Target Stock: A Poor Business Strategy Ahead

Guess what Wal-Mart Stores, Inc. just did in my former university town today? They launched a clearance sale at their Wal-Mart Express mini-location that will be closing down for good this Friday. This anecdote is not location specific. Wal-Mart is in the process of closing all 102 of its Wal-Mart Express locations this year.

Carol Spieckerman, a retailer, offered the most succinct of why this project failed: “Wal-Mart openly acknowledged its struggles to manage everything from pack sizes to back room processes and transportation to urban location. It was faced with operating a model that was more unique that synergistic with its core business. The small-format landscape is also quite crowded with seasoned competitors such as dollar stores, drug retailers, and hard discounters.”

That analysis was perfectly on point. Anything else is just an elaboration of those three sentences. When you hear “Walgreens”, you think about cold beverages and medicine. When you hear “Dollar Store”, you think of greeting cards and petty knick-knacks. When you hear “Gas Station”, you think of beer and overpriced junk food.

These small retail locations already have their niche carved out–picturing a mini Wal-Mart gives you little intuitive guidance about what products such a store will sell. Does it sell fruit? Can you pick up a frozen pizza? Can you get a flashlight? The breadth of the offerings aren’t obvious, and the products sold already have a pre-existing constituency from these competitors that offer a quick fix.

This lack of natural demand also mixed with an inability to keep costs low consistent with Wal-Mart’s reputation. Wal-Mart’s costs were almost 30% higher at its express locations than its supercenter stores. The small stores included greater driving distance and lower bulk orders, and meant that Wal-Mart failed to offer competitive pricing that would draw away traffic from the drug stores, gas stations, and dollar stores where customers had already gotten in the habit of shopping.

It is usually wise life advice to learn as many hard lessons vicariously through others as you can so you don’t have to make the same mistakes in your own life. And it applies to business as well.

That is why I was surprised to see the news today that Target is launching its own mini-marts in the same year that Wal-Mart finally surrendered on the concept. I think this move is a diversion to distract from its poor e-commerce penetration and the continued fallout from the bathroom policy that is akin to waving the shiny keys around.

The Wall Street Journal reported: “Near the University of Minnesota campus, Target opened a store less than 15% the size of an average store. It stocks a limited assortment of products geared toward college students, like miniature ironing boards and twin-size sheets. Ping-pong balls are near the beer. There are no children’s toys or strollers.”

Chief Executive Brian Cornell said: “We could see hundreds of these. It could be a huge part of future growth outlook over time.”

That last sentence does not have a realistic possibility of being Target’s future reality. You will not be reading articles five years from now talking about how Target’s small locations are gripping the nation and bringing big growth back to retail because the hurdles are too high. It is going to have the exact same problems that Wal-Mart did: (1) lack of initial pop to steal business from well-defined competitors; (2) cost overruns; (3) unclear merchandise in the eyes of the population at large that diminishes foot traffic; and (4) and meagre profit margins because the merchandise will already be priced too high to address the cost overruns. This is not a wise use of retained earnings to gear for the future.

Right now, Wal-Mart gets it. They are leaving behind a segment where their retail expertise couldn’t convert to market penetration / profit growth. They are pursuing the obvious trend in favor of online purchase orders by recognizing the long-time limitations of and buying outright and considering a minority stake in the Indian equivalent If you are a shareholder, you should appreciate the retrenchment from a subpar idea while simultaneously making a meaningful push towards the dominant platform of the future.

Meanwhile, Target is about to become the 2014 version of Wal-Mart (no bold e-commerce plans, a doubling down on brick-and-mortar in an area beyond sphere of competence / expertise). It is a poor use of the profits that are retained on behalf of shareholders.

An important point I should note is that I chose my title for a reason. I think these small stores are a dumb use of retained earnings, but I do not hold the opinion that Target shareholders will receive poor returns from this point forward. The bad earnings news and the bathroom politics are more than priced into the stock. The fair value of the company is somewhere between 16 and 18x earnings. It is trading at 13x earnings now. It has a 3.5% dividend. It is repurchasing about 3% of its own stock. That is essentially a 6.5% annual floor of returns plus the likelihood of 5% core earnings growth for the long haul. When you get buybacks, solid dividends, core earnings growth, and a low starting P/E ratio, you’re probably going to beat the market over the next ten years.

But that does not mean that you should be permitted to squander some shareholder wealth without scrutiny. I imagine that Target will be a great investment for shareholders that buy at $68, but it is not going to be because of this move into the small-store concept.