Be Wary of Sales Growth at Target

Most investors drool when they see sales growth, but not the savvy ones. There’s a good reason for this.

Dan Moskowitz
Dan Moskowitz
Jul 6, 2014 at 1:02PM
Consumer Goods

Target (NYSE:TGT) and Wal-Mart Stores (NYSE:WMT), offer value through a wide assortment of merchandise at low prices to consumers in order to drive traffic and sales growth.

The Target slogan "Expect More, Pay Less" and the Wal-Mart slogan "Everyday Low Prices" emphasize value. The tricky part is that Target and Wal-Mart must also focus on their margins if they want to show profitable growth.

Smaller future targets
Target has a cautious outlook for several reasons. First, most consumers (excluding the high-income consumer) aren't in a spending mood these days. Average disposable incomes are up 1.2% year over year, but this is versus a long-term average of up 3%. It's also likely that higher earners are skewing this number to the upside. At the same time, average hourly earnings and inflation are growing at the same pace -- 2.1%, which doesn't allow for consumer spending growth for the average consumer.

Second, Target still doesn't know the total cost of the data breach, and it doesn't expect to know until at least the third quarter.

Third, Target's Canadian segment is underperforming expectations and requires further investment.

Fourth, Target got a late start in e-commerce compared to peers that include Wal-Mart, which is ranked No. 4 in sales by Internet Retailer (Target is ranked No. 18). 

Given these facts, Target expects lower operating margins in both its U.S. and Canadian segments this year. While these items may not directly impact operating margins, increased promotional activity in their wake could play a major role. With the data breach in the U.S. and a difficult-to-acquire consumer in Canada, Target must use promotions to drive traffic and sales. Over the long haul, Target expects this to lead to market share gains, but don't count on it.

Domestically, Target must compete with Wal-Mart and That's an unflattering position to be in given that they're the largest retailer and largest online retailer in the world, respectively. But let's get more specific prior to drumming up any investment conclusions. 

Specific future expectations
For the fiscal year, Target expects comp sales to come in between flat and up 2%. That's not bad, but keep in mind that this comparison might be relatively easy given the data breach that occurred late last year, which led to massive declines in foot traffic. Target expects a gross margin of below 30%, which relates to the aforementioned promotions, as well as digital and product investments.

Looking at Canada specifically -- a channel Target is relying on for future growth -- Target expects sales of approximately $2 billion. That's good (sales totaled $1.3 billion in fiscal-year 2013) , but Target expects gross margin to contract because of higher-than-anticipated expenses. It expects an EBITDA margin of negative 20% versus a prior expectation of negative 10%, which is due to promotions and the continued clearing of excess inventory.  

Excited yet? It's unlikely. Perhaps Target isn't the company to be excited about. 

Important comparisons
The chart below shows how Wal-Mart and Target have performed on revenue and profit margin. Remember, the key for these retailers is to grow their top lines by offering value -- without hurting their margins too much.

WMT Revenue (TTM) Chart

WMT Revenue (TTM) data by YCharts

Over the past five years, Wal-Mart has grown its top line faster than Target. This has been a consistent trend well before the data breach. Target had been significantly more impressive on the profit margin front, but that dive you see doesn't stem from the data breach. A hesitant consumer, ineffective marketing, and Canada played bigger roles. The data breach just exacerbated the decline.

Wal-Mart has been doing its best to keep margins afloat, but it hasn't been easy. Fortunately for Wal-Mart, it's growing rapidly in the e-commerce channel, which when coupled with the likelihood of future store closings of underperforming locations, should lead to margin expansion.  

The Foolish takeaway
Target might turn its ship around, but it's facing rough seas. Wal-Mart is also facing some headwinds, but it's better positioned for these challenges going forward. Wal-Mart appears to be capable of driving top-line growth while managing margins. Therefore, you should consider Wal-Mart before Target.