Painting a Target on the Organics Business

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In case anyone thought that organic food sales was just a passing craze, Target (NYSE: TGT) is giving even more credence to the category by launching its own brand of organics called Simply Balanced. The fact that Target is launching an organic store brand is news enough, but what investors need to understand is how this new brand could affect Target's future growth as well as its competition’s results.

Why Now and Why Organics?

According to the CBS news article I read about Simply Balanced, one of the main reasons Target wants to capture this market is that organic foods are growing at a rate roughly double the overall grocery rate. In fact, organic foods account for less than 10% of total grocery sales, so not only is the growth rate faster, but the categories penetration is relatively low as well.

Apparently, Target thinks enough of the organic foods business that the company expects to boost its organic selection to 25% over the next four years. Considering that last year Target got about 20% of its sales from groceries, if the company further expands its grocery offerings, the Simply Balanced lineup could come at just the right time.

If you look at some of Target’s primary competition in the organics market, the two best-known names are Whole Foods Market (NASDAQ: WFM) and The Fresh Market (NASDAQ: TFM). Both of these companies are much smaller than Target, and might be called an organic only grocery store. With analysts calling for earnings growth of 18% from Whole Foods Market, and over 20% growth from The Fresh Market, it’s not hard to understand why Target would want a piece of this business. In addition, traditional grocers like Kroger (NYSE: KR) are also looking to expand their organic selections to maintain and grow their market share.

How Important Is Convenience and Price?

If Target is successful in pushing Simply Balanced into the hands of its customers, the ripple effect could be significant. For example, primarily because of their organic selections, Whole Foods Market carries a gross margin of 36.37%. Not far behind, The Fresh Market has a gross margin of over 35%.

While Target still manages a gross margin of 31%, as the company expands its grocery options you can see the direction its margin could move by looking at Kroger and their gross margin of just less than 21%. It’s more than a bit ironic that the new lineup will be called Simply Balanced, because this business could allow Target to simply balance gross margin erosion from traditional groceries and keep the higher margins that the chain is known for.

For shoppers looking for a convenient way to get organic products at a fair price, the fact that Target has over 1,700 domestic locations compared to a few hundred locations at both Whole Foods and The Fresh Market could be a major selling point. The fact that Simply Balanced is being produced by Target should also mean their product pricing will benefit Target's gross margin, but at the same time come in lower than the pricing at these two organic grocers.

Who Wins and Who Loses?

Depending on how Target approaches this new venture, the effects could be felt across the grocery industry. Two of the obvious potential losers would be Whole Foods and The Fresh Market. With each company offering far less convenience, and usually higher prices, some customers may choose to visit Target instead of these alternatives. With analysts calling for 11.4% revenue growth at Whole Foods and 15.6% revenue growth at The Fresh Market, any decline in these companies' customer bases could hit their revenue growth and stunt their earnings growth as well.

Kroger already has the challenge of competing against Target in the traditional grocery business, and as the company expands its grocery selection this competition will only intensify. With analysts calling for revenue growth at Kroger of just 2.7%, if shoppers choose the convenience of Target over this traditional grocery store, shares of Kroger could suffer.

If shoppers choose to buy their organics at Target the company will need to dedicate a section of each store to this business. This will allow customers interested in this type of grocery item to find it quickly among the myriad of items in a typical Target location. If the company is successful, imagine what could happen if Target benefits from faster revenue growth.

Considering that Target shares trade for about 16 times projected earnings growth, imagine what might happen if instead of 2.2% revenue growth the company turns in a higher number. At present, it’s fairly easy to recommend Target over Kroger, given that Target pays a higher yield, is growing faster, and has much better margins. It’s more difficult to compare Target to Whole Foods and The Fresh Market as both companies carry P/E ratios above 30.

However, an increased move into the grocery business along with high margin organic selections could make it easier for investors to choose Target over these faster growing but less proven businesses. In fact, you might say that buying Target is a great way to build a simply balanced portfolio for growth and income.

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Chad Henage owns shares of Target. The Motley Fool recommends The Fresh Market and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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