This year, Target (NYSE:TGT) dove headfirst into the Canadian market, opening 124 stores in the span of seven months. Unfortunately, this ambitious expansion has not gone according to plan. While there was a surge of initial interest as Target opened new stores, the company has had much more trouble convincing customers to return frequently.
The result has been lower-than-expected sales and big markdowns, and this has created a huge drag on Target's earnings. Management still expects Canada to be a profitable market over the long term, but it could be a much more modest success than many investors originally expected.
Plans gone awry
When Target laid out its plans for Canadian expansion at the beginning of 2013, company leaders expected a relatively smooth start-up period. The costs of opening more than 100 stores in a short period of time were sure to impact earnings in the short run, but the effect was supposed to be minimal and short-lived.
Going into the year, Target projected that the Canadian expansion would reduce full-year EPS by $0.45, with the vast majority of that dilution occurring in the first half of the year. In the first quarter, while the Canadian segment lost money, it achieved a strong gross margin performance and the launch seemed to be on track. At that time, management expected that the Canadian operation would turn profitable as early as the fourth quarter!
However, the wheels started to come off in the second quarter, as further waves of store openings began and the initial stores began to mature. While plenty of people came to check out the stores when they opened, Target has had trouble changing shoppers' habits and getting them to visit Target more regularly for basics like food and health care items. In August, the company revised its forecast for EPS dilution to $0.82 to account for the weaker sales.
Last quarter, Target hit bottom. Lower-than-expected sales in Canada forced Target to take big markdowns to clear inventory. Gross margin plummeted to 14.8%, down from a higher-than-planned 38.4% rate in the first quarter. This led to the biggest loss yet for the Canadian segment.
While Target executives realized months ago that sales in Canada were falling short, by then the company already had significant inventory commitments. As a result, the inventory overhang in Canada is likely to continue well into 2014 despite the company's best efforts to optimize inventory levels. This means that Target's Canadian operations are likely to lose money again next year.
In addition to weighing on GAAP EPS, Target's Canadian expansion has also siphoned capital away from other potential uses. For example, in the third quarter, Target halted its share repurchase program in order to bolster its balance sheet. Target does expect to have more free cash flow available for share repurchases next year, but free cash flow will still be held back by the losses in Canada.
To be fair, there's no reason to believe that the Target business model won't work in Canada. Over time, consumers are likely to catch on to the chain's value proposition. However, investors still need to ratchet down their expectations for how much Canada will contribute to Target's long-term growth.
Target stock is fairly inexpensive at 13.5 times forward earnings, but between the weak start-up in Canada and anemic sales growth in the U.S., the company doesn't seem like the great investment opportunity it once was. I would like to see some clearer signs of improvement before considering an investment here.
Fool contributor Adam Levine-Weinberg 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.