Target vs. Wal-Mart: The Next Phase

The economic downturn has made an already competitive retail landscape especially brutal and unforgiving. Exhibit A is the rivalry between discount retailers Wal-Mart (WMT) and Target (TGT).

The clear winner in the current downturn was Wal-Mart. Amid millions of job losses and plunging stock and housing markets, new customers flocked to Wal-Mart, at the expense of almost every other U.S. retailer except ultralow-price dollar stores.

It appears that "cheap chic"—Target's famous selling point—is not the primary concern of recession-battered consumers. Last quarter, the average U.S. Wal-Mart store actually saw traffic increase 1.3% from the year before. By contrast, last quarter Target's traffic was down 2.6% from a year ago.

"Even with lower sales than we'd expected," Wal-Mart Chief Executive Officer Mike Duke told analysts Aug. 13, "we believe that our comparable store sales outperformed the retail sector almost every place where we do business."

Wal-Mart's advantage during a recession is its low prices. "Everybody is becoming more price-conscious rather than fashion-conscious," says Thomas Nyheim, a portfolio manager at Christiana Bank & Trust Co., which owns Wal-Mart shares. "Nobody can match Wal-Mart on pricing."

One of Target's problems is its reliance on discretionary purchases, which make up about three-fifths of sales. Target customers"now focus their shopping more on need than entertainment," Target Merchandising Executive Vice-President Kathy Tesija told analysts Aug. 18. That skews purchases toward food and other necessities, and away from clothing and items for the home.

Wal-Mart did feel the impact from slower consumer spending. U.S. same-store sales dropped 1.2% last quarter, according to results released Aug. 13.

And, Target, like Wal-Mart, benefits from consumers trading down from the pricey to the less expensive. "We continue to gain affluent guests from department stores," Tesija said.

However, Target—despite its status as a discounter—did far worse than Wal-Mart in its sales. It saw same-store sales tumble 6.2% in a year.

Both firms win kudos from analysts and investors for managing inventories and costs at a tough time. Earnings figures for both beat Wall Street expectations.

But if the main fight between Wal-Mart and Target is over customers and sales figures, Wal-Mart clearly won out in the past year.

In all, total sales at Wal-Mart rose 2.7% last quarter from a year ago, to $104.3 billion, when one ignores the impact of currency fluctuations, which hurt Wal-Mart's large overseas operations. At Target, sales fell 2.7%, to $14.6 billion in the second quarter.

Target Will Lead in a RecoveryThose numbers, however, reflect the trends of the past year, a particularly tough time. For investors and even executives, the crucial question is what happens next.

Those who are expecting an improvement in the economy and a recovery in consumer spending tend to favor Target.

"People were shopping at Wal-Mart because it was the cheap place to shop," says Bernie McGinn, chief investment officer at McGinn, McKean & O'Neill. An owner of Target shares, he believes consumers will gradually return to "a sense of normalcy."

"If you're feeling less pinched, you go out to Target," McGinn says. "You know you're going to get a good value, and you're going to walk out with something a little classier than [at] Wal-Mart."

Target is trying two strategies to win back customer traffic. First, it is reminding customers the chain offers good prices. Through its "Low Price Promise," Target now promises to match the advertised price on any product offered by a competitor in the same market.

At the same time, however, Target executives "really don't want to stray too far into deep discount territory," says Morningstar (MORN) analyst Kimberly Picciola. Thus, the chain must make customers aware of the value it offers, while also boasting of better merchandise and a more pleasant store.

Even as it touts low prices, Target is planning to offer clothes designed by Anna Sui, jewelry by Anna Sheffield, and handbags by Carlos Falchi.

As always, Wal-Mart emphasizes its low prices. "There's a 'new normal' now where people are saving more, consuming less, and being more frugal and thoughtful in their purchases," Wal-Mart's Duke said. He added: "Wal-Mart can continue to attract new customers, because we're helping [the typical consumer] to do more with what she has."

Christiana's Nyheim owns Wal-Mart shares because he believes consumers will remain very careful about their spending. "We think everybody's going to be competing on price for the next year, because we're going to be in a much slower economy," Nyheim says.

At the same time, however, Wal-Mart is trying to compete in ways other than price. Consumers may have traded down to Wal-Mart for its low prices, but the chain hopes to hold onto those customers through improvements in their stores, including renovations and improved layouts.

"Wal-Mart has done a good job of reinventing themselves and cleaning up their stores," says Steven Roge, a portfolio manager at R.W. Rogé & Co.

In 2008, while the recession was at its worst point and economists were gloomy, Wal-Mart was one of the most popular stocks on Wall Street. Since March, however, investors have become more optimistic. That has helped shares of other retailers, including Target.

While Wal-Mart shares have drifted lower this year, investor expectations for Target have improved dramatically. In the past 12 months, Wal-Mart shares are down 12.7%, while Target shares are down 11.4%. Since the start of 2009, Target shares are up 28%, while Wal-Mart's stock is down 8.4%.

Much of Target's recent gains occurred on Aug. 18, in reaction to second-quarter earnings, when shares jumped 7.55%, to 44.32.

Though the two chains are fiercely competitive, it's possible that both retailers could do well. As discounters, both have a natural advantage in hard times. In better times, both could see sales rebound.

Harvey Robinson, president of Robinson Capital Group, believes the economy is recovering but the consumer will remain "exceptionally cautious."

"As the economy picks up, I believe Wal-Mart and Target will continue to benefit," says Robinson, who owns neither stock. The move of customers toward cheaper options could be permanent, he says. "Consumers are more interested in buying from discounters."

In other words, a slight recovery in the economy could be enough to get shoppers buying again. But it may not be enough to send customers back to pricier specialty and department stores.

In any environment, the competition between Target and Wal-Mart will remain cutthroat. The onus is on Target to prove it can stop the slide in sales and customer traffic. And, Wal-Mart, with its global reach and deep pockets, is not known for taking competition lying down.

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