When Target (NYSE:TGT) closed on the sale of its chain of Mervyn's department stores a couple of months ago, the company pocketed a tidy $1.65 billion in cash. Since then, speculation has been rife that the company is thinking about using these proceeds to acquire U.K.-based Sainsbury's as a way to jump-start its international expansion. But company executives have repeatedly denied this rumor, which leaves unanswered the question of what Target will do with its newly found pile of cash.

As highlighted in a recent issue of Fortune magazine, Target is widely known for taking risks and "daring to be different." With that in mind, I have a couple of suggestions for the company regarding what to do with its cash.

Idea No. 1: Acquire Toys "R" Us
As Alyce Lomax first reported in August, Toys "R" Us (NYSE:TOY) has made it clear that it intends to sell its toy business to focus on its fast-growing Babies "R" Us unit, which sells baby furniture, clothing, and bedding.

Toys "R" Us has three primary segments, according to its 2003 10-K, and the economics make it clear why the current management wants to sell off the two toy divisions and focus on Babies "R" Us. Let's take a look at the segments:

  • Toys (U.S.): Revenues of $6.5 billion in 2003, down 6% from 2001, with EBITDA of $303 million, or 5% of sales. Operating profits are down more than 60% since 2001. Of the 685 stores in the U.S., 312 are owned outright by the company. According to Reuters, analysts believe the real estate assets are worth $2.3 billion to $2.9 billion. In 2003, comparable store sales were down 3.6%.
  • Toys (International): Revenues of $2.5 billion in 2003, up 34% since 2001, with EBITDA of $231 million, or 9% of sales. Of the 574 international stores, only 83 are owned outright by the company. In 2003, comparable store sales were up 2.1%.
  • Babies "R" Us: This division had revenues of $1.8 billion in 2003, up 24% from 2001, and EBITDA of $228 million, a healthy 13% of sales. There are 198 Babies "R" Us stores, all in the U.S. The company owns 28 of the stores outright and owns the buildings of another 63 stores. In 2003, comparable store sales were up 2.8%. Babies "R" Us has another valuable asset -- its computerized baby registry -- which is widely believed to be the leading registry for expecting parents in the U.S.

In my opinion, Toys "R" Us, as a stand-alone toy business, is not viable -- particularly not the U.S. piece. Like many other retail sectors, the $27 billion U.S. toy business is rapidly being taken over by big-box discounters such as Wal-Mart (NYSE:WMT) and Target. According to the Economist magazine, Wal-Mart already controls one-fifth of the U.S. market, while Target is close behind with 18%.

As a result, I am skeptical that Toys "R" Us will be able to unlock real value by selling off the two toy businesses to financial buyers. For the U.S. business in particular, I have a hard time imagining how anyone will pay significantly more than the value of the real estate assets. And in the long term, I also believe that the Babies "R" Us business on its own lacks a strong source of strategic control; Wal-Mart, Target, Costco (NASDAQ:COST), and others will soon begin to chip away at that business too.

But a merger of the whole company (including Babies "R" Us) with Target could create significant value for both Target and Toys "R" Us shareholders.

The combined U.S. toy business would control over 40% of the domestic toy market, double the share that Wal-Mart currently has. This would immediately create opportunities for savings in the supply chain, particularly in warehousing and purchasing, as well as in overhead expenses. Then, over time, the U.S. store network would be rationalized -- real estate assets could be sold off or remodeled into Target stores as the Toys "R" Us brand name is phased out.

The Babies "R" Us division would be a great fit with Target's existing business. As with the toy business, there are likely to be significant overhead and supply chain cost synergies. In addition, owning the country's largest baby registry (especially when combined with Target's existing baby registry), would allow Target to grab a much bigger "share of wallet" of the Babies "R" Us customers. Cross-selling mechanisms could include targeted marketing to the customers on the registry and creating Babies "R" Us store-within-a-store concepts. The technology and expertise from the Babies "R" Us registry would also likely improve Target's capabilities in the wedding registry business.

As for the international division, one option would be for Target to simply sell it off. Given the division's growth and profitability, it would likely fetch a decent price. On the other hand, Target could also use it as a low-risk way to learn about international operations, to groom talent, and to prepare for Target's move abroad, which will ultimately occur.

Toys "R" Us currently has an enterprise value of $5.25 billion -- less than 0.5 times revenues, which is an attractive price, particularly before you factor in any synergies. Although $1.7 billion is not enough for an all-cash deal, Target's stock is currently at an all time high, so a combination of cash and stock could be a very attractive way to finance the merger.

Idea No. 2: Buy Peets Coffee
As it pursues growth through licensing, Starbucks (NASDAQ:SBUX) coffee shops have rapidly proliferated, including inside Target stores. By year-end 2004, Starbucks expects to have more than 225 locations within Target stores, with plans to continue expansion. There's no doubt that being able to sip a latte while pushing a shopping cart down the aisles is attractive to Target shoppers. And, according to consultancy A.T. Kearney, the typical Target shopper has an average income of more than $50,000, compared with that of about $30,000 for a typical Wal-Mart shopper.

At first blush, this partnership may seem like a great deal for both companies. But I believe that Target may be able to do even better by controlling the coffee shops itself, rather than partnering with Starbucks and giving up a large share of the profits.

Acquiring Peets (NASDAQ:PEET) could be an attractive way for Target to capture the full value of having high-end coffee shops inside its stores, and the move would further separate Target from its competitors. Based in Berkeley, Calif., Peets has a loyal following of "Peetniks," who insist that Peets java is better than coffee found anywhere else (in particular, at Starbucks). Its edgy culture and reputation for high quality are a natural fit with Target, which has been successful in creating hip consumer brands in a variety of categories that appeal to its relatively high-income customer base.

Peets only has 75 locations and just over $100 million in revenues today, but it has the management expertise required to run a network of coffee stores successfully and to oversee growth. When combined with Target's access to capital and existing network of more than 1,200 stores in 47 states, the growth potential is huge: It's easy to imagine $1 billion in coffee-store sales in 5-10 years, just from sales inside Target stores.

Of course, a key question is whether Target would be able to back out of its contract with Starbucks, and what the cost of that would be. But assuming that is feasible, buying Peets would not be a big stretch for Target. Peets' enterprise value of about $320 million is little more than a drop in the bucket when you are sitting on a $1.7 billion pile of cash

I have no doubt that the management team at Target has spent a lot of time thinking about what to do with its cash. As far as management problems go, it's a pleasant one to tackle. But my guess is that management's focus has been on options that are traditionally in the center of a company's radar screen, like buying a direct competitor or paying down debt. Some non-traditional options -- such as acquiring Toys "R" Us or Peets -- may well be worth careful consideration.

Fool contributor Salim Haji lives in Denver where his pile of cash is, sadly, a lot smaller than Target's. He owns shares in Costco, but not in any of the other companies mentioned. The Motley Fool is investors writing for investors.