inventory.

Over the past five years, Target as a whole has averaged a gross margin of 30.57%. Over that same time frame, the lowest recorded gross margin was 26.94% for the quarter ended January 2014. This isn't surprising given the data breach took place during the same quarter. The highest recorded gross margin was 32.52% for the quarter ended July 2011. However you want to look at it, 18.7% is supbar for Target. According to Target, gross margin for Target Canada should come in around 30% for 2014. Based on the giant retailer's history, this would be a somewhat respectable number.

Here's the tricky part. Target Canada is currently offering many promotions in order to drive traffic to its stores. Promotions mean discounted prices, which then lead to contracting (not expanding) margins. Therefore, gross margin should weaken, right? In most cases, yes. However, this is one of those situations where it's easy to show improvement due to such a terrible number in the past. The reason Target should be capable of showing vast improvement in gross margin is thanks to a much leaner inventory.

Now the road winds back in another direction. While improvements are good, they don't always indicate sustainable success. For instance, what happens after 2014, when Target Canada must compare its 2015 margins to 2014 -- a time when inventory was leaner? If promotions were necessary in order to maintain or grow foot traffic, then the long-term picture wouldn't be good. Nobody knows the future with absolute certainty, but at the moment, it appears as though margin expansion for Target Canada will be difficult to achieve. 

In order to increase its odds of success, Target Canada has made several management changes. For instance, Mark Schnidele is the new president of Target Canada, and he brings along 15 years of experience at Target with merchandising and operations. The goal is for Schnidele and others to bring a fresh perspective to Canadian operations. Will it work? That's impossible to determine at the moment.

On one hand, Target Canada has reported greatly improved responses in its customer surveys. On the other hand, a bad first impression is difficult to overcome, as is a $941 million loss in one year. If you're going to invest in Canadian consumers via an American company, then perhaps a better option exists.

Warmer reception
Would you prefer to invest in a retailer that has been established in Canada since 1994? And what if this company was the fastest-growing retailer in Canada for groceries and general merchandise? Let's add a first-quarter year-over-year online sales increase of 134%. To top it off, let's also add the fact that operating income growth outpaced sales growth in the first quarter -- a very good sign for future profitable growth.

Yes, this retailer goes by the name of Wal-Mart Stores (NYSE:WMT). Not only is Wal-Mart outperforming Target in Canada by light years, but it has already earned the trust of Canadian consumers -- something that will be very difficult for Target to do. Additionally, Wal-Mart has 390 retail units in Canada, whereas Target only has 127. The problem for Target is that if it expands its store base in Canada, then it will be infringing on Wal-Mart territory. Given Wal-Mart's already-established presence, it will be challenging for Target to steal share.

The Foolish conclusion
Nothing is impossible, and Target expects vast improvements in Canada this year. Just keep in mind that the improvement in revenue will partially relate to new store growth, and the gross margin improvement will relate to easy comparisons to a year with heavy markdowns made to clear excess inventory. Over the long haul, Target has many headwinds to fight in Canada, and the most likely scenario is that Canada continues to harm, not help, the bottom line. That being the case, if you want investment exposure to Canadian consumers, then you should be better off with Wal-Mart.

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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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