Target (NYSE:TGT) is on the comeback trail. The retailing giant saw its stock price decline significantly over the first half of the year because of falling domestic sales and an expensive growth initiative that hasn't panned out. These two headwinds stopped Target in its tracks, but fortunately, the stock price recovered thanks to gradual improvements here in the United States. However, Target's woes in Canada persist. After making a concerted effort to aggressively expand into our neighbor to the north, Target's operations in Canada remain in shambles, and continue to post losses each quarter.
On Nov. 19, Target reported third-quarter earnings. The company beat Wall Street estimates on sales and profit, and the stock jumped 7% on the day. It's certainly true that Target is firming up its U.S. operations and is on the track for a real recovery here. But management also revealed that conditions remain very weak in Canada. And in a more telling move, management also said that Target's entire strategy in Canada is about to go under review.
Here's why, upon concluding its review, Target management should close its Canadian operations entirely.
The inconvenient truth: It's not working
For most of its history, Target has been limited to within the United States. It has grown into one of the biggest retailers in the country. But now that it's a mature company, it's running out of new avenues for growth. That makes perfect sense, of course, and expanding into new markets is a natural choice for large domestic companies. Consider that Wal-Mart Stores (NYSE:WMT) are spread across 27 different countries worldwide. Wal-Mart's international sales clocked in at approximately $100 billion over the first three quarters of the fiscal year, representing 28% of its total sales. Operating profit in its international business is up 5% through the third quarter, far better than the 2.6% decline in the United States.
Considering the potential for international growth, Target decided to open new stores in Canada in 2013. The rationale was that if consumers took to the idea, Target stores would eventually become profitable and meaningfully add to earnings growth.
But that hasn't happened. Instead, the trend seems to be that Target stores are registering impressive growth immediately after opening, but sales growth drops off tremendously soon after. For evidence, look to Target's earnings results. Its stores in Canada grew total sales by 43% versus the same quarter one year ago, which sounds impressive. But the jump is due almost entirely to the benefit of opening new stores. Comparable sales, a metric that measures sales at locations open at least one year, rose by just 1% in Canada last quarter.
Here's what management had to say in the company's earnings release: "Comparable sales were negatively affected by market densification later in 2013, which redistributed sales from earlier store openings." In plain English, that means that when Target built two stores remotely close to each other, the newer store simply cannibalized customers from the first store. Many of the new stores were drawing existing customers away from other existing Target stores.
Not surprisingly Target is losing money in its Canadian business. Last quarter alone, the company lost $211 million in Canada before interest and taxes, despite $479 million in sales. Target is only getting the sales it is because it's aggressively discounting to lure shoppers. This approach is bringing customers in the door, but it's crushing the bottom line. Target's gross margin in Canada is 19.5%. In the U.S., gross margin stands at 29.5%.
Over a year into Target's Canadian experiment, a dire picture is beginning to form.
Target: Cut your losses
Initially, Target's idea to expand into a new country was a good one. Target is a big-box retailer with a strong footprint in the United States. It's just about saturated the domestic market, and other discount retailers such as Wal-Mart have enjoyed success in new markets. But Target needs to admit that its strategy in Canada simply isn't working.
Once the honeymoon period ends, it will be unavoidable to see that the Canadian stores aren't generating any substantial sales growth, and they're losing huge amounts of money. Target is spending more than it's making in Canada, and that's not a viable long-term scenario. In the interests of its shareholders, Target needs to cut its losses and move on.
Bob Ciura and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.