Following retail giant Wal-Mart (NYSE:WMT) and department store Macy’s, Target (NYSE:TGT) also reported disappointing results in the recently concluded quarter. The retailer’s comparable store sales growth of 1.2% was well below the market’s expectations as the sluggish U.S. economy weighed on its business. Additionally, its profits fell by 13% due to high costs related to its expansion in Canada. Target lowered its comparable store sales growth outlook for fiscal 2013 to 1% against its previous expectation of 2%-2.5%. 
Although the company slashed its guidance for the year, we believe that it is well-poised for long-term growth. Target’s online business is growing at a rapid pace and holds tremendous promise. Its smaller format CityTarget stores are also doing well, and can aid its expansion in the U.S. where it already has a substantial presence. Though the retailer’s Canadian operations are off to a choppy start due to low customer satisfaction and initial expansion costs, the scenario is likely to improve once Target develops a strong supply chain and store network.
Weak Economy Weighed On Target’s Sales In The U.S.
U.S. consumer spending has been weak so far this year mainly due to the payroll tax increase, delayed tax refunds and high unemployment. In early 2013, the U.S. government increased the payroll tax by 2%, taking a chunk out of an average consumer’s earnings and leaving them with less to spend. The unemployment rate in the country remained on the higher side as employers slowed hiring outside the farming sector.  During July, the unemployment rate rose in about 28 states and remained at the same level in 14.  Negative household formation among the younger demographic groups also reflects the weak state of the economy. 
These factors weighed on Target’s growth as its store traffic declined during the quarter. The economy is not likely to improve in the near term as the payroll tax increase will continue to affect consumer confidence. The National Retail Federation has forecast an 8% decline in spending during the back-to-school season, and we don’t expect the following seasons to be any significantly different. 
Why We Remain Optimistic About Target’s Long-Term Growth?
Online Sales Are Growing Fast
Continuing the momentum, Target’s online business grew in teens driven by a triple digit rise in mobile traffic and sales in the second quarter.  This is a good sign for the company as Forrester forecasts online retail sales in the U.S. to increase at a compounded annual growth rate of 9% over the next few years. 
Target is making efforts to remain at the forefront of this growth. Its mobile app, Cartwheel, has been growing rapidly and more than 50% of its active users have made multiple transactions. The app is now among top 20 lifestyle apps in Apple (NASDAQ:AAPL ) app store. Target recently launched the beta version of this app which generated impressive engagement statistics.  The company is also investing in enhancing feed, search and product information on its mobile website. To boost its online product offerings, it made some meaningful acquisitions in the past such as Chefs.com and Cooking.com, and recently added DermStore Beauty Group to the list. 
Continued Adoption Of REDcard
The REDcard program’s penetration has jumped significantly over the past three years, and the trend continued in the second quarter. Target managed to post positive comparable store sales growth despite a decline in store traffic. This can be attributed to an increase in average basket size, which has been a notable trend with REDcard customers.  In Canada, REDcard penetration has gone up to 2.3% within two quarters. As the penetration increases in both the markets, Target’s sales growth will pick up.
Smaller Format CityTarget Stores
A typical SuperTarget store is quite big, and it may be convenient for customers to shop for groceries from local dollar stores. To tap this opportunity and continue expanding in the U.S., Target has been opening its smaller format stores in densely populated urban areas. These stores have performed well so far, and the company plans to add them across the U.S. and Canada over time. There exists significant market potential which is evident from the fact that Family Dollar has close to 10,500 stores in the U.S. However, Target needs to ramp up CityTarget’s expansion as Wal-Mart is expanding its smaller format stores at a faster pace.
Canada Can Get Better After A Bumpy Start
Target started its business in Canada this year and had 68 stores operational at the end of Q2 fiscal 2013.  Although the initial response was good, the company isn’t doing too well in terms of customer satisfaction. According to a survey conducted by Forum Research, only 27% of the customers polled were “very satisfied” with their experience at Target.  Others felt that the products were too expensive and that Target was not able to meet customer demand as a lot of products were out of stock.  Moreover, the initial costs related to expansion have weighed on the company’s overall earnings. The Canadian segment generated $275 million in revenues during the second quarter and reported a loss of $169 million due to $207 million start-up related costs.
However, the company believes that it can reach $6 billion mark by the end of the fifth year.  As Target continues to expand in the region and builds a stable supply chain, it will be in a better position to manage its inventory and offer competitive prices. The retailer is building new supply chain infrastructure, focusing on technological advancements and hiring more store staff. 
Our price estimate for Target stands at $85, implying a premium of near 30% to the market price. However, we are in the process of updating the model in the light of recent earnings.Notes:
- Target’s Q2 fiscal 2013 earnings transcript, Aug 21 2013 [↩] [↩] [↩] [↩] [↩] [↩] [↩] [↩]
- Retailers boost July sales with heavy discounts, promotions, Reuters, Aug 8 2013 [↩]
- Unemployment rates rise in most US states in July, CNBC, Aug 20 2013 [↩]
- On heels of historically high back-to-school season, 2013 spending expectations decline, National Retail Federation, Jul 18 2013 [↩]
- US Online Retail Forecast, 2012 to 2017, Forrester, Mar 13 2013 [↩]
- Target profits dragged down by Canadian expansion, wary shoppers, CBC News, Aug 21 2013 [↩] [↩]
- Target Canada continues to be a drag on earnings, The Star, Aug 21 2013 [↩]