Will Target Succeed North Of The Border?

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Unlike its gigantic rival Wal-Mart (NYSE: WMT)Target (NYSE: TGT) tends to play it safe by limiting expansion and sticking to its core business. So it certainly caught my eye when Target decided to expand into Canada and open 125 stores in just one year. Target has never operated outside the U.S. before, but now it is opening 125 stores in a different country.

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The expansion seems to contradict Target’s successful strategy of sticking to discount retail in the U.S. As you can see, that strategy has certainly paid off for the company and its shareholders. Target had a diluted earnings per share ratio of 4.36% on July 31, which was actually higher than that of Costco (NASDAQ: COST), a value investor’s favorite. Costco’s diluted EPS ratio was 3.89%. These figures prove that Target’s business model of low prices and a quality shopping experience pays off.

But will it work in Canada? After all, Target has never expanded outside the United States before. The Canadian retail market is very different from that in the U.S., and Target is taking a big gamble north of the border. The 125 stores it plans to open there equal 7% of the company’s current operations.

Some analysts expect the added cash flow from the Canadian stores to start boosting Target’s EPS as early as 2014. Analyst Christopher Horvers of JPMorgan told the Canadian newspaper, the Financial Post, that he thinks Target will be able to increase its buybacks of stock with additional cash flow from the Canada operations. Horvers also said that Target will be able to increase its ability to borrow because of the added cash flow.

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On the plus side, Target seems like a good fit with Canadian consumers, who are overwhelmingly from the middle class and brand and value conscious. They also lack the loyalty to particular retail chains that Americans have. Target has been able to attract a lot of media attention in Canada and generate a lot of good publicity, even though it hasn’t rang up a single cash register sale in the country yet.

Canadian Success Isn’t Guaranteed

Target will face some problems in Canada; Wal-Mart doesn’t have the kind of social stigma in Canada that it has in the U.S. Middle class Canadians don’t seem to be afraid to shop there. Canadian Wal-Mart stores are similar to Target’s, with higher end products and an emphasis on designer clothes. If Canadians see little difference between Wal-Mart and Target, Target might not be able to attract the sales it needs to justify its venture.

Wal-Mart apparently has a plan to compete against Target in Canada, yet some analysts believe that Target is more likely to steal business from retailers such as Sears Canada (SCC.TO) and Canadian Tire (CTC.TO) than Wal-Mart. Sears Canada is closing stores in cities like Vancouver, Calgary, and Ottawa, which are most likely to be in direction competition with Target.

To succeed in Canada, Target will have to deliver high sales right out of the gate. Despite the media cheerleading, there’s no guarantee that Target can do that. The company might just be expanding too aggressively. Instead of opening a few stores and getting to know the market, it’s taking a huge plunge.

This expansion is obviously going to cost a lot of money. If anything goes wrong, one of the first casualties will be Target’s cash. If Target can’t generate fairly large sales quickly, it might have to start dipping into cash or borrowing to fund the expansion. Target currently has just $1.44 billion in cash and ST investments, compared to Wal-Mart’s $7.93 billion, and Costco’s $4.85 billion, so it might not have the cash on hand to cover losses from Canada.

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Target already has quite a bit of debt, around $18.51 billion, compared to Costco’s $1.38 billion. It also has a debt to equity ratio of 1.165%, compared to Wal-Mart’s .7629%, so it might not take much additional debt to start eating into Target’s quarterly profit margin.

Target is taking much bigger risks in Canada than the analysts and journalists are admitting. It may be expanding too fast in a new market. The company may have to spend a lot of money to get Canadians to like it.

So what is the best course of action for value investors here? If you currently own Target, hold on to it, because if the Canadian venture succeeds, its share value will get a big boost. If you don’t own Target, wait and see if the Canadian adventure works out. Despite the hype, Canada hasn’t added any value to Target yet.

StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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