Target Aims for Fresh Strategy With New CEO

 Target (TGT) has announced that PepsiCo's (PEP) Brian Cornell will become chairman and CEO in mid-August. This is the first time that Target has appointed an outsider to this executive role, but the decision isn't completely surprising, given the need for a fresh strategic perspective in the face of several challenges. We believe Cornell's first order of business will be evaluating the Canadian operations, managing through the lingering impact from the data breach, and building out the company's omnichannel presence. We don't anticipate a material change to our $65 fair value estimate or our no-moat, stable moat trend, and standard stewardship ratings, at least until we have a clearer idea about Cornell's strategic vision.

Cornell has more than 30 years of experience at consumer product firms and retailers. His previous roles include CEO positions at PepsiCo Americas Foods, Sam's Club, and Michaels Stores, as well as chief marketing officer of Safeway. We think his experience in a variety of retail concepts, both traditional grocery and warehouse club, gives him a solid base from which to tackle the challenges of low customer switching costs in the retail channel. That said, there is still execution risk associated with repositioning the firm as a leading omnichannel player, and improving Canadian operations (or leaving the region) will take time. Thus, while the shares currently trade at a discount to our fair value estimate, we suggest that only long-term investors with a high tolerance for risk consider taking a position in this name.

Target Likely to Miss Targets
Target set aggressive five-year goals in the face of intense competition, but it's become increasingly unlikely that the firm will hit its 2017 targets. Target originally set a goal to generate $100 billion in total sales by 2017 (from $73 billion in 2012), but backed off this goal in late 2013, as weak consumer spending continues to weigh on U.S. sales. The firm still maintained a goal to generate around $85 billion in revenue in the United States (implying 3%-4% annual growth), $6 billion of revenue in Canada, and $8.00 in earnings per share by 2017. However, given intense competition in the U.S. and early missteps in Canada, we don't think Target will achieve these goals either.

Target's entry into Canada has not gone as smoothly as planned, as material markdowns on excess inventory and higher start-up costs resulted in a nearly $1 billion operating loss in the most recent fiscal year. We intend to keep a close eye on developments in Canada. The firm may still be able to hit its top-line objective if Canadian Target stores generate sales/square foot levels comparable to those of U.S. stores, but achieving this feat could be very challenging, and Target could decide to exit this market if results don't improve.

Switching costs are virtually nonexistent in retail, and we expect industry consolidation to lead to intensified price competition in the years to come. In food, Wal-Mart (WMT) has enormous scale, Kroger (KR) deploys gas as a product loss leader, and Costco (COST) has the ability to sell not only gas as a loss leader but also food. In general merchandise, Amazon (AMZN) is much stronger today than it was in the past, forcing many traditional specialty retailers to be more aggressive on pricing. Target's push into Canada could bolster sales (assuming it continues with its expansion plans), but even then the company will still face incumbent competition from Loblaw (L), Metro (MRU), and Canadian Tire (CTC.A), as well as U.S. firms that are also expanding in the region.

To confront competition, Target has allocated more square footage to traffic-driving food items and is aggressively pushing its REDcard credit card to cultivate customer loyalty. The food initiative is similar to the strategy Wal-Mart implemented (with great success) in the 1990s, but we do not expect PFresh to yield the same results because there are more firms with greater scale deploying this strategy. Target's REDcard helps average ticket with existing customers; sales should further benefit if the company can continue driving national penetration above current levels (in the high teens). That said, we remain skeptical that REDcard's 5% discount alone will help Target capture incremental market share from price leaders like Wal-Mart, Costco, and Amazon.

Brand Doesn't Support Competitive Advantage
We do not believe Target has an economic moat. The only competitive advantages that could support a narrow Morningstar Economic Moat Rating are scale cost advantages and a brand intangible asset. However, the company has strategically shifted store floor space to the food business, a category in which Target lacks the economies of scale boasted by Wal-Mart and Kroger, the number-one and -two share leaders, respectively. Moreover, Wal-Mart and Kroger, to an even a greater degree, deploy gasoline as a loss leader to drive customer traffic. Providing the indispensable inelastic product that powers most consumers' work, school, or shopping trips at or below cost is a statistically significant traffic driver, especially when gas prices rise dramatically. Costco, the number-three market share leader in retail food, uses not only gas but also groceries as loss leaders and could do the same for any other additional product categories at its discretion, because membership fees account for most of its operating profit. With regard to Target's brand strength, merchandising missteps and subsequent market share losses in the general merchandise category have occurred in the past, influencing our doubt that Target's brand supports a sustainable competitive advantage.

Risks Include Competition, Execution, Economic Downturn
Our fair value uncertainty rating for Target is medium. Increased competition from rivals such as Wal-Mart, Costco, and Amazon is an ongoing threat to Target's share of domestic retail sales. Execution risk also exists, as Target's ability to provide an innovative, trend-right, and quality product assortment at the right price is a key differentiator. The company's core customers are more affluent than those of discount stores, but as recent results illustrate, that doesn't insulate Target from the impact of a prolonged economic downturn. A macro environment of sustained high unemployment could continue to cause sales weakness in the higher-margin general merchandise category. As a result of the recent data breach, Target may be required to pay (potentially) large liabilities in the future. Weakened customer confidence in Target could also negatively affect traffic and REDcard penetration for quite some time. Finally, Target faces many challenges in Canada, where its recent entry did not go as planned. Even if Target is able to clear excess inventory and effectively position its price and product assortment (all of which is not guaranteed to occur), the Canadian segment could still produce losses until store productivity levels increase over the next couple of years.